Ratio Analysis: 6 Types of Ratio Analysis

Financial ratio analysis is a form of quantitative analysis that measures a company’s overall financial health. Several different ratio analyses focus on various aspects of a company’s financial statements. With careful financial statement analysis, it’s possible to see how well a company uses all its potential assets, earnings, and debts to maximize financial performance.

Ratio analysis is an essential tool for analyzing a business’s available documents: the balance sheet, the income statement, and the statement of cash flows. Internal and external figures (accountants and financial directors would be internal, investors and lenders external) can use ratio analysis to understand how a company is doing on its debt obligations, profitability, and overall financial health.

Ratio analyses are broken down into different categories, depending on the financial information they measure. The categories include:

1. 1. Liquidity ratios: Liquidity ratios measure a company’s ability to pay its short-term debt. Liquidity ratios include the working capital ratio or current ratio, which subtracts current debt from current assets; the quick ratio, also known as the acid test, which looks at whether the company can pay its current liabilities using accounts receivables; and the cash ratio, which measures how much a company’s liabilities and short-term obligations are payable using only cash or cash-equivalents.
2. 2. Efficiency ratios: Efficiency ratios measure a company’s ability to use its assets, meet its liabilities, and make sales to turn a profit. The inventory turnover ratio is a metric that compares the cost of goods sold to the average value of inventory within an accounting period. The fixed asset return ratio compares the use of fixed assets with sales figures, and the total assets turnover ratio compares fixed assets to total assets. These ratios, known as activity ratios or asset management ratios, provide essential data to financial directors and investors essential data.
3. 3. Solvency ratios: Solvency ratios, also known as debt management ratios, show how a company is financing its operations with long-term debt versus financing them with equity or retained earnings. Companies can calculate the total debt ratio by dividing the total assets by total liabilities, and can find the debt-to-equity ratio by dividing the total liabilities by the shareholder's equity.
4. 4. Profitability ratios: Financial directors can calculate profitability ratios in a few ways. One example is to divide net income by sales, giving a figure of profit per dollar or the net profit margin. Companies can also divide the net income by total assets to determine the return on total assets or ROA. Another method is to divide the earnings before interest and taxes (EBIT, sometimes also expanded to earnings before interest, taxes, depreciation, and amortization, or EBITDA) by total assets to get the BEP, or basic earning power ratio. You can also divide the net income by common equity to calculate the return on equity or ROE. Another example of a profitability ratio is gross profit margin ratio or gross margin, which shows how much profit a company retains after covering costs.
5. 5. Interest coverage ratios: Interest coverage ratios show how well a company can service its debt. Companies can calculate these in two ways: by dividing the EBIT by the interest expense and dividing the net operating income by the total debt service charges, resulting in the debt service coverage ratio, or the DSCR.
6. 6. Market value ratios: The market value ratios, also known as market prospect ratios, are essential for large, publicly traded firms, as they deal with share prices and market valuation in an attempt to determine the financial soundness of a company as an investment. Market value ratios include the P/E ratio or price/earnings ratio, determined by dividing the price per share by earnings per share. Companies calculate the price/cash flow ratio by dividing the stock price by the cash flow per share, and can divide the stock price by the book value per share to get the market/book ratio. Market prospect ratios also include dividend yield, dividing dividends per share by stock price per share.

Get the MasterClass Annual Membership for exclusive access to video lessons taught by business luminaries, including Daniel Pink, Chris Voss, Robin Roberts, Sara Blakely, Bob Iger, Howard Schultz, Anna Wintour, and more.