To judge the overall financial health of a company, analysis of some ratios from the financial statements can prove to be useful.
Ratio analysis is used to evaluate the relationship between financial statements. Various ratios can be used to identify trends over time for one company or to compare two or more companies. Additionally, ratio analysis helps you judge all the companies on the same metrics, despite the differences between their volumes of sales, the costs that they incur, etc.
Ratio analysis can be used for the following purposes:
- To evaluate performance over time
- To evaluate performance against industry average
- To evaluate performance against peers
There are four categories of ratios that will help you perform a critical evaluation and delve deeper into the figures mentioned in the financial statements. The categories are as follows:
- Liquidity Ratio
- Solvency Ratio
- Profitability Ratio
- Efficiency Ratio
Solvency ratios:
Suppose you are the manager of an FMCG company, and you decide to start a variety of company products that you need to borrow. Do you think any lender can invest in your company without analyzing the solvency status of your company?
Solvency ratios measure the ability of a company to fulfil its long-term obligations as and when they are due.
What, according to you, will be the most important factor in the consideration of lenders?
However, lenders may want to invest in a company that is able to repay their interest rates on time and repay them in real time. But, how do they confirm this?
Much analysis is done before lenders make any investment. Part of the analysis involves calculating the company's solvency estimates.
The three types of solvency ratios are as follows:
Debt-to-equity ratio: This ratio measures how much debt the company has taken for every rupee of equity invested in the company.
A high ratio indicates that the company will use more debt to fund new projects. However, the inability to pay the interest obligation on a high debt may result in the company going insolvent.
It is calculated using the following formula:
| Debt | ratio = | Short−term debt + Long−term debt |
| Equity | Shareholders′ equity |
Debt-to-asset ratio: This ratio measures how much asset is funded by debt and how much is funded by equity.
The higher the ratio, the more alarming is the situation.
It is calculated using the following formula:
| Debt | ratio = | Short−term debt+Long−term debt |
| Assets | Total assets |
Interest coverage ratio: It measures the ability of the company to pay interest and interest expenses as and when they are due. It shows how many times the company's earnings before interest and taxes EBIT can cover its interest obligation.
The higher the ratio, the better it is for the company.
It is calculated using the following formula:
| Interest coverage ratio | = | Earnings before interest and taxes (EBIT) |
| Interest expense |
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