When it comes to analyzing financial statements, you can use*Formulas for ratio analysis*to interpret the data presented in the financial statements (balance sheet,Win and loss) better. In this article, we'll start with the meaning and definition of ratio analysis, then continue with examples of different financial metrics before concluding with a summary of its limitations.

## Introduction to balance sheet analysis

As we know, a ratio shows the relationship between two numbers. It shows how big one number is compared to another.

If we have three apples and two pears, we say we have apples and pears in a 3:2 ratio, or "three is two". This means that for every two oranges we have three apples.

In the world of finance, metrics show the performance of companies in key functions and help managers and investors analyze the operations and sustainability of the companies.

For example, a company's "current ratio" or liquidity ratio indicates the ratio of its current assets (assets that are expected to be cashed in 12 months) to its current liabilities (liabilities that have to be paid off in 12 months).

When we say a company's current ratio is 4:1, or 4, we mean that its current assets are four times its current liabilities - meaning the company can pay its current debt four times.

## Applications of Ratio Analysis

Metrics calculated from information in financial statements help investors in three ways:

- They simplify financial statements: KPI analysis is simply information presented in company financial statements. Investors can easily get data from a few metrics instead of trying to understand whole statements.
- They help spot a problematic trend: any type of metric analyzed over a long period of time can indicate a flaw in how a company is functioning. The analysis can also predict the future performance of a company in a specific business aspect.
- They facilitate comparisons: KPIs not only help analyze a company's performance, but also allow a comparison of the performance of two or more companies within an industry or sector.
For example, two companies in the traditional manufacturing sector can be compared based on their current key figures. For example, a company with a current ratio of 3:1 can pay off its ongoing debt more easily than one with a current ratio of 1.5:1.

These ratios can be compared to the general standard flow ratio for companies in this sector, which can be 2:1.

## Types of financial metrics

In the field of balance sheet analysis, financial metrics fall into the following broad categories: liquidity, solvency, efficiency, profitability, and valuation.

### liquidity ratios

Liquiditätskennzahlen zeigen die Liquiditätsverfügbarkeit eines Unternehmens und seine Fähigkeit, kurzfristige Verbindlichkeiten zu erfüllen.

In other words, liquidity ratios are an indicator of a company's ability to pay its current liabilities (debts that have to be paid off within a year). Not only do they indicate the amount of cash they have, but also assets that can be quickly converted into cash to meet their obligations.

**Examples of liquidity ratios:**Quick ratio (endurance test ratio) and working capital ratio (current ratio).

The quick ratio, or endurance test ratio, measures a company's ability to pay its current liabilities using only its "quick assets" (assets that can be converted into cash within 90 days, including cash itself, alongside short-term investments), marketable securities, etc.).

**Formula for ratio analysis:**The quick ratio is calculated by adding up all the current assets and dividing that number by the current liabilities.

**What does it mean for investors?**The quick ratio shows how quickly a company can convert its quick assets into cash to pay its ongoing charges without disrupting its capital assets. This shows the liquidity of the company.

Our second example, the working capital ratio or current ratio, shows whether a company can service its current liabilities with its current assets (assets that can be converted into cash within a year: for example cash and cash equivalents).

**Ratio Analysis Formula for Capital Ratio:**The working capital ratio is calculated by dividing current assets by current liabilities.

**What does it mean for investors?**This ratio indicates whether a company has sufficient cash to run its day-to-day operations, which is why it's called the working capital ratio.

### solvency ratios

Solvency ratios indicate a company's long-term viability - whether it can meet its long-term obligations to creditors and be self-sustaining. These metrics compare a company's debt to its equity, earnings, and net worth.

**Example solvency ratio:**gearing.

Gearing is the ratio of a company's debt to its equity. It shows how much of its funds come from banks and other creditors versus how much comes from its shareholders.

**Leverage formula:**Der Verschuldungsgrad wird berechnet, indem die gesamten Verbindlichkeiten durch das gesamte Eigenkapital dividiert werden.

**What does it mean for investors?**The lower the level of debt, the better the health of the company, since funding from shareholders and other investors is often considered better than funding from banks and other creditors.

### efficiencies

Efficiency metrics show how efficiently a company uses its assets to generate profits or turn its inventories into cash. These metrics measure how quickly a business is able to collect cash from its customers for goods or services supplied to them on credit.

In other words, efficiency metrics reflect how efficiently day-to-day managers are making and selling products to make a profit.

**Example of efficiency:**Receivables turnover rate.

First, accounts receivable are claims on a company from its creditworthy customers. Receivables turnover rate expresses how efficiently a company collects money owed by its customers for goods or services supplied on credit, or how often (rotus) it collects these amounts per year.

**Formula for ratio analysis:**If a company's average receivables for a given year is Rs. 1 crore (the average is calculated using receivables at the beginning and end of the year) and it accumulated Rs. 2 crore during the year, its receivables turnover ratio is Rs Rs. 2 crore divided by Rs. 1 crore, so 2.

That means the company collected its receivables twice a year or once every six months.

A company that has a receivables turnover ratio of 4 collected its receivables every 90 days, or four times a year.

**What does it mean for investors?**The higher the receivables turnover rate, the more frequently the company collects its receivables and the more efficient it is.

## profitability metrics

Profitability metrics show how effectively a company is using its assets to generate profits.

**Example of profitability metrics:**Return on Assets Ratio.

The return on assets compares a company's total net income to the investments in its total assets during a period. It's an important index because the ratio includes capital assets, often the largest investment for most businesses.

**Formula for ratio analysis:**The return on assets is calculated by dividing the net profit for the year by the average total assets (total assets at the beginning and end of the year divided by two).

**What does it mean for investors?**A high return on assets indicates that assets are being used optimally; a low ratio indicates that investments in assets are higher than necessary or that the assets are not fully used to generate profits.

### valuation ratios

Valuation metrics help investors gauge the value of a company's stock and decide whether to buy, hold, or sell its shares. These metrics also allow them to predict the future of the stock and expected returns.

**Example valuation ratio:**price-earnings ratio.

The price-to-earnings (PE) ratio is a valuation ratio that compares the price paid for a stock to the earnings it generates. It shows the stock market's assessment of the value of a company's shares based on the declared share profits.

**Price to Earnings Ratio Formula:**The ratio is calculated by dividing the market value of a share by the earnings per share and is usually determined at the end of a financial year.

**What does it mean for investors?**The PE ratio indicates the expected price of a stock based on its earnings. It tells a stock buyer what returns to expect from the stock in the form of higher dividends or a higher stock price at the time of sale.

The ratio can be used to compare companies in the same industry, but is susceptible to management manipulation. For example, an extremely high ratio may indicate that earnings have likely been overstated and a stock price decline is imminent.

Therefore, as shown above, financial metrics are figureheads that show a company's performance in relation to various parameters. The ratio analysis shows investors the sustainability and future of their investments.

For example, certain numbers may show that a company is profitable, but the relevant financial metrics may indicate a cash flow problem. Financial metrics, on the other hand, can inform managers about the areas in their companies that need their attention.

## Limitations of Ratio Analysis

Although financial metrics and metrics analysis have many advantages, they also have disadvantages:

- Historical or old data feeds into the calculation of financial ratios and ratio analysis, making the information they provide far from up-to-date.
- Various estimates go into calculating financial ratios, and as such, the information that the ratio analysis purports to provide may not be accurate.
- Financial ratios and ratio analysis may not be an appropriate tool to compare companies from different sectors as they may operate in wildly different economic environments.
They may not even be appropriate for comparing companies from the same industry as they may have different accounting practices and operating policies.

## Important financial issues

–Introduction to Finance

—balance sheets

—Win and loss

—cash flow

—Abgezinster Cashflow

Back to the top:MBA Syllabus

## FAQs

### What is ratio analysis in MBA? ›

What is Ratio Analysis? Ratio analysis is **a quantitative analysis of data enclosed in an enterprise's financial statements**. It is used to assess multiple perspectives of an enterprise's working and financial performance such as its liquidity, turnover, solvency and profitability.

**What are 5 most important ratios in financial analysis? ›**

The common financial ratios every business should track are 1) **liquidity ratios** 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios.

**What are the 5 methods of financial statement analysis? ›**

There are five commonplace approaches to financial statement analysis: **horizontal analysis, vertical analysis, ratio analysis, trend analysis and cost-volume profit analysis**. Each technique allows the building of a more detailed and nuanced financial profile.

**What are the 3 main ratios? ›**

Financial ratios are grouped into the following categories: **Liquidity ratios**. **Leverage ratios**. **Efficiency ratios**.

**What are the 6 financial ratios? ›**

There are six basic ratios that are often used to pick stocks for investment portfolios. These include **the working capital ratio, the quick ratio, earnings per share (EPS), price-earnings (P/E), debt-to-equity, and return on equity (ROE)**.

**What are the types of ratio analysis? ›**

A few basic types of ratios used in ratio analysis are profitability ratios, debt or leverage ratios, activity ratios or efficiency ratios, liquidity ratios, solvency ratios, earnings ratios, turnover ratios, and market ratios.

**What are the three methods of ratio analysis? ›**

In general, there are four categories of ratio analysis: **profitability, liquidity, solvency, and valuation**. Common ratios include the price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity (D/E).

**What are the 12 types of financial analysis? ›**

The most common types of financial analysis are vertical analysis, horizontal analysis, leverage analysis, growth rates, profitability analysis, liquidity analysis, efficiency analysis, cash flow, rates of return, valuation analysis, scenario and sensitivity analysis, and variance analysis.

**What are the 3 tools of financial analysis? ›**

The three major tools for financial statement analyses are **horizontal analysis, vertical analysis, and ratios analysis**.

**What are the 4 four key of financial statement? ›**

But if you're looking for investors for your business, or want to apply for credit, you'll find that four types of financial statements—**the balance sheet, the income statement, the cash flow statement, and the statement of owner's equity**—can be crucial in helping you meet your financing goals.

### What is basic ratio analysis? ›

Ratio analysis is referred to as **the study or analysis of the line items present in the financial statements of the company**. It can be used to check various factors of a business such as profitability, liquidity, solvency and efficiency of the company or the business.

**What is ratio analysis example? ›**

For example. the debt-to-asset ratio for 2020 is: Total Liabilities/Total Assets = $1074/3373 = 31.8%. 3 This means that 31.8% of the firm's assets are financed with debt.

**What are the rules of ratio analysis? ›**

It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. **It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio**.

**What is the most important ratio? ›**

**Return on equity ratio**

This is one of the most important financial ratios for calculating profit, looking at a company's net earnings minus dividends and dividing this figure by shareholders equity. The result tells you about a company's overall profitability, and can also be referred to as return on net worth.

**Why are ratios useful? ›**

Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This **allows you to follow your company's performance over time and uncover signs of trouble**.

**What are the 2 profitability ratios? ›**

Profitability ratios are one of the most popular metrics used in financial analysis, and they generally fall into two categories—**margin ratios and return ratios**. Margin ratios give insight, from several different angles, on a company's ability to turn sales into a profit.

**How many types are there in ratio? ›**

What Are the Types of Ratio Analysis? Financial ratio analysis is often broken into **five** different types: profitability, solvency, liquidity, turnover, and earnings ratios.

**What are the 4 solvency ratios? ›**

The main solvency ratios include the **debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio**.

**Why is it called ratio? ›**

**It was a direct borrowing from the Latin word that gave us ratio**—which is conveniently ratio. In Latin, ratio meant everything from "reason" to "calculation" to "proportion," and it was this final meaning that was drawn upon for the mathematical and English ratio.

**How many formulas are there in ratio analysis? ›**

It has mainly **two types of ratios**. The first one is the Current ratio which let us know the short term solvency of any firm. The second one is the Quick ratio which helps to find the solvency for six months.

### What is ratio analysis and its steps? ›

Ratio Analysis is **a process of determining and interpreting relationships between the items of financial statements**. Its purpose is to provide a meaningful understanding of the performance and financial position of an enterprise. Thus, it is a technique for analyzing the financial statements by computing ratios.

**What is the 80/10/10 rule finance? ›**

An 80-10-10 mortgage is **structured with two mortgages: the first being a fixed-rate loan at 80% of the home's cost; the second being 10% as a home equity loan; and the remaining 10% as a cash down payment**.

**What is the 50 30 20 rule finance? ›**

One of the most common percentage-based budgets is the 50/30/20 rule. The idea is to **divide your income into three categories, spending 50% on needs, 30% on wants, and 20% on savings**. Learn more about the 50/30/20 budget rule and if it's right for you.

**What is the 70 20 10 Money Rule? ›**

How the 70/20/10 Budget Rule Works. Following the 70/20/10 rule of budgeting, **you separate your take-home pay into three buckets based on a specific percentage**. Seventy percent of your income will go to monthly bills and everyday spending, 20% goes to saving and investing and 10% goes to debt repayment or donation.

**What are the 5 financial elements? ›**

The elements of the financial statements will be **assets, liabilities, net assets/equity, revenues and expenses**. It is noted in Study 1 that moving along the spectrum from cash to accrual accounting does not mean a loss of the cash based information which can still be generated from an accrual accounting system.

**Why is it important to use ratios to analyze financial statements? ›**

Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This **allows you to follow your company's performance over time and uncover signs of trouble**.

**What are the methods of financial ratio analysis? ›**

A few basic types of ratios used in ratio analysis are profitability ratios, debt or leverage ratios, activity ratios or efficiency ratios, liquidity ratios, solvency ratios, earnings ratios, turnover ratios, and market ratios.

**What is the financial ratio analysis with example? ›**

Debt-to-Asset Ratio

Total Liabilities/Total Assets = $1074/3373 = 31.8%. 3 This means that 31.8% of the firm's assets are financed with debt. In 2021, the debt ratio is 27.8%. In 2021, the business is using more equity financing than debt financing to operate the company.

**What are the main objectives of ratio analysis? ›**

Objectives of Ratio Analysis are:

**Determine liquidity or Short-term solvency and Long-term solvency**. Short-term solvency is the ability of the enterprise to meet its short-term financial obligations. Whereas, Long-term solvency is the ability of the enterprise to pay its long-term liabilities of the business.

**What is the most important ratio analysis? ›**

**Return on equity ratio**

This is one of the most important financial ratios for calculating profit, looking at a company's net earnings minus dividends and dividing this figure by shareholders equity. The result tells you about a company's overall profitability, and can also be referred to as return on net worth.

### What are the 3 types of financial analysis? ›

**Horizontal, vertical, and ratio analysis** are three techniques that analysts use when analyzing financial statements.

**What are the 3 methods of analysis? ›**

Data analysis also provides researchers with a vast selection of different tools, such as **descriptive statistics, inferential analysis, and quantitative analysis**.