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What is Ratio Analysis?
Ratio analysis is a process in accounting that compares financial relevant data in accounting records to help organizations obtain insight into their liquidity, profitability, and operational efficiency. The bedrock of a company’s fundamental analysis is ratio analysis. Businesses may use this analysis to assess the relationships between the elements in their financial statements. However, these ratios could be used to compare two or more organizations at the same time or to determine a company’s tendencies in terms of profitability, liquidity, and solvency over time. Get the best ratio analysis assignment help from our competent academic tutors. ORDER NOW
Types of financial ratios used in statement analysis
Several types of accounting ratios are used in financial statements analysis. They include but are not limited to the following;
Revenues and profit Ratios
Investors and analysts use return on assets to examine a firm’s ability to make profit (revenue) in relation to its turnover, operational costs, shareholders’ equity, and balance sheet assets over time. These metrics also illustrate how well a business uses its resources to generate profit and wealth for its owners. Return ratios and profit margin ratios are the two types of profitability ratios.
To complete the finance assignment dealing with financial ratios in accounting, you must first understand the fundamentals, which are as follows.
- Return on assets (ROA) is a metric used to measure how much profit (after-tax profit) a firm makes for each and every dollar invested in assets it owns. Additionally, it measures the amount of profit (after-tax profit) a company generates for every dollar of assets it owns. It also calculates the asset productivity of a corporation.
- Return on equity (ROE), which is used to indicate the proportion of a firm’s net profit compared to its shareholders’ equity, or the amount of returns investors can expect on their money invested in a company.
- Return on invested capital is a metric that compares a company’s financial performance to the capital it has acquired from management and investors to invest in its operations .
Profit Margin Ratios
This group of profitability ratios comprises the following:
- Gross profit margin, which compares a firm’s gross profit from operations with its total revenue. It depicts a company’s financial performance after deducting the necessary costs of production.
- Operating profit margin, which measures a company’s profits (operating profit) as a percentage of revenue before taxes and other deductions and interest.
- iii)Net profit margin- a very important ratio, which compares a company’s net income (after subtracting taxes and interest from operating profit) to total sales and gives a comprehensive view of profitability.
- Cash flow margin is a term used to describe the connection between a firm’s sales revenue and the free cash flow generated by its operations. Moreover, this ratio also assesses a company’s capacity to convert sales into cash (liquidation). The greater the value of this ratio, the more cash a corporation has available from sales to pay dividends, creditors’ dues, utilities, service debt, and buy capital assets.
- EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin, which measures a profitability of the company prior to actually non-operating costs like interest, tax payments, and non-cash expenses like amortization and depreciation are factored in.
Ratios of Liquidity
These ratios assess a corporation’s capacity to meet short-term financial commitments, such as debts, as well as unforeseen cash needs. As a result, analyzing liquidity ratios is critical for creditors and lenders who want to gain a sense of a company’s financial position before extending loans.
The current ratio, quick ratio, and working capital ratio are the most widely utilized liquidity ratios.
- The current ratio shows a firm’s ability to satisfy short-term debt or debt responsibilities, and it determines if the company has sufficient resources to settle its debts within the next 12 months.
- The quick ratio assesses a company’s capacity to satisfy all of its short-term financial obligations with cash reserves (cash or fast convertible assets). As a result, it reveals an ability to pay short debts, which it can settle by selling its liquid assets to lenders on short notice.
3 The working capital ratio, on the other hand, is used to determine a firm’s capacity to achieve current outstanding debts and how many liquid assets it has on hand.
The solvency ratio is a metric that assesses a company’s ability to pay down long-term debts. Furthermore, it determines the size of a corporation after deducting its non-cash expenditures such as wear and tear. It assesses a company’s financial performance to determine its sustainability. The debt-to-equity ratio, debt-to-asset ratio, and debt-to-capital ratio are some of the most frequent solvency measures used to assess a company’s solvency.
- The debt-to-equity ratio shows how well a corporation finances its assets by dividing its debts by its stockholders’ assets.
- The debt-to-assets ratio is a measure of a company’s financial leverage. It shows how much of a company’s total assets were purchased or funded by its creditors.
- The debt-to-capital ratio, which indicates a solvency ratio, is computed by dividing interest-bearing debt (including short – range and long term debts) by invested wealth .
Efficiency ratios assess a company’s ability to successfully utilize its assets and manage its financial obligations in the short to medium term or for the current financial cycle. The most common ratios include;
- Inventory turnover ratio, which measures the flow or use of inventory.
- Accounts turnover ratio, which measures how quickly a company gathers its debts from debtors.
- Assets turnover ratio, which investigates the strength of an entity ’s financial position or sales divided by the value of assets it possesses .This ratio serves as a measure of a company’s efficiency in generating revenue from assets.
Importance of Ratio Analysis
The importance of ratio analysis is mostly attributable to the consumers of analyzed financial information such as the management and the business owners.
Importance of Ratio Analysis to Investors
Investors benefit from ratio analysis since it allows them to evaluate their current and future investments. It aids consumers in making better investment decisions because they can compare investment ratios of several companies and select the finest alternative. Market ratios such as Earnings per share, the price-earnings ratio, the dividend yield ratio, and the reserve to capital ratio are all key measures for investors to consider. They can also correlate their stake to dividends, market price, and earnings using ratio analysis. It also allows them to anticipate the market price of their investment in the future.
Importance of Ratio Analysis to the management
Managers need to understand ratio analysis since it aids them in performing basic responsibilities including planning, communicating, supervision, and decision-making. It focuses on the degree of capital management and asset use efficiency. They can make various strategic choices more effectively this way. Managers can also use ratio analysis to communicate with owners and other stakeholders about the company’s growth. Managers will benefit from it as well, since it helps to keep a tighter grip on organizational processes.
Steps for writing excellent ratio analysis essays
Title and Introduction
Write a clear concise title for your ratio analysis essay. Write a short introductory paragraph outline the main focus of your essay. You can also define the main key words in your ratio analysis essay. For example, you can write a paragraph like the one defining ratio analysis above.
Main Body of the Essay
After writing the introductory paragraph, go straight to discuss your ratio analysis main points in paragraph forms for every point. For example;
Ratio analysis is carried out by looking at a firm ’s financial statements and focusing on three main elements: profitability, cash flow, and stability. In reality, these ratios assist interested stakeholders or investors in evaluating a firm’s financial performance and efficiency by matching it to that of another company prior to making investment decisions .Marketing experts now utilize many sorts of financial metrics to evaluate businesses, although business executives rely less on all these ratios as they have accessibility to more precise operating and financial data.
This study, on the other hand, entails assessing a company’s financial performance and sustainability by utilizing accounting information from its previous and contemporary financial statements. This study is sometimes used to create a pattern based on a company’s financial outcomes across a number of fiscal years, or accounting cycles. This is called a time series comparison of accounting records. It is used to establish the growth of a firm over time based on the changes in accounting elements such as revenue and profits.
The conclusion is usually a summary of the key points in your essay. It can also include recommendations for improvement in a certain way, for example reviewing the methods of calculation of ratios to match current trends. Your conclusion must be a recap of the points in the main body of your essay.
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