What are the main types of ratio analysis used in financial analysis?
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There are five main types of ratio analysis. This includes leverage, performance, liquidity, valuation and activity ratios.
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The different types of ratio analysis play a massive role in helping organisations prepare their financial statements that reflect their overall financial situation. The preparation of a company’s financial statements takes many intricacies into account and helps project the success of its operations.
Once these financial statements have been prepared, various tools, including ratio analysis, are used to evaluate the statement to provide the company’s stakeholders with more information regarding the company’s financial position. Here, we will take a look at the different types of ratio analysis that companies use to analyse their financial statements.
There is so much one can learn upon analyzing a company's financial statements. This includes greater insights into a company’s liquidity, how efficient its operations are and its overall profitability. When it comes to fundamental equity research, traders and investors tend to rely heavily on ratio analysis.
To help use the process of ratio analysis to calculate how a company has performed fiscally factors like the company’s debt, liquidity, profitability, market ratios and activity of the company is taken into account. The basis of ratio analysis is about comparing the various components listed in the company’s financial statements.
The main purpose of the different types of ratio analysis is to help bring the different elements of a company’s financial situation to the fore. A company’s overall financial performance cannot be competently analyzed with a single type of ratio analysis. This is why all 5 different types of ratio analysis need to be considered together to get an overall idea of the company’s performance.
Here’s a look at the five different types of ratio analysis
Leverage Ratios
Also known as solvency ratios, this type of ratio analyses how competent the company is at paying down long-term loans. With the help of leverage ratios, a company’s day-to-day reliance on debt can be analysed while also gauging how the company is able to meet its everyday obligations.
Performance Ratios
Also known as the profitability ratio, the performance ratios work as they are named. The main aim of the performance or profitability ratios is to bring the company’s market performance to the forefront, i.e. the profit/loss the company has experienced.
Liquidity Ratios
The liquidity ratio determines how able a corporation is to pay off its debts. With the help of the liquidity ratio, one can find out if the company has enough assets to pay off long-term debts. Other than this, the liquidity ratio also analyses whether or not the company’s cash flow can cover its overall expenses. This ratio is mainly important for small-cap and penny firms since the chances of smaller businesses facing financial struggles are higher.
Valuation Ratios
With the help of valuation ratios, one can determine how profitable it might be to invest in a company’s stock, by taking its current share price into account. As the main purpose of these ratios is to determine how attractive a company’s stocks are in the stock market, it is also known as the market ratio.
Activity Ratios
Activity ratios gauge a business’s activity to determine how well it is using its resources to generate revenue.
While on the one hand, the different ratio analyses undoubtedly help analyse the overall financial health of a company, it does have certain limitations.
When the data provided is insufficient or is not updated, ratio analysis might not be accurate.
Any future projections that come out of ratio analysis, based on historical market movements, might not turn out to be as accurate.
Only knowledgeable analysts can use the ratio analysis method well enough to produce accurate results.
As organizations in different sectors may employ different accounting standards and operate in different environments, ratio analysis cannot be used to compare their performance.
The different types of ratio analysis play a major role in helping bring together the financial statement of a company. Since there are various aspects of these financial statements, the different ratio analysis helps analyse these different aspects effectively, thus helping provide traders and stakeholders with a comprehensive insight into a business’s financial health.
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There are five main types of ratio analysis. This includes leverage, performance, liquidity, valuation and activity ratios.
The liquidity ratio determines how able a corporation is to pay off its debts. With the help of the liquidity ratio, one can find out if the company has enough assets to pay off long-term debts.
The main aim of the performance or profitability ratios is to bring the company’s market performance to the forefront, i.e. the profit/loss the company has experienced.
The liquidity ratio determines how able a corporation is to pay off its debts while the solvency ratio looks into the long-term financial health of the company.
Efficiency ratios or activity ratios gauge a business’s activity to determine how well it is using its resources to generate revenue.
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