Financial Ratio An analysis of the 4 types of ratios

  1. Fundamental Analysis
    1. fundamental analysis Tools and Skills for smart Investing
    2. What is compound interest in investment with examples
    3. Long term investment Tips for qualitative and quantitative analysis
    4. “Annual Report Explained Understanding Company Financials and Insights “
    5. Financial Statements Guide to Understanding Profit and Loss, Balance Sheets, and Cash Flow
    6. Understanding financial statements from two different angles
    7. Profit and Loss Statement How to understand Revenue Figures and Other Key Metrics for smart Investment Decisions
    8. Understanding Profit and Loss Statement Statement Profit before tax Net Profit after tax with examples
    9. Balance Sheet Definition and Examples
    10. liability Understanding 3 types of liabilities with examples
    11. Asset Understanding types of Assets in Balance Sheet
    12. Cash Flow Statement How to Read and Understand with examples
    13. Everything about Cash Flow Statement and Financial Statement
    14. Financial Ratio An analysis of the 4 types of ratios
    15. EBITDA understanding margin formula with examples
    16. Leverage Ratio 4 types of ratios and how to calculate with formula
    17. “Operating Ratio 7 types of ratios and how to calculate with the formula and examples “
    18. 3 valuation ratios Price to Sales (P/S), Price to Book Value (P/BV) and Price to Earnings (P/E) analysis with formula
    19. How to Pick a Share Basic Best Practices for New Investors with checklist
    20. Equity Research Guide to Evaluating Share Investment Potential with checklist
    21. Discounted Cash Flow technique The Key to Evaluating Share Prices and Maximizing Investment Returns
    22. DCF Analysis A Step-by-Step Guide to Valuing Shares like a Pro with examples
    23. NPV Net Present Value What does it mean with examples
    24. When to Sell a Share A Guide to Maximizing Profits and Protecting Your Portfolio
    25. Current Assets and Noncurrent Assets: What id the Difference with examples
    26. Return on Equity ROE What It Means and How to Calculate
    27. ROE, ROA, and ROCE How to calculate with examples
    28. asset turnover ratio Definition and Understanding the Impact
    29. Inventory Turnover Ratio What It Is, How It Works and how to calculate
    30. pe ratio Understanding Price Earning Ratio to Assess a Shares
    31. economic moat Advantage  in business
    32. Equity Research Step-by-Step Checklist for Analysing Company Performance
    33. Financial Health – Definition, Determinants, How to calculate
    34. Time Value of Money Understanding and Calculating Future and Present Value
    35. Sell Shares: Factors to Consider for Profit Booking

In the past few chapters, we have become familiar with how to read financial statements, and now, our concentration will be on how to analyse them. The concept of financial ratios was established by Benjamin Graham, famously known as the pioneer of fundamental analysis. With this tool, companies can examine the outcomes, compare yearly figures and measure up against others in their respective industry.

To understand financial ratios, we must be familiar with specific characteristics. This requires using data from financial statements to calculate its numerical value.

The financial ratio of a company alone tells us very little. Take Ambuja Cements Limited, for example; they have a 15% profit margin, but it’s impossible to tell if it’s the best without more context.

Once you have calculated Ultratech Cement’s profit margin at 12%, it is logical to compare this with Ambuja Cements Limited to see which one is more profitable. However, simply computing the ratio does not always give a complete picture; analysis of the ratio (by comparison to another similar-sized organisation or by tracking its historical trend) is essential to gain meaningful insights.

You should remember that accounting policies can differ between companies and through various financial years. Thus, a detailed analyst must take this into consideration, adjusting any data where necessary before calculating the financial ratio.

 – Financial Ratios

Financial ratios can be divided into categories such as liquidity ratios, profitability ratios, activity ratios and leverage ratios. These classifications offer a broad overview of a company’s performance.

  1. Profitability Ratios
  2. Leverage Ratios
  3. Valuation Ratios
  4. Operating Ratios

The Profitability ratios allow the analyst to gauge a company’s effectiveness in generating profits. This reveals the competitiveness of the management, which is essential for business growth and distributing dividends to shareholders. Therefore, it is imperative to take account of a company’s profitability.

Leverage ratios, alternatively referred to as solvency or gearing ratios, assess the ability of a company to fulfil its long-term financial obligations. This type of measure takes into account the extent to which debt has been used to support firm operations and growth. By understanding a concern’s ability to pay its bills and liabilities, these ratios give us an idea of the sustainability of its activity in the future.

Valuation ratios compare a company’s stock price with either its profitability or its overall value to get an idea of how expensive or inexpensive it is trading. This helps to determine whether the current share price is seen as high or low by providing a comparison between the cost of the security and the benefits of holding the stock.

The Operating Ratios, also known as ‘Activity Ratios’, measure the effectiveness with which a business can convert its assets (both current and noncurrent) into revenue. This ratio gives us an insight into the efficiency of the company’s management. As such, these ratios are sometimes referred to as ‘Management Ratios’.

Ratios in any category offer insight into the financial status of a company. A good example is the ‘Profitability Ratio’, which measures the efficiency of a business and is derived from the ‘Operating Ratio’. Because specific ratios can overlap, it can be hard to classify them accurately. As such, ratios tend to be ‘loosely’ divided.