Ratio Analysis Explained | Financial Ratios for Beginners

raw materials need processing to materialize their value similarly raw numbers in the financial statements when processed into ratios can be used to your advantage and derive inferences now that you have learned about the raw materials in the financial statements it's time to process those numbers and make sense out of them add its score a financial ratio is simply a comparison of one number to another in the finan fincial realm we use ratios to gain insights into various aspects of a company's performance efficiency and overall health there are several categories of ratios each serving a specific purpose let's dive into each one of them individually let's start off with liquidity ratios imagine a captain navigating a ship in an ocean and he finds out that there's a hole in the ship which could sink it now to save the ship the captain has to make sure that the ship stays afloat by reducing the weight to have enough time to fix the hole the liquidity ratio is somewhat similar to this example it gives us an idea of how a company can meet its short-term obligations these ratios are like the vital signs that indicate its cash flow to health it helps us understand if a company can withstand bad market conditions or uncertainties if the ratio is more than one the company can take care of its Financial Obligations with some assets left over if it is less than one it means that the company has more liabilities than assets which can get tricky during a financial distress if it's exactly at one then it is a Net Zero casee where it might have to raise funds to run business further but if it chooses to shut down it will be able to fulfill all its dues there are different types of liquidity ratios let's take a look at the first one which is current ratio this is simply a ratio of current assets to current liabilities let's take an example of a company to understand this better please take a look at all the numbers that are shown on your screen so the current ratio comes out to be current assets to current liabilities which is 1. 67 in this case this means for every 1 rupee of liability the company has 1. 67 rupees worth of assets and the company can meet its Financial Obligations still having some leftover cash next up is the quick ratio and as the name suggests it tells how immediate immediately the company can fulfill its Financial Obligations it's calculated as liquid assets to current liabilities here liquid assets are the same as current assets just excluding inventory there is some uncertainty in cash that the company gets on clearing its inventory there might be an instance where the company is not able to clear its inventory due to less demand in the market and the company might have to sell off the inventory at a loss considering the previous example of ABC limited the quick ratio will come out to be 1. 33 this means that the company ABC can clear all its liabilities and still have some of its assets intact next up is the cash ratio this ratio just focuses on cash and cash equivalents in comparison to current liabilities and removes the uncertainties that might come from the delay in accounts receivable considering the same example the cash ratio for ABC limited will come out to be 1. 16 meaning for every 1 rupee of current liability the company has 1. 16 rupe worth of cash last is the net working capital ratio this ratio gives an idea of how much Capital the company is left with after clearing off all its liabilities this ratio can be a negative or a positive number here means that the company can comfortably manage its day-to-day operations it's calculated as current assets minus current liabilities upon current liabilities which comes out to be 67 in the same example alternatively you can simply Calculate working capital ratio by subtracting one from the current ratio to understand more you can

check all these ratios under the financial ratios filter on ticker tape very easily after knowing the health of a company in the shortterm with liquidity ratios it's time to check its long-term Financial Health that's when solvency ratio comes into the picture it reveals how well a company can handle its long long-term obligations a solvency ratio is one of many metrics used to determine whether a company would be sustainable in the long term or not solvency ratio is a more comprehensive metric as it measures a company's actual cash flow rather than net income solvency ratios include the debt to equity ratio current ratio yes it appears here too and interest coverage ratio let's begin with debt to equity ratio it is one of the most important metrics to look at when analyzing a company this ratio assesses the proportion of debt used to finance a company's assets relative to its Equity it's checking the balance between borrowed funds and shareholders Investments hence a lower debt to equity ratio May indicate lower Financial Risk is calculated as total debt upon total Equity consider two companies company a and Company B both operating in the manufacturing sector let's break down their solvency ratios to understand better about their Financial Health you can take a look at the specific numbers of company a and Company B on your screen therefore the debt to equity ratio for company a comes out to be. 25 this means that company a has taken a strategic approach relying on its internal funds and shareholders Investments rather than external debt on the other hand company B's debt to equity ratio comes out to be 67 meaning that Company B has decided to leverage their operations more aggressively taking on debt a lower debt to equity ratio as in the case of company a indicates a conservative Financial strategy with less Reliance on borrowed funds on the other hand company B's higher ratio suggests a slightly more aggressive approach next up is current ratio while we discussed it under liquidity the current ratio interpretation changes over here in the context of solvency a higher current ratio can be seen as a positive sign indicating the company's ability to meet both short-term and long-term obligations continuing with the same example company A's current ratio will come out to be 1. 67 and Company B's 3. 5 in the context of solvency a higher current ratio is considered positive indicating better capability to meet both shortterm and long-term obligation company B's higher current ratio implies a more robust financial position lastly the interest coverage ratio this ratio measures a company's ability to cover its interest expenses with its operating income it's like assessing if the company generates enough earnings to comfortably pay off its interest obligations this ratio is calculated as operating income upon interest expense again continuing with the same example company A's interest coverage ratio will come out to be eight while company B's four in general a higher interest coverage ratio indicates a better ability to meet interest obligations in this scenario company a demonstrates a stronger capacity to cover its interest expenses as compared to Company B understanding these solvency ratios is Cru crucial for investors as it provides insights into a company's ability to meet its long-term commitments now let's take a virtual tour through ticker tape to see how these ratios are displayed for a company last up is return ratios now that you know how sustainable a company is in the short term as well as in the long term it it's time to check its

returns so let's dive into the return ratios provide us with insights into how efficiently a company is utilizing its resources to generate returns for its investors it's usually denoted in percentage and higher the percentage better it is from a company standpoint let's get into the specific return ratios first is return on investment we are investing our money in a company what do we look at the most obvious answer is return on investments yes that's our first return ratio it measures the performance of an investment and is calculated by dividing the net profit from investment by the initial cost of the investment it's a broader metric that provide insights into the overall profitability of an investment next is return on assets it examines how efficiently a company employs its assets to generate earnings Roa is calculated by dividing net income upon average total assets for example if the same ABC company has a total asset of 50 cross and net income of 20 CR then Roa will be 20 upon 50 which comes out to be4 this means for every 100 rupee worth of assets the company is generating 40 rupees of return moving on to return on Capital employed or roce this metric serves as the efficiency report card showcasing how well a company utilizes its capital to generate profits it is calculated as operating profits upon Capital employed where Capital employed is nothing but total assets minus total current liabilities operating income is the income before interest rest and tax so if ABC company's operating income or ebit is 25 Cross and current liabilities is 10 CR then its roce will come out to be42 which means for every 100 rupees worth of employed Capital the company is generating 42 rupees of return lastly return on Equity or Roe this metric communicates a company's ability to turn shareholders Equity into profits it's the ultimate expression of profitability and shareholder value creation it is calculated by dividing the net income upon average shareholders Equity a higher Roe indicates that the company is effectively using Equity to generate profits hence as per ABC's financials the total shareholder Equity stands at 100 cross therefore the Roe of the company will come out to be02 indicating for every 100 rupes worth of equity the company is generating 20 rupees of return please note that all these returns mentioned doesn't necessarily come to you in the form of cash the company can use some of these profits for expansion and some can be passed on to the investors in the form of dividends to understand more you can check all these ratios under the profitability filter on ticket tap investments in the Securities Market are subject to Market risks read all the related documents carefully before investing