4 Different Types of Ratio Analysis and Its Limitations

It would seem hard to try to comprehend a company's financial health without any structured data, wouldn't it? Financial ratio analysis is useful in this situation. It provides information on a company's profitability, liquidity, efficiency, and long-term stability, much like a financial x-ray. Ratio analysis is a useful technique for deciphering complex financial statements, whether you're an investor searching for the next big opportunity or a business owner aiming for financial stability. However, it has limits just like any other analytical tool. This blog will thoroughly examine the four types of ratio analysis, along with the difficulties they provide and how they aid in decision-making.

4 Types of Ratio Analysis-

There are four types of ratio analysis, each intended to assess various facets of financial health and performance to assist investors and organizations in making well-informed choices. Let's examine them in more detail:

1. Ratios of liquidity

As a way to ensure financial stability, liquidity ratios assess a company's capacity to fulfil short-term tasks. In times of economic difficulty, they oblige creditors and investors to evaluate operational sustainability and cash flow management. The fast ratio for urgent obligations, the cash ratio for cash availability, and the current ratio, which gauges total liquidity, are important liquidity ratios.

Common Ratios of Liquidity:

The ability of a business to pay down short-term loans is assessed with the use of liquidity ratios.

• Current Ratio: This ratio explains whether the business can cope with its short-term responsibilities by comparing current assets to current liabilities. Better liquidity is indicated by a greater ratio. In this Current Assets / Current Liabilities is the formula in use.
  
• Quick Ratio (Acid Test Ratio): A more attentive approach that does not comprise inventory, which can take longer to convert into cash. It signifies that the business can pay its debts without depending on inventory sales.(Current Assets - Inventory) / Current Liabilities is the formula in use.
  
• Cash Ratio: The most rigid liquidity metric, the cash ratio, assesses short-term debt payment capabilities solely by looking at cash and cash equivalents. Cash and Cash Equivalents / Current Liabilities is the formula in use.
  

2. Ratios of profitability

An understanding of operational efficiency and financial health is provided by profitability ratios, which define a company's ability to turn a profit in terms of revenue, assets, or equity. Return on equity (ROE) for shareholders' return, return on assets (ROA) for economic use, net profit margin for overall profitability, and gross profit margin, which evaluates productivity, are important profit margins.

Typical Ratios of Profitability:

• Gross profit margin: The gross profit margin, which shows profitability at the production level, is the percentage of revenue that is higher than the cost of products sold. (Revenue - Cost of Goods Sold) / Revenue is the formula.
  
• Net Profit Margin: The ability of a business to turn income into actual profit after all costs are deducted is reflected in its net profit margin. Net Income / Revenue is the formula.
  
• Return on Assets (ROA): Recognize how well a company utilizes its assets to generate profit, evaluating overall performance. The formula uses net income / total assets.
  
• Return on Equity: Recognize financial efficiency and evaluate how well a business makes cut-price of the investments made by shareholders. The formula used is net income divided by shareholders' equity.
  

3. Ratios of Efficiency:

Efficiency ratios examine how well a business earns money and manages expenses using its assets and liabilities. They help in evaluating resource management and operational efficiency. Accounts Receivable Turnover, which shows how well a business collects debts, Asset Turnover, which records revenue in a single container, and Inventory Turnover, which shows how quickly inventory is sold, are important performance metrics.

Normal Performance Range:

• Inventory Turnover Ratio: The Inventory Turnover Ratio assists us in understanding how frequently a company disposes and restocks its products over a certain time. A higher ratio recommends that the company is doing a great job supervising its inventory and making strong sales. To calculate this ratio, you compare the cost of the goods sold to the average amount of inventory the company has.
  
• Asset Turnover Ratio: This ratio defines how well a business uses its resources to generate revenue. A high level indicates that the business is using its resources to increase sales. By dividing the net sales by the average total assets, you can calculate this ratio.
  
• Accounts Receivable Turnover Ratio: Evaluates how well a company collects outstanding debts from customers. A high ratio indicates a strong credit policy and good collections. Net Credit Sales / Average Accounts Receivable is the formula.
  

4. Ratios of Solvency

By considering the company's ability to settle long-term debt, the debt provides insight into its longevity and stability. Creditors and investors can use these criteria to determine sustainability and financial problems. Key metrics measure leverage and ability to repay debt-to-equity, interest coverage, and debt-to-equity ratio.

Common Ratios of Solvency:

• Debt to Equity: This means how much a business borrows in proportion to how much it has invested locally. The greater risk may be specified by a higher ratio, which expresses that the business depends heavily on borrowed funds. The simplest method to dictate this is to divide the total amount of debt owed by the business by its equity, or the capital invested by its owners.
  
• Interest Coverage Ratio: Recommends how readily a business can resolve its interest obligations. A greater ratio shows that the business is better positioned to control its debt payments, which lowers the likelihood that it will have trouble making those payments. EBIT (earnings before interest and taxes) divided by interest expense is the formula in use.
• Debt-to-asset ratio: The debt-to-asset ratio gives a glimpse of the company's risk and financial health by showing how much of its assets are backed by debt. A low ratio suggests that the business depends more on its own funds (equity) than on loans. Just divide the total debt by the total asset value to determine it.
  

Importance of Ratio Analysis in Financial Management

For any business or entrepreneur, making good financial decisions is very important. Ratio analysis is one of the best ways to evaluate the performance of a company. Better policy, resource allocation, and risk management are supported by a comprehensive picture of the strengths and weaknesses of the funds it provides. In addition to this, providing a clear understanding of the benefits, operating costs, and performance, makes it easier to analyse investment opportunities.

Quantitative analysis and financial management assist companies in cost optimization, profitability, and financial stability when incorporated into strategic planning. Despite its advantages, the analysis of the limited scope may make it necessary to use it with other financial evaluation methods to reach a complete conclusion and prevent misunderstandings.

Limitations of Ratio Analysis:

One popular financial tool for measuring a company's performance, effectiveness, and financial health is ratio analysis. Despite its advantages, it has many drawbacks that can reduce its productivity. These constraints stem from various changes in accounting practices, prevailing economic conditions, and the loss of good assets. The following are some of the disadvantages of the research process:

• Ignoring Good Things: The research's reliance on quantitative data neglecting the qualitative aspects is one of its drawbacks. Non-financial factors, including customer loyalty, employee satisfaction, market conditions, and brand reputation, are not taken into account by financial ratios. These factors are important for the long-term performance of the business, but they cannot be adequately captured by the margin.
• Different Financial Systems: Businesses can use different accounting techniques, including different techniques for acknowledging revenue, cost of goods, and depreciation. These differences can source differences in financial systems, which make comparisons of companies tough. For instance, even though they have the same business, a company that applies FIFO (first-in, first-out) may report a different profit than one that applies LIFO (last-in, first-out).
• The Effects of Inflation: Over time, inflation affects the value of money, although financial data may not always reflect this change. Especially when comparing financial systems several times, it can lead to wrong conclusions.
• Variations by Industry: Not all industries can use financial ratios in the same way. Direct comparisons are problematic since different industries have different financial procedures, cost structures, and company models. For instance, a debt-to-equity ratio that is deemed acceptable in the banking sector can be deemed overly high in the manufacturing sector. Companies should only be compared to their peers in the same industry, not to companies in adjacent fields, in order to make significant conclusions.
• Dependency of Historical Data: A company's current or future financial health may not necessarily be reflected in the historical financial data that ratio analysis depends on. Market dynamics, technology developments, and economic swings all affect business environments. Making poor estimates and investing choices can result from relying only on past ratios. 

Conclusion:

Businesses and investors can fruitfully assess the financial situation if they know the four types of financial analysis: profitability, value, quality, and satisfaction. These numbers give important information about a company's performance, long-term financial health, short-term stability, and profitability. However, the use of these measures has a disadvantage because it cannot explain the differences of companies, data constraints, financial effects, and problem-solving. 

Investors need to use a mix of research methods, such as traditional studies, market surveys, and sample research, along with numbers and data, to make smart decisions. By looking at things from all angles, businesses can better understand their financial health, spot potential risks and opportunities, and make plans for long-term success, especially in challenging business conditions.