What Do You Mean By Ratio Analysis? Definition, Uses

Ratio Analysis as the name suggests, is an analysis of any document using ratios as a parameter. During investments, the majority of people research various companies based on their performances using ratio analysis methods.

Ratio analysis is an analysis of financial statements with the help of various existing accounting ratios. It helps us decide whether an enterprise is good enough to give us a good return by analysing its financial stability and performance. Let us dive into a detailed analysis of Ratio analysis methods, formulas, and usage.

What is Ratio Analysis?

Ratio analysis is a method where various parameters of a financial statement are studied and compared to predict the financial health and performance of an enterprise. Financial experts often use these ratio analysis methods to measure a company’s profitability, and performance based on other competitor companies.

Using Ratio analysis we calculate and interpret financial ratios, cash flow statements, balance sheets, and other documents to get an idea of whether or not a company has a growth potential in the coming future.

Ratio Analysis Definition: Key Takeaways

Ratio analysis is a method to determine an enterprise’s financial health and performance during a given tenure using its financial statements.
It helps to identify investment opportunities and identify trends in a particular sector.
Ratio analysis tracks a company’s performance and also help compare its competitors in the same industry or sector.

What are the uses of Ratio Analysis in the Investment Market?

Ratio analysis is an important concept in the investment market as it consists of various factors that are used to calculate the financial well-being of a company. There are many uses of ratio analysis in the real-world investment market, let us pen down some of them below.

Comparing Competitors: The first major benefit of the ratio analysis method is that you can easily compare your competitors based on various factors such as profitability ratios, activity ratios, liquidity ratios, and more.
Finding Trends: You can also use activity ratios such as inventory ratios, turnover ratios, etc to identify any surge in trends. Using financial statements companies can easily collect their future financial performance and compare it with their competitors.
Operational Management: Ratio analysis calculates whether a company can manage its assets and liabilities. It also determines whether the resources of a company are over-utilised or under-utilised.
Assessing Financial health: It helps investors and enterprises to determine whether the company’s performance is good and it can meet short-term obligations.
Evaluate Profitability: Ratios like Net Profit Margin, ROA, ROE, and others indicate how well a company can generate profit from sales, assets, and equity.
Risk Assessments: It also helps to determine the risk factors of investing in a company. Using debt to equity ratio investors can decide whether a company has a higher level of debt than assets. Higher debts indicate higher financial risks.

Ratio Analysis Formula

Ratio analysis is not a single formula; it consists of various formulas in the form of different ratios which are evaluated from the financial statements of a company and present the financial health of a company. However, a general representation of the ratio analysis formula can be interpreted as follows.

Ratio Analysis = a/b x 100

This ratio value when converted into percentage represents an enterprise on various parameters.

Limitation of Ratio Analysis

Ratio analysis gives a complete picture of a company’s financial structure but sometimes enterprises make a slight change in their operations or structure which cannot be evaluated in financial statements and make an attractive growth. It is important to keep these limitations in mind while evaluating a company’s financial strength.

Also, financial ratios cannot be used alone which means a single ratio cannot determine the overall financial well-being of a company. They must be used together to get a complete picture of the company and whether or not it can give higher returns for long-term investments.

Categories of Ratio Analysis

There are many financial ratios that are used to give an output of ratio analysis. Let us know about them based on their categories.

1. Liquidity Ratios

Liquidity ratios are used to measure a company’s ability to meet its short-term debt obligations using available assets. Companies can use their assets and convert them into cash when they are high on debt. Some of the major liquidity ratios are given below.

Quick Ratio (Acid-Test Ratio)
Cash Ratio
Current Ratio
Operating Cash flow ratio

2. Solvency Ratio

Unlike Liquidity ratios, solvency ratios are used to determine the long-term financial viability of a company and its ability to meet long term obligations. Public organisations like governments, banks, and employees use solvency ratios.

Debt to equity ratio
Interest coverage ratio
Equity Ratio
Fixed Charge Coverage Ratio
Cash Flow to Debt Ratio

3. Efficiency Ratios

Efficiency ratios mark an important place in ratio analysis used to analyse a company’s ability to effectively employ its resources and generate profits. A higher efficiency ratio indicates that a company can easily convert its resources to generate higher revenues. Some of the major efficiency ratios are given below.

Asset Turnover Ratio
Inventory Turnover Ratio
Payables turnover
Fixed Asset Turnover Ratio
Receivables turnover ratio

4. Coverage Ratios

A coverage ratio is a measure of a company’s ability to meet its debt and financial obligations, such as interest payments or dividends. The higher the coverage ratio, the easier it is to make interest payments on debts or dividends. Some of the major coverage ratios are given below.

Interest Coverage Ratio
Debt Service Coverage Ratio
Asset Coverage Ratio

5. Profitability Ratios

Profitability ratios assess the ability of a business to generate earnings based on revenue, operating costs, and shareholder’s equity. The higher the profitability ratio of a business the better is their overall performance. Some of the profitability ratios that help to determine the profit level of a company are given below.

Gross Profit Margin
EBITDA Margin
Return on Equity
Return on Assets
Return on Invested Capital
Operating Profit Margin

6. Market Value Ratio

Market Value ratios are financial metrics that are used to measure and analyse stock prices and compare the market value of competitors. It is a price on which an asset can be brought or sold in the market. It tells whether a business stock or assets are undervalued or overvalued.

Book Value per Share
Dividend yield
Earnings per share
Market Value per share
Price/earnings ratio

Examples of Ratio Analysis

Let us look at some of the major examples of popular categories of ratio analysis below.

Liquidity Ratio

Suppose a company has current assets of $30,000, including 10,000 in cash, $50,000 in accounts receivable, and $150,0000 in inventory. Its current liabilities are $150,000. Now the current ratio of the company will be calculated using the given formula.

Current Ratio = Current Assets/Current Liabilities = $3,00,000/$1,50,000 = 2.0

The current ratio of 2.0 signifies the company has twice as many assets as compared to its current liabilities.

Solvency Ratios

We can calculate debt-to-equity ratios to understand financial leverage and potential risk. A Company has a total of $600,000, which includes $200,000 in short-term debt and $400,000 in long-term debt. Its total equity is $1,200,000.

The debt-to-equity ratio can be calculated here based on the given formula

Debt to equity ratio = Total Debt/ Total Equity

Debt To Equity Ratio = $600,000/$1,200,000 = 0.5

A debt-to-equity ratio of 0.5 indicates potential risks and financial leverage within the enterprise.

Efficiency Ratio

Suppose a company has a cost of goods sold (COGS) of $900,000 over the year. Its beginning inventory was $200,000, and its ending inventory was $300,000, making the average inventory $250,000. The inventory turnover ratio will be calculated using the given formula.

Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory

Inventory Turnover = 3.6 which means the company can sell and replaces its inventory 3.6 times in a year which indicates a good inventory management.

Coverage Ratio

Suppose a company has earnings before interest and taxes (EBIT) of $400,000 and an interest expense of $100,000. The interest coverage ratio will be calculated using the given formula.

Interest Coverage Ratio = EBIT / Interest Expense = $400,000/$100,000 = 4.0

An interest coverage of 4.0 indicates the company earns 4 times more than their expenses on the interest which is a positive sign for the investors.

Profitability Ratio

Suppose a company has a net income of $120,000 and total revenue of $1,000,000. The net profit margin will be calculated using the given formula.

Net Profit Margin = Net Income / Revenue = $1,20,000/$1,000,000 = 12%

A net profit margin of 12% means the company can make a profit of 0.12% for every $1 of revenue generated which indicates a good profitability factor for the company.

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Ratio Analysis FAQs

Q1. What is Ratio Analysis?

Ans: Ratio analysis is a quantitative procedure used to determine the financial health and performance of an enterprise during a given tenure using its financial statements. There are many ratio analysis used to measure a company's overall financial health and help decide whether or not to make investments.

Q2. What are the major types of ratio analysis?

Ans: Some major categories of financial ratio analysis are liquidity ratio, profitability ratio, market ratio, efficiency ratio, leverage ratio, coverage ratio, etc.

Q3. What is the Ratio analysis formula?

Ans: The ratio analysis formula is generally presented in the form of a/b x 100 to get the percentage value, which helps us decide the financial structure of a company.

Q4. Is ratio analysis a single metric?

Ans: Ratio analysis is not a single and no single parameter can be used to evaluate whether a company is worth investing in and giving higher returns. There are many financial ratios like equity ratios, debt ratios, coverage ratios, etc.