Analyzing Financial Ratios

ByAKDSEO

Jan 5, 2023

Financial Ratios If you are studying accounting, then how to analyze financial ratios is important to know. This analysis will always be us in the business world, especially investment and management. Investors usually calculate and analyze the company’s financial ratios to see the size of the investment opportunity to be invest. So, how to analyze it, let’s see in full here.

What is Financial Ratio Analysis?

Financial ratio analysis  an effort made to measure the financial condition of a company or business. The way to analyze financial ratios is by utilizing data from financial reports to make comparisons. In accounting, financial ratio analysis is usually carri out at the end of a company’s period in one year.

This financial ratio analysis is generally us to determine the strategy for planning a company or business in the future. Apart from internal needs, financial ratio analysis can also be us as a way to show the performance of a company or business to investors. Through this analysis, it is hop that the potential feasibility of obtaining investment or funds will seen.

Types of Financial Ratios

How to analyze financial ratios can be determin from the type you want to see. Below are several types of financial ratios:

1. Solvency Ratio

The solvency ratio is us to determine the company’s effectiveness in using its assets or wealth. The way to analyze financial ratios with this type is as follows:

a. Debt Ratio

The way to calculate the debt ratio is to divide the amount of debt by the total assets of the company or business. This calculation can provide information about the amount of assets of a company or business to see how much the total assets are financ by debt.

The lower the percentage, the better. Here is the formula:

Debt Ratio = (Total Debt : Total Assets) x 100%

b. Debt Ratio with Capital Approach

The way to analyze financial ratios of this type is to divide the amount of debt by the amount of capital. The smaller the percentage generated, the healthier the finances of a company or business. This means that the debt that is own does not exce the capital.

Here’s the calculation formula:

Debt Ratio = (Total Debt : Total Equity) x 100%

2. Liquidity Ratio

The liquidity ratio is a type of calculation that is us to see a company’s liquidity capacity. The calculation takes into account current assets and current liabilities owned. The following are several types of liquidity ratios:

a. Current Ratio

The calculation of the current ratio is to divide current assets by current debt. The percentage of results can provide information about the company’s ability to pay current liabilities in a short period of time.

Here’s how to analyze financial ratios of this type:

Current Ratio = (Current Assets : Current Liabilities) x 100%

b. Cash Ratio

The way to calculate financial ratios of this type is to add up cash and cash equivalent assets, then divide the result by current liabilities. If the result is close to 100%, the better for the company or business.

Here’s the calculation formula:

Cash Ratio = ((Cash + Cash Equivalent Assets) : Current Liabilities) x 100%

c. Fast Ratio

The quick ratio is the result of the difference between current assets and inventory which is then divid by current liabilities. The percentage can show the financial health of a company or business. The closer to 100%, the better.

Here’s how to calculate financial ratios of this type:

Quick Ratio = ((Current Assets – Inventory) : Current Liabilities) x 100%

3. Activity Ratio

The activity ratio is us to see the productivity of the assets own in a company or business. There are several types of activity ratios, namely:

a. Inventory Turnover Ratio

Inventory turnover ratio is us to determine the company’s liquidity. The higher the resulting ratio, the better the inventory management. Here’s how to calculate it:

Inventory Turnover Ratio = Cost of Goods Sold : Inventory

b. Accounts Receivable Turnover Ratio

Receivables turnover ratio is us to determine the amount of company or business receivables. The greater the turnover of receivables, the better for the company’s finances. Here’s how to analyze financial ratios of this type:

Accounts Receivable Turnover Ratio = Total Receivables : Average Receivables

c. Fixed Asset Turnover Ratio

This ratio shows the company’s ability to generate sales using fixed assets. The greater the ratio, the better the financial company or business.

How to calculate financial ratios of this type are as follows:

Fixed Asset Turnover Ratio = Sales: Fixed Assets

d. Total Asset Turnover Ratio

The way to calculate this ratio is to compare sales with the total or total assets of the company. Total assets consist of current assets and fixed assets. The bigger the ratio, the better. Here’s how to calculate it:

Total Asset Turnover Ratio = Sales : Total Assets

4. Profitability Ratios

Profitability ratios are us to calculate the profit of a company or business. The calculation of this ratio can be us in the following types:

a. Gross Profit Margin Ratio

This type of ratio is us to determine the comparison between gross profit and sales. The greater the ratio, the better the company’s finances. Here’s how to calculate it:

Gross Profit Margin Ratio = Gross Profit : Sales

b. Net Profit Margin Ratio

This type of ratio is us to see the ability of a company or business to generate profits after deducting all costs. Here’s how it’s calculat:

Net Profit Margin Ratio = Net Profit After Tax: Sales

c. Operating Profit Margin Ratio

This ratio is us to calculate the profit generat before tax and interest. Here’s how to calculate it:

Operating Profit Margin Ratio = Profit Before Tax and Interest : Sales

d. Return On Investment (ROI)

ROI is a ratio that is us to determine a company’s ability to generate profit on total investment. The calculation method is as below:

ROI Ratio = Profit After Tax: Investment

e. Return On Assets

ROA is a ratio that contains information about the size of a company’s assets to generate profits. How to calculate financial ratios with this type are as follows:

ROA Ratio = Profit Before Tax and Interest : Total Assets

Purpose of Financial Ratio Analysis

The purpose of financial analysis is to help provide an overview or financial information to various parties involved in a company or business, including investors.

The following are some of the objectives of financial analysis:

Provides an overview of the performance of company resources
Presents management operational effectiveness data
Demonstrate the effectiveness of the company or business strategy
Displays data for consideration of the tax amount
Become a reference material
Become an evaluation material

Financial Ratio Analysis Method

How to analyze the right financial statements? To do this, you must first know the method of financial ratio analysis.

Here’s how to analyze financial ratios:

Time Series Analysis and Forecasting
How to analyze financial ratios using this method is to compare financial data for a certain period.

This comparison is us as a projection or estimate of a company’s financial condition in the future.

Time series analysis and forecasting have several points that must be consider because of their influence on changes in financial structure.

These points include government regulations, changes in competition, acquisitions, and changes in technology.

There are several steps that must  understood on how to analyze financial ratios with the method of time series analysis and forecasting as follows:

Specifies the base year

Calculates another year’s index number
Estimating the direction and historical trend of financial statement items
Summarize the results of the analysis
Common Size Analysis
The way to analyze financial ratios using the common size analysis method is to compare changes between various items with total assets, liabilities, and sales.

The results of this comparative analysis are present in the form of percentages for each component in the financial statements, both balance sheet and profit and loss.

How to analyze financial ratios with this method allows a company to obtain information about the relativity of current assets to fixed assets (investment composition) and the relativity of company debt to capital (capital structure).

Common size analysis can be us by companies for various assessments, both in comparing the financial statements of the previous period with the current one, as well as comparing competitors and the company itself.

Example of Financial Ratio Analysis

Financial ratio analysis can be appli according to the type and purpose desired by the company, business or other parties.

An example of a simple financial analysis is for example the calculation of the net profit margin of company X during December 21-24 in the financial statements.

After deducting taxes on net income and dividing by sales, we get the following results:

December

21: 32.97%
22: 29.55%
December 23: 26.97%
December 24: 19.10%
From these data, it can be conclud that the tendency of company X’s net profit margin is decreasing.

If you want to see how the performance of the company’s resources, it means that it cannot be categoriz as optimal.