Introduction
Although the profit and loss account and balance sheet are the main sources of financial information on a company which are readily available, skill is required to make sense of them. Ratio analysis is a technique used to describe and interpret the relationships of certain financial data in the financial statements which would otherwise be devoid of meaning.
Ratios can be used to assess a company's past financial performance, evaluate its financial stability and to predict its future financial performance.
Financial ratios can be organised into six main categories:
Liquidity Measurement Ratios
Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets (or, those that can be easily converted to cash), its short-term liabilities.
Some important liquidity ratios are:
a) Current Ratio
b) Quick Ratio
c) Cash Ratio
d) Cash Conversion Cycle
Profitability Indicator Ratios
These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.
Some profitability ratios are listed below:
a) Return On Assets
b) Return On Equity
c) Return On Capital Employed
Debt Ratios
These ratios give users a general idea of the company's overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy.
Types:
a) Debt Ratio
b) Debt-Equity Ratio
c) Capitalization ...