Ratio Analysis: Meaning and Types
In an organization, once the financial statement is prepared, it requires to be analyzed. The standard tool used to analyze and evaluate the financial status of a company is ratio analysis. This tool helps stakeholders to have a better understanding of the present financial situation of a firm.
Let us now understand the definition of ratio analysis.
In a financial statement, ratio analysis helps in comparing the line items and used to calculating profitability, operation efficiency, and liquidity of a firm.
This type of analysis is used in making a financial report of a firm for external bodies who make decisions according to the statement. They take this statement as their primary source of information.
Types of Ratio Analysis
The two most common ratio analysis used is mentioned below.
- Trend line – It can evaluate the ratio for several reporting terms, to check if there is any trend in the details determined. The trend can help in specifying financial issues which is not possible to find while examining a single reporting term. The trend lines can be applied to determine the steps required to achieve positive future ratio performance.
- Industry comparison – It calculates and compares the ratios of a firm with its competitors of the same industry. These businesses have the same capital structures and fixed asset investments, therefore, the ratio analysis results should also be the same.
However, If the evaluation result does not match, then it indicates that there is an issue and the firm’s ability to make a profit that is notably lesser than the rest of the industry. The industry comparison is used to check which enterprise within an industry is most valuable or profitable.
Other ratios used for reviewing purposes by a small group to understand an entity are.
- Current ratio – Compares current assets to current liabilities.
- Days sales outstanding – Checks the firm’s ability to issue a credit to customers efficiently and be paid back on time.
- Debt to equity ratio – Compares equity to the proportion of debt, to check if an entity has too much debt.
- Dividend payout ratio – This analyses the percentage of earnings rewarded to investors as dividends.
- Gross profit ratio – Evaluates a part of earnings produced by the goods and services sale, before managerial expenses are incorporated.
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