Ratio analysis is an important tool that is used in inter-business and intra-business comparison.

For a quick indication of a business’s financial health in key areas, ratio analysis comes handy. Ratio analysis is broadly classified into four types:

1. Liquidity Ratios
2.  Profitability Ratios
3. Activity Ratios
4. Solvency Ratios

Liquidity Ratios

To help identify the short term liquidity of a firm, this ratio is used. It has mainly two types of ratio under this. Current ratio which let us know the short term solvency of a firm.

\[\large Current\;Ratio=\frac{Current\;Asset}{Current\;Liabilities}\]
\[\large Quick\;Ratio=\frac{(Total\;Current\;Ratio-Inventory)}{Total\;Current\;Liabilities}\]

Quick ratio helps us find the solvency for six months and the reason why inventory is subtracted is that inventory usually take more than six month to convert into liquid asset.  

Profitability Ratios

Profit is the main objective of business. All business needs to be operating on profit. These ratios are used to know the profitability of a business and the measure the success effectively over a period of time.

These ratios are used by the business owners, creditors, government officials to know how the business is faring. If a business is asking for loan from a bank, then the bank with by default check the profitability status using these ratios.

The main ratios covered within this category are:

\[\large Net\;Profit\;Ratio=\frac{-Net\;profit\;after\;tax}{Net\;Sales}\times 100\]
\[\large Gross\;Profit\;Ratio=\frac{Gross\;Profit}{Net\;Sales}\times 100\]
\[\large Operating\;Ratio=\frac{Operating\;Cost}{Net\;Sales}\times 100\]
\[\large Earnings\;per\;share=\frac{Net\;Income-Preferred\;Dividend}{Weighted\;Average\;number\;of\;shares\;outstanding}\times 100\]

Activity Ratios

This ratio is also known as turnover ratio, this ratio measures the efficiency of a firm and converting its products into cash. The ratio is measured in days.

The ratios under this category are:

  • This ratio helps in letting the business know how many times the product is turning into cash during a specified period of time.
\[\large Inventory\;Turnover\;Ratio=\frac{Cost\;of\;goods\;sold}{Average\;Inventory}\]
  • Receivables turnover Ratio helps in knowing how many times the credit is collected in a given period of time. 
\[\large Receivables\;Turnover\;Ratio=\frac{Net\;Credit\;Sales}{Average\;Trade\;Receivable}\]

Solvency Ratios

To see if the business can survive for the long term period, solvency ratios are used. This ratio helps evaluate the ability to pay the long term debt of a business.

  • Debt – Equity Ratio: To see the soundness of llong-termfinancial policies of a business, debt equity ratio is used. IT simply means the total liabilities divided by total stakeholder’s equity.

Mathematically it is written as:

\[\large Debt\;Equity\;Ratio=\frac{Total\;Liabilities}{Stakeholder’s\;Equity}\]
  • Proprietary Ratio: is used to evaluate the soundness of capital structure of a business. Different business use different capital structure, It could be 50% equity and 50% debt, while for some it might 30% equity and 70% debt.

The ratio is given as:

\[\large Proprietary\;Ratio=\frac{Stakeholder’s\;Equity}{Total\;Assets}\times 100\]


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