Please read the following two statements:
In 2019, our company has increased its net profit from USD 30,000 to USD 50,000.
In 2019, our company has increased its net profit to USD 50,000, a 10% increase in profitability.
Have you noticed any differences in comprehension while reading the above two statements? In the 2nd statement, we can not only know the incremental increase in profitability but also can draw a meaningful comparison between the two years. This is the beauty of ratio analysis.
With the use of ratio, anyone can present a myriad of information in a way that actually makes sense. In general, financial ratios can be categorized into the following 5 distinctive groups:
- Liquidity ratios
- Efficiency ratios
- Profitability ratios
- Solvency ratios
- Valuation ratios
Liquidity Ratio: It helps us to understand how quickly a current asset like accounts receivable, inventory etc., with useful life less than one year, can be converted into cash or how quickly a current liability like accounts payable, accrued expenses can be paid off. In liquidity ratio, current assets and current liabilities are used as numerator and denominator respectively.
Current ratio, Quick ratio, and Cash ratio are three variants of liquidity ratio where the 1st one is less liquid measure and the last one is the most liquid measure. A liquidity ratio greater than one is a measure of good liquidity.
Efficiency Ratio: It helps us to measure how effectively a company is using its assets in terms of revenue generation. Increased asset utilization (profit per unit of asset), improved receivable turnover (sales/average receivables) or inventory turnover (cost of goods sold/average inventory) and decline in payable turnover (purchase/average notes payable) are good examples of improved efficiency. These ratios can be named as asset turnover ratio, accounts receivable turnover ratio, inventory turnover ratio and payable turnover ratio respectively.
Profitability Ratio: All profitability ratios gauge profitability from different dimensions. Gross Profit Margin, Net Profit Margin, and Operating Profit Margin are the most commonly used profitability ratios.
- Gross Profit Margin = (Sales- Cost of Goods Sold) / Sales
- Net Profit Margin = (Sales-Cost of Goods Sold – Operating cost + other income – other expenses – Interest -Tax) / Sales
- Operating Profit Margin = Earning from Normal operation / Sales
Solvency Ratio: These ratios measure the company’s ability to satisfy debt obligation. Interest coverage ratio measures how sufficient operating income is to pay off interest and lease expense whereas Debt to Equity ratio measures how much a company is debt-financed compared to one unit of owners’ equity. Debt to equity ratio of 1x means a capital structure of 50% debt and 50% equity.
Valuation Ratio: These ratios are called multiples like earning multiple. Price-to-earnings, Price-to-book, Price-to-sales, Price-to-Cash flow are commonly used valuation metrics. Low multiples are considered undervalued (favorably priced with respect to their earning or cash flow or sales). For example, for a company with low Price-to-Cash flow multiple essential pays less than that of relatively high priced company with similar amount of cash flow.