What is meant by ratio analysis?

What is meant by ratio analysis?

Financial analysis using financial ratios is considered to be synonymous with the vertical analysis method, whereby the figures in the financial statements for the same period are compared to enable financial decision, whereby the accounts or items of the financial statements that are linked with causality are compared to enable financial decision, and the outcome of this comparison is a financial ratio.

Deriving a large number of financial analysis techniques and ratio analysis, financial analysts have been able to use them as indicators in assessing the performance of companies and their various activities to make a financial decision.

 Definition of ratio analysis 

Ratio analysis is defined as "the analysis of the financial performance of an entity through different measures including profitability, liquidity, assets efficiency, etc. which enable stakeholders from taking financial decisions"

 Using ratio analysis 

Generally, financial analysis through ratio analysis can be limited to the following five groups of ratio analysis:

1. Liquidity ratios.
2. Measuring activity efficiency ratios.
3. Profitability ratios.
4. Leverage ratios.
5. Market ratios

 Liquidity ratio 

One of the main components of ratio analysis is liquidity ratios are used as instruments to assess an entity's credit position and financial analysis, which usually reflects its ability to meet its short-term obligations. Liquidity is the ratio of the ratio that measures an entity's ability to meet short-term liabilities by providing appropriate liquidity. Cash generated from an activity can also be attributed to sales or debt. Liquidity ratios include:

• Trading ratios = current assets divided by current liabilities.
• Quick liquidity ratio = current assets - inventory and dividing by current liabilities.
• Cash ratio = cash and cash equivalents divided by current liabilities.

 Activity efficiency ratios 

Another component of ratio analysis is activity efficiency ratios is another type of ratio analysis that measures the success of the company in managing its assets and liabilities. In other words, these ratios are financial analysis ratios that measures the company's ability to convert balance sheet accounts into cash or sales amounts. Relative ratio analysis often uses this group to assess the performance of company suspended in the short-term financial position. These ratio analysis use financial analysis to assess the extent to which an entity's management has been successful in managing assets and liabilities. Efficiency ratios are divided in two main groups:

Turnover of current assets and liabilities which include:

• Accounts Receivables turnover = net sales divided by receivables

Relative analysis measures both the efficiency of credit management and the effectiveness of credit and collection policies. The higher the turnover of receivables or the average collection period, the better the indicator and vice versa.

• Inventory turnover = cost of goods sold divided by inventory
• Average stock retention period = 365 divided by stock turnover

The analysis measures the efficiency and effectiveness of inventory management and the higher the stock turnover rate or the lower the average stock retention period, the better the index and vice versa, taking into account that too high increases the risk of inventory management.

• Payables turnover = cost of goods sold divided by creditors

Or = purchases divided by creditors' balance

• Average credit period = 365 divided by turnover of payables

The analysis measures these rates to the extent of the success of the reconciliation between the policies of buying and selling, so the lower the turnover of accounts payable and more than the average credit period, it is an indicator of reducing the pressure that will be placed by the entity from the angle of liquidity, because a financial decision will increase the length of time it gives suppliers to pay purchase invoices and this reduces liquidity pressures.

• Turnover rate of net working capital = net sales divided by balancing net working capital
• The higher this rate was evidence of the efficiency of net capital management and vice versa.

Long-term assets turnover:

Another component of ratio analysis is the efficiency of management in the exploitation of its fixed assets effectively achieve maximum return and the higher these rates was a guide to quality and vice versa, the most important rates:

• Assets turnover = net sales divided by total assets
• Turnover rate of operating assets = net sales divided by total assets - non-operating assets
• Turnover of tangible assets = net sales divided by total assets - intangible assets.

Profitability Ratios:

Since profitability and maximizing the shareholders' wealth is the primary objective of those concerned, financial analysis is interested in studying this part in detail.

Profitability ratios are concerned with financial analysis to measure the company's ability to generate profits from its operating activities. It is preferable to divide profitability ratios into two types as follows:

1. Ratios that measure project profitability based on project sales.
2. Ratios that measure the profitability of the project based on the volume of investments in the project.

Also, the net profit can be attributed to any of the accounts and items of the financial statements, to determine the relationship of contribution to make a financial decision this item in making profit.

Leverage Ratios:

Another component of ratio analysis is leverage which is the extent to which a company relies and makes a financial decision to finance its investments on debt by borrowing or using any financial instrument (such as financial options or futures contracts) that amplifies the impact of profits or losses on an investor. Capital and coverage rates.

Market Ratios:

These ratios measure the impact of the company's performance on ordinary stock prices in the market based on the overall objective of the finance department to make a financial decision to maximize shareholders' wealth by maximizing market share.

 Watch: Ratio Analysis 

With greetings: Al - Manara Consulting to help researchers and graduate students