8.5 Ratio analysis; nature of financial ratios, classification and calculation of financial ratios and limitation of financial ratios

Ratio analysis is a technique used to evaluate a company’s financial performance and position by analyzing various financial ratios. Financial ratios are mathematical calculations that provide insights into different aspects of a company’s operations, profitability, liquidity, solvency, and efficiency. Here are some common types of financial ratios and their classifications:

1. Profitability Ratios:

• Gross Profit Margin = (Gross Profit / Revenue) x 100
• Net Profit Margin = (Net Profit / Revenue) x 100
• Return on Assets (ROA) = (Net Profit / Total Assets) x 100
• Return on Equity (ROE) = (Net Profit / Shareholders’ Equity) x 100

2. Liquidity Ratios:

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets – Inventory) / Current Liabilities
• Cash Ratio = Cash and Cash Equivalents / Current Liabilities

3. Solvency Ratios:

• Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
• Debt Ratio = Total Debt / Total Assets
• Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expense

4. Efficiency Ratios:

• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable
• Asset Turnover = Revenue / Average Total Assets

It’s important to note that there are many more financial ratios available, and the selection of ratios depends on the specific industry, company, and analysis objectives.

Limitations of Financial Ratios:

1. Limited Comparability: Financial ratios may not be directly comparable across companies or industries due to differences in accounting methods, industry norms, and company-specific factors.
2. Lack of Context: Financial ratios provide numerical information but may not provide the full context of the company’s operations or industry dynamics. Additional qualitative analysis is often needed to interpret the ratios accurately.
3. Historical Focus: Financial ratios are based on historical financial data and may not capture future performance or changes in the business environment.
4. Simplified Analysis: Ratios provide a simplified view of a company’s financial performance and may overlook important nuances or specific aspects of the business.
5. Subject to Manipulation: Financial ratios can be manipulated by companies through creative accounting practices or timing of transactions, which may distort the true financial picture.

To overcome these limitations, it is essential to use financial ratios as part of a comprehensive analysis and consider other factors such as industry benchmarks, qualitative information, management commentary, and future prospects of the company.

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