A financial ratio analysis explains how well a company is performing. It indicates whether the business is profitable, cash-generative, or too indebted. Simply put, financial ratio analysis is a number-based analysis of a company’s accounts to check its health. It provides insights into a company’s profitability, spending, and growth. Investors use these ratios to make informed business or investment decisions.
Financial ratio analysis allows comparisons between one company and another. It also tracks how a company develops over time. This tool comes in handy for investors or business owners who are looking to expand.
What are Financial Ratios?
Financial ratios are nothing more than simple math tools. To get them, people divide one number from a company’s financial statement by another number. These ratios provide insights into profitability, leverage, liquidity, etc. These ratios help people analyze a company’s performance. These ratios assist investors in determining whether or not to invest in a company. They also help business owners understand how well their company runs. The ratios are a great way to rationalize financial decision-making.
Begin your financial ratios with simple examples. A financial ratios list is used to gain insight into the ratios.
| Financial Ratio | Formula | What It Shows |
| Current Ratio | Current Assets / Current Liabilities | Company’s ability to pay short-term bills |
| Debt to Equity Ratio | Total Debt / Total Equity | Company’s reliance on debt compared to equity |
| Return on Assets | Net Income / Total Assets | Profit earned from using assets |
| Net Profit Margin | Net Profit / Revenue | Profit kept from each rupee earned |
| Inventory Turnover | Cost of Goods Sold / Average Inventory | How fast inventory is sold |
Every Ratio provides this new insight. Others, how much debt a company carries. Some demonstrate whether a company makes enough profit. Some tell us how fast a company pays its bills. These financial ratios formulas are simple to learn but provide powerful information.
Financial Ratio Analysis
What we have seen above are different sides of ratios pertaining to a business. Some tell us about profits. Some tell about debts. They are doing a strong job of calling attention to how a company functions on a day-to-day basis. Types of Financial Ratios are as follows:-
Liquidity Ratios
Liquidity ratios indicate whether a company can pay all of its short-term debts. They assist during emergencies. So, the most common one that would apply here is the Current Ratio. It uses the following liquidity ratio formula:
Current Ratio = Current Assets / Current Liabilities
A ratio greater than 1 indicates that the company is able to pay its bills. Below 1 means trouble. The Quick Ratio is another liquidity ratio. It also takes inventory out of current assets for tighter control.
Profitability Ratios
How much money a business makes is determined through profitability ratio analysis. For example, they can be the Net Profit Margin and the Return on Assets.
Net Profit Margin = Net Profit ÷ Revenue
Δ Return on Assets = Net Income / Total Assets
These ratios tell you how effectively a company is using its money to generate profits. These tell people if the business is worth investing in.
Solvency Ratios
Reduced solvent ratios with examples allow us to know whether a corporation has the means to repay long-term loans. One of the most common is the Debt to Equity Ratio.
Debt to Equity Ratio = Total Debt Total Equity
A higher number indicates excessive debt for that company. The Interest Coverage Ratio is another example. It shows how easily a company can make interest payments.
Efficiency Ratios
These are ratios that indicate how efficient a business is at using resources. The Inventory Turnover Ratio is perhaps the most common example.
Inventory Turnover = COGS / Average Inventory
It tells us how quickly a company moves product. A higher number indicates better stock management.
Market Ratios
These ratios allow investors to determine whether a stock is the right price or not. One such metric is the Price to Earnings (P/E) Ratio.
P/E Ratio = Market Price per Share/Earnings per Share
A high P/E indicates high hopes for growth. A lower P/E means a lower market belief the company will grow. We can use these types of financial ratios to interpret ratio analysis. They provide full views from various perspectives.
Why Financial Ratio Analysis is Important?
With actual infallible, valid grounds, you either believe a business/ investment or you do not! It is sort of a health report card for a company.” Business owners use it to grow. Investors use it to keep them safe.
For Investors
For investors, ratio analysis provides facts. Investors don’t need to speculate. They see whether the company is making money, managing debt, and growing consistently.
For instance, a Net Profit Margin represents how much profit the business keeps with each sale. A high Debt to Equity Ratio indicates risk. Investors shun such companies.
These ratios also play a role in comparing a company to another company within the same field. It shows investors who perform better.
For Business Owners
Ratios help business people identify the problem. They fix cash flow if the Current Ratio is low. Things if Inventory Turnover is slow, so the product movement is.
Such ratios are helpful in the determination of targets. Businesses become better at producing more ROX over time. Metrics with Numbers Owners Can Measure Success.
Business owners also use these to speak with banks or investors. Loans are easy to get if the ratios are good. It builds trust.
Real Use Cases
Let’s take an example. A small business that wants to expand needs a loan. The bank investigates its solvency ratios with examples. It analyzes the debt-to-equity and Interest Coverage Ratio.
The bank assigns a loan if the business passes. If not, the business needs to correct its finances first. This is an example of financial ratio analysis in real life.
Limitations of Financial Ratio Analysis
The ratio analysis is quite useful, but it has few limitations. They need to be known to avoid wrong choices. Knowing these limits allows you to make better use of financial ratio analysis.
Changes in Accounting Rules
One major concern is changing accounting practices. The two companies could do it differently, Which makes their ratios difficult to compare. Ratio results may also change, even within one company, if rules change.
This is an even bigger problem in global comparisons. Keep in mind that companies in India might have different standards when compared to companies in the USA or UK. So, the ratios won’t match.
Time-Based Comparisons
The data for financial ratios analysis many times is taken from a single year. But companies change fast. A single good or bad year can send false signals.
For example, the Net Profit Margin of a business may appear lousy if it suffered a one-time loss due to an accident. Yet, this does not reflect the actual state of the business. To see the real picture, you have to look at many years.
Industry Differences
Industry standards differ across fields. For example, the inventory turnover ratio of a retail company would be completely different from that of a service-based company.
Results are not useful if you compare them. Comparing companies from the same industry is always a good idea. That’s how you achieve a balanced perspective.
Ignores Non-Financial Factors
The financial ratio analysis, on the other hand, is based only on numbers. It does not indicate whether workers are happy or whether the company has a strong brand name.
A business with weak ratios may still be good for some other good reasons. So don’t trust numbers alone. They use ratios and real-world knowledge.
Risk of Manipulation
Companies may also report fake profits or conceal debt. This improves the appearance of their ratios. Investors who believe in this fake data might lose money as a result.
And that’s why it’s good to make sure the company is being honest. Always read all audit reports and other documents.
These all are the limitations of financial ratio analysis. These do not imply you should not use ratios. But you must use them wisely.
Relevance to ACCA Syllabus
Nothing is more fundamental to ACCA Financial Reporting (FR) and Strategic Business Reporting (SBR) papers than financial ratio analysis. It helps students understand various features of company performance, liquidity, solvency, and efficiency through ratio interpretation. Students prepare for the ACCA using this to compare companies, spot trends, and make choices — all things that we assess in both objective questions and case-based.
Financial Ratio Analysis ACCA Questions
Q1. What The Current Ratio can tell you The Current Ratio
A) Profitability
B) Solvency
C) Liquidity
D) Efficiency
Ans: C) Liquidity
Q2. What is a profitability ratio measure?
A) Quick Ratio
B) ROCE (Return on Capital Employed)
C) Inventory Turnover
D) Debt-to-Equity Ratio
Ans: B) Return on Capital Employed(ROCE)
Q3. So what does it mean to have high gearing for a business?
A) High liquidity
B) Low risk of default
C) Greater reliance on equity
D) Greater reliance on debt
ANS: D) More reliance on debt
Q4. A low inventory turnover ratio is what?
A) Strong sales
And option B) products that are slow or overstocked
C) Identified inventory management success
D) High return on sales
Ans : B) Excess Inventory or Slow-moving Merchandise
Q5. Which of the following ratios is the most accurate indicator of how effectively a company is using its assets to generate a profit?
A) Operating Profit Margin
B) Asset Turnover Ratio
C) Current Ratio
D) Debt Ratio
Ans: B) Asset Turnover Ratio
Relevance to US CMA Syllabus
One is carrying out financial ratio analysis, it is part 1: Financial Planning, Performance, and Analytics of US CMA (Certified Management Accountant) syllabus. Performance and Risk Assessment: Key Financial Ratios That Aid Management Decisions — This is one of the key focus areas of the CMA exam. Benefits of Ratio application in budgeting, forecast, and variance analysis.
Financial Ratio Analysis US CMA Questions
Q1. What does a debt-to-equity ratio tell you?
A) Cost of capital
B) Profits not reealized until in the hands of stockholders
C) Company Financial Leverage
D) Operating cost structure
Explanation: C) Company’s Financial Leverage
Q2. What metrics would you like to see to measure operational efficiency?
A) Net Profit Margin
B) Inventory Turnover
C) Earnings Per Share (EPS)
D) Quick Ratio
Ans: B) Inventory Turnover
Q3. A quick ratio below 1 means:
A) The dosh simply flows with no difficulty to the firm for its liabilities
A) more current liabilities than quick assets
C) Company has NO Long term debt
D) Liabilities exceed assets
Ans: B) Quick assets>Current liabilities
Q4. Which Ratio help you to determine the profitability of a company in its core business operations?
A) Return on Equity
B) Gross Profit Margin
C) Operating Profit Margin
D) Price-Earnings Ratio
Ans: C) Operating Profit Margin
Q5. This ratio measures capital employed in order to obtain profits, which of the following?
A) ROCE
B) Current Ratio
C) Inventory Turnover
D) Debt Ratio
Ans: A) ROCE
Relevance to US CPA Syllabus
Thus, analyzing financial ratios is used by students to learn and apply to find out the performance of a company, especially in the areas of FAR & BEC on the US CPA test. It is important for financial statement analysis, determining a business’s health and making audit-related decisions and managerial decisions. CPA candidates will be stepping into actual companies and using ratios.
Financial Ratio analysis US CPA Questions
Q1. This is a yardstick of near-term financial strength.
A) Return on Equity
B) Earnings Per Share
C) Current Ratio
D) Dividend Payout Ratio
Ans: C) Current Ratio
Q2. When you have a high ROE, what does it essentially tell you?
A) The company is overvalued
Over time, B) they have delivered strong returns to their shareholders, the analysis finds.
C) High gearing
D) Low profit margin
A) Require good returns to the shareholders
Q3. Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
A) Gross Profit / Total Assets
B) Gross Profit / Net Sales
C) Operating Income / Revenue
D) Net Income / Revenue
Ans: B) GROSS PROFIT / NET SALES
Q4. Interest coverage ratio across all 3 markers—100
A) Ability to repay principal
B) Return to Investors
C) Interest coverage ratio
D) Tax efficiency
Ans: C) Year long payment of interest on debt
Q5. Why do you think asset use efficiency ratio is the best?
A) Debt Ratio
B) Total Asset Turnover
C) Quick Ratio
D) ROE
Ans: B) Total Asset Turnover
Relevance to CFA Syllabus
A crucial aspect underlying equity considerations and credit risk in the CFA Program (especially for Level 1 and 2) is financial ratio analysis. This is background candidates study in Financial Reporting and Analysis (FRA). All of these are essential for live financial modelling and investment analysis and the ratios are immensely useful for CFA candidates to understand profitability, valuation, leverage and risk.
Financial Ratio Analysis CFA Questions
Q1. What Ratio is used to evaluable its profit in relation to total assets?
A) ROE
B) Operating Margin
C) ROA
D) Debt/Equity
Ans: C) ROA
Q2. The best basis on which to compare a business on the equity markets.
A) Quick Ratio
B) EPS
C) P/E Ratio
D) Current Ratio
Ans: C) P/E Ratio
Q3. It indicates:
A) High liquidity
B) Strong financial health
C) Risk of default
D) High return on capital
Ans: C) Risk of default
Q4. The DuPont analysis breaks down ROE into what?
A) Understanding liquidity, solvency, and valuation
B) Profitability and efficiency and leverage
C) Value of assets, and debt and cash flow
D) earnings, capitulation, and taxes
Ans: B) Efficiency, Leverage and Profitability
Q5. Long-term Growth and Profit – What relevant Ratio: medieval store perspective and marketplace
A) P/E Ratio
B) Inventory Turnover
C) Debt Ratio
D) ROCE
Ans: A) P/E Ratio
