Financial Ratio Analysis: Definition, Types, Examples, and How to Use

When I first started exploring the area of corporate financial statements, I was totally lost. Numbers were everywhere, difficult terms were the order of the day, and to tell the truth, I even found it hard to recognize the traits of a healthy company financially. But at that moment, ratio analysis turned out to be my savior, and it made my understanding of business money matters smooth.

Therefore, I am going to take you through the complete procedure of financial ratio analysis in the simplest way possible. By the time you complete this tutorial, you will have the capability to view the financial statements of any company and to be completely aware of the situation going on.

What Is Financial Ratio Analysis?

Ratio analysis is a procedure that, in a very simple way, indicates the financial wellness of a company by relating various numbers shown in its financial statements.

It is just like monitoring your health you do not just depend on one measure, right? You take into account your weight, blood pressure, heart rate, etc. Similarly, financial ratios are the main indicators that guide us to see the financial health of a company from different perspectives.

Definition and Overview

To put it simply, the meaning of ratio analysis is: comparing two connected figures from a firm's financial statements by dividing one by the other in order to obtain a significant comparison. These comparisons uncover stories about the company performance.

For example, a company with assets amounting to ₹100 and debts of ₹50 will have a debt-to-assets ratio of 0.5 or 50%. This indicates that the company has financed half of its ownership through loans.

Purpose of Ratio Analysis

I have come across ratio analysis as one of the key financial tools that provide multiple important benefits: understanding performance fast: rather than going through hundreds of pages of financial reports, you can just check 10-15 key ratios and get the whole picture right away. 

Easier comparisons: it is possible to compare a small business with revenue of ₹10 crore to a large company with revenue of ₹1000 crore, since ratios remove the size difference.

Monitoring of problems: this ratios indicate the existence of issues that are not yet evident. I have experienced companies that appeared to be doing well, yet their ratios indicated otherwise.

Supporting better choices: whether as an investor, creditor, or businessman, ratios will provide you with solid numbers to rely on for your decisions.

History and Evolution

The concept of financial ratio analysis is not a recent one. In the beginning of the last century, banks employed ratios as their primary tool in determining the creditworthiness of potential borrowers. With the gradual evolution of the business world, more advanced ratios were created to interpret various dimensions of fiscal well-being.

At present, the ratio analysis method has become an essential tool for all, starting from solo investors and up to huge investment companies.

Who Performs Ratio Analysis

From what I have seen, the practice of financial ratio analysis is related to many different people:

Ratios are used by investors, such as you and me, to come to a conclusion on which stocks to acquire. The management of the company uses ratios for both monitoring and creating strategies.

Financial institutions and creditors analyze ratios in order to determine if they should grant loans or not. Creditors would not hesitate to provide their customers with credit if the latters' ratios were good. The same goes for credit rating organizations, which rely on ratios for their ratings.

On rare occasions, even workers may look at their employer’s ratios as indicators of stability and growth of their positions.

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Understanding Financial Statements for Ratio Analysis

First and foremost, the origin of numbers must be ascertained before any financial ratios can be computed. The four primary financial statements are published by every company, and to tell the truth, once you get these, everything is pretty much clear.

Income Statement (Profit & Loss)

This declaration indicates the financial activities of the solid in terms of money earned and money consumed during a specific period (generally, a year or a quarter). It presents the revenues first and the net profit last.

This document reveals significant figures like revenue (whole sales), cost of goods sold, gross profit, operating expenses, operating profit, interest expense, taxes, and at last net profit.

Balance Sheet

The balance sheet serves as a snapshot of a company’s financial situation as of a certain date, revealing both its possessions and liabilities. It consists of three main parts:

Assets (the company’s property): Among these are cash, stocks, tools, office buildings, and more. Assets are further classified into two categories: current assets (can be turned into cash in less than a year) and non-current assets (long-term assets).

Liabilities (the company’s debts): These comprise loans, bills that have not been paid, and any other debts. Just like assets, liabilities are also classified into two categories: current (repayable within a year) and long-term liabilities.

Equity (the owners’ share): This is the basic difference between assets and liabilities. It is the amount that would go to the owners if the company liquidated all its assets and settled all its liabilities.

Cash Flow Statement

This is probably the most misunderstood statement, but it's extremely important. It shows actual cash coming in and going out of the business.

The statement has three sections: operating activities (cash from main business), investing activities (cash spent on or received from investments), and financing activities (cash from loans or paid to investors).

I've learned that a company can show profit on the income statement but still run out of cash. The cash flow statement reveals this truth.

Statement of Changes in Equity

This particular assertion indicates the alterations that took place in the equity segment throughout the year. Among the items included are the profits which were distributed to the retained earnings, new stocks which were allocated and dividends paid to the investors.

How Ratios Connect These Statements

The strength of ratio analysis lies in the fact that we can interrelate figures from various statements to obtain a more profound understanding.

One such instance is taking the net profit figure from the income statement and dividing it by the total assets figure from the balance sheet to arrive at the Return on Assets (ROA) ratio. This ratio indicates the company's efficiency in using its assets to produce profits.

Another instance of this is the comparison of cash flow from operations reported on the cash flow statement with the current liabilities reported on the balance sheet, which reveals whether the company can meet its short-term debts from the cash it generates.

These interrelationships between statements are the very reason why ratios are considered critical for analysis.

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How Financial Ratio Analysis Works

Let me explain the basic concept behind financial ratio analysis. It's actually quite simple once you understand the logic.

Basic Concept of Ratio Calculation

A ratio is only a means of comparing two figures. In finance, however, we frequently juxtapose the figures to uncover the relationships between them which are not at all apparent when the figures are looked at individually.

For instance, if I were to inform you about a company's cash holding being ₹10 crores, would you consider it a good or a bad situation? You wouldn't be able to tell, would you? But if I further disclosed the short-term liabilities of the firm being ₹2 crores along with the cash holding, you would immediately grasp a valuable piece of information they have cash worth five times that of their short-term debts. This is the usefulness of ratios.

General Formula: Ratio = Value A ÷ Value B

Most financial ratios follow this simple formula:

Ratio = Value A ÷ Value B

Occasionally, we take the outcome and multiply it by 100 to get the percentage but the fundamental notion still holds.

The current ratio is determined as follows:

• Current Ratio = Current Assets ÷ Current Liabilities

• Net Profit Margin = (Net Profit ÷ Revenue) × 100

Step-by-Step Process

Can I tell you about the way I proceed with a statement of financial position comparison?

Choosing the right ratios Not every ratio is applicable in each case. I select ratios according to the piece of information I want to get about the firm.

Financial data collection I take the most recent financial statement of the company. Usually, companies make these publicly available on their websites, and in the case of India, these can be found on the BSE or NSE websites. Moreover, platforms like Dhanarthi provide very user-friendly ways for beginners to access such financial data.

Number calculating I compute each ratio through the formulas. At times, I use a calculator; on other occasions, I work with a spreadsheet.

Result analysis This is the stage where expertise counts. I consider what the value of the ratio indicates is it positive, negative, or alarming?

Comparison with benchmarks: I do the comparison of ratios with both, industry standards and the company's historical ratios as well as that of competitors.

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Types of Financial Ratios

Now comes the important part understanding the different types of ratio analysis. Financial analysts have developed dozens of ratios, but they fall into five main categories. Let me explain each category and the most important ratios in detail.

1. Liquidity Ratios

Liquidity ratios are indicators of the capacity of a company to settle its short-term responsibilities . To put it simply, if the company is supposed to pay its dues the next day, does it have sufficient cash or readily convertible assets?

Liquidity ratios are the first ones I always check because a company may be making profits but still go through bankruptcy if it is unable to settle its urgent accounts. I have already witnessed such a situation, and it is very unpleasant.

Current Ratio

This is the most basic and most frequently used liquidity ratio.

Formula: Current Assets ÷ Current Liabilities

Assuming a corporation possessed:

• Current Assets: ₹150 crore (cash, inventory, receivables)

• Current Liabilities: ₹100 crore (short-term debts, payables)

Current Ratio = 150 ÷ 100 = 1.5

Interpretation:Typically, the desired range is around 1.5 to 3.0. A ratio of 1.5 indicates that for every ₹1 of current liabilities, the company has ₹1.50 in current assets. This is considered to be a good sign overall.

Quick Ratio (Acid-Test Ratio)

This is a stricter version of the current ratio because it excludes inventory.

Formula: (Current Assets - Inventory) ÷ Current Liabilities

Using our previous example, if inventory is ₹30 crore:

Quick Ratio = (150 - 30) ÷ 100 = 1.2

Interpretation:A perfect quick ratio is 1.0 or above. This ratio is less aggressive since the stock is not always readily convertible into cash. We remove inventory to determine the business's immediate liquidity because you cannot turn inventory into cash right away.

From what I have seen, the quick ratio reflects a situation closer to the truth, mainly for businesses with stagnant inventory.

Cash Ratio

This is the most conservative liquidity measure.

Formula: Cash & Cash Equivalents ÷ Current Liabilities

If the company has ₹40 crore in cash:

Cash Ratio = 40 ÷ 100 = 0.4

Interpretation:This indicates that the firm is capable of settling 40% of its current obligations just with cash. The majority of businesses maintain a cash ratio less than 1.0 which is considered normal. Only cash-rich companies, such as tech firms, may have ratios greater than 1.0.

Working Capital Ratio

Formula: Current Assets - Current Liabilities

Working Capital = 150 - 100 = ₹50 crore

Interpretation: The term "positive working capital" refers to a situation in which a corporation's current assets exceed its current liabilities. This ₹50 crores is the company's daily operations fund. A negative working capital situation raises flags unless the company has a specific business model (like certain retailers who get cash first and then pay their suppliers) that allows it to do so.

Operating Cash Flow Ratio

Formula: Operating Cash Flow ÷ Current Liabilities

If operating cash flow is ₹80 crore:

Operating Cash Flow Ratio = 80 ÷ 100 = 0.8

Interpretation:This indicates that the company is capable of using its operational cash flow to meet 80% of its current liabilities. A ratio greater than 1.0 ismaximum it shows that the company has enough cash flow from its business to settle all short-term debts.

2. Profitability Ratios

Profitability ratios are indicators of a company's efficiency in producing profits from its business activities. The ratios provide a clear answer to the query: Is this company a good money maker?

From my point of view, profitability ratios are the key factor for most investors because, in the end, we all desire to be part of the companies that produce great profits.

Gross Profit Margin

This ratio reveals the percentage of revenue that remains after taking away the cost of goods sold.

Formula: (Gross Profit ÷ Revenue) × 100

Example:

• Revenue: ₹500 crore

• Cost of Goods Sold: ₹300 crore

• Gross Profit: ₹200 crore

Gross Profit Margin = (200 ÷ 500) × 100 = 40%

Interpretation: If a company's gross margin is 40% it implies that out of every ₹100 sales the company earns ₹40 after product cost. Higher margins are always better but what is considered as "good" depends on the particular industry. Companies in a software business may have margins of 80% or more, while those in grocery retailing might settle for only 20%-25%.

Operating Profit Margin

This ratio represents operational profits before considering financing costs and taxonomies.

Formula: (Operating Income ÷ Revenue) × 100

If operating income is ₹100 crore:

Operating Profit Margin = (100 ÷ 500) × 100 = 20%

Interpretation: This is a measure of how well the company is performing in its most essential activities. It does not take into account financial costs (for example, interest) and it is completely dedicated to operational efficiency. I apply this ratio for making comparisons between firms operating in the same sector.

Net Profit Margin

To put it simply, how much does every dollar amount of sales flush out as real profit--once all expenses have been considered.

Formula: (Net Income ÷ Revenue) × 100

If net income is ₹60 crore:

Net Profit Margin = (60 ÷ 500) × 100 = 12%

Interpretation:Having a 12% net margin indicates that the business is receiving ₹12 as a profit for every ₹100 in revenue. It is the broadest measure of profitability. I constantly check net margins over multiple years to determine whether the firm's profitability is on the uptrend or the downtrend.

Return on Assets (ROA)

This measures how efficiently a company uses its assets to generate profit.

Formula: Net Income ÷ Total Assets

If total assets are ₹1000 crore:

ROA = 60 ÷ 1000 = 0.06 or 6%

Interpretation: A 6% return on assets indicates that the firm is making a profit of ₹6 for every ₹100 that has been put into assets. A greater return on assets reflects a more efficient use of assets. This ratio can be especially helpful in comparing companies that have different amounts of assets.

Return on Equity (ROE)

I would like to add this shareholders' perspectives-the earnings per share.

Formula: Net Income ÷ Shareholders' Equity

If shareholders' equity is ₹400 crore:

ROE = 60 ÷ 400 = 0.15 or 15%

Interpretation: If a company's ROE is 15%, it indicates that the shareholders will receive ₹15 as a return on every ₹100 they have vested in the company. Warren Buffett is known to search for such companies that have high ROE consistently over a long period. Typical standards deem an ROE of higher than 15% as good, yet still, it depends on the industry.

Return on Capital Employed (ROCE)

This ratio measures how efficiently a company uses all its capital (both debt and equity).

Formula: EBIT ÷ Capital Employed

If earnings before interest and taxes and capital employed are Rs.120 and Rs. 700000, respectively:

ROCE = 120 ÷ 700 = 0.171 or 17.1%

Interpretation: The figure of 17.1% ROCE indicates that the firm is producing the operating profit of ₹17.10 on every amount of ₹100 that is employed as capital. I like to use ROCE rather than ROE when making comparisons among the companies having diverse debt situations since it takes into account all the capital, not just equity.

Return on Investment (ROI)

Formula: (Net Profit ÷ Cost of Investment) × 100

If you invested ₹10 lakh and got back ₹12 lakh:

ROI = [(12 - 10) ÷ 10] × 100 = 20%

Interpretation: This is more commonly used for specific projects or investments rather than whole companies. A 20% ROI means you earned 20% profit on your investment.

EBITDA Margin

EBITDA is an abbreviated that denotes Earnings Before Interest, Taxes, Depreciation, and amortization. This ratio eliminates non-cash deductions thus revealing the real performance of the company in its operations.

Formula: EBITDA ÷ Revenue × 100

If EBITDA is ₹150 crore:

EBITDA Margin = (150 ÷ 500) × 100 = 30%

Interpretation:A 30% EBITDA margin means that there is a high level of operational profitability before making accounting adjustments. This ratio is preferred by a lot of analysts as depreciation and amortization can differ according to the company's accounting policies.

Earnings Per Share (EPS)

This shows how much profit each share of stock earns.

Formula: (Net Income - Preferred Dividends) ÷ Weighted Average Shares Outstanding

In a scenario where the net income stands at ₹60 crore, there are no preferred dividends, and the total number of outstanding shares is Rs. 10 crores, the following calculations can be made:

EPS = 60 ÷ 10 = ₹6 per share

Interpretation: Every share made a profit of ₹6. A higher EPS is preferable, and a consistent increase in EPS is what the shareholders expect the most. I never fail to see if the EPS growth is a result of the real profit increase or merely a consequence of lowering the number of shares.

3. Efficiency Ratios

Efficiency ratios, which are sometimes referred to as activity ratios, assess a firm's ability to produce sales with the help of its resources. It indicates whether the company is working hard or being lazy with its assets.

Asset Turnover Ratio

It reflects the efficiency with which a company uses its assets to produce sales.

Formula: Net Sales ÷ Average Total Assets

If net sales are ₹500 crore and average total assets are ₹1000 crore:

Asset Turnover Ratio = 500 ÷ 1000 = 0.5

Interpretation: A ratio of 0.5 means the company generates ₹0.50 in revenue for every ₹1 of assets. Higher is generally better, but this varies significantly by industry. Retail companies might have ratios of 2-3, while capital-intensive industries like utilities might have ratios below 1.0.

Inventory Turnover Ratio

This measures how quickly a company sells its inventory.

Formula: Cost of Goods Sold ÷ Average Inventory

If COGS is ₹300 crore and average inventory is ₹50 crore:

Inventory Turnover Ratio = 300 ÷ 50 = 6

Interpretation:A turnover of 6 means that the firm sells and replenishes its total stock 6 times in a year. In most cases, a high turnover is considered a good thing for businesses because it implies that the products are not just piled up and waiting for sale. However, an excessively high turnover could indicate that the firm has run out of stocks already.

Days Sales in Inventory (DSI)

It is how many days that the current level of inventory covers the sales number hinted at.

Formula: 365 ÷ Inventory Turnover Ratio

DSI = 365 ÷ 6 = 60.8 days

Interpretation: Selling inventory takes around 61 days on average. A low DSI is generally better but again it depends on the industry. Fresh food businesses need very low DSI (maybe 7 to 14 days), while furniture stores might have DSI of 90 days or more.

Receivables Turnover Ratio

On the other hand, it assesses the speed of payment collection from the customers purchasing goods on credit.

Formula: Net Credit Sales ÷ Average Accounts Receivable

If credit sales are ₹400 crore and average receivables are ₹80 crore:

Receivables Turnover Ratio = 400 ÷ 80 = 5

Interpretation: The firm's collection of its receivables occurs on a yearly basis 5 times. The higher the ratios, the better the company in terms of fast collections, which is a cash flow benefit.

Days Sales Outstanding (DSO)

This is the average number of days it takes to receive a payment after a sale has been made.

Formula: 365 ÷ Receivables Turnover Ratio

DSO = 365 ÷ 5 = 73 days

Interpretation: Typically, 73 days are required to receive payments from customers. The shorter the time taken, the better it is as this signifies faster cash flow. Gradual DSO increase may signal issues with collecting payments.

According to my experience, it is critical to compare DSO with payment terms. In case your payment terms are of 30 days but DSO is 73 days, it means that a large number of customers are paying late.

Payables Turnover Ratio

This measures how quickly a company pays its suppliers.

Formula: Cost of Goods Sold ÷ Average Accounts Payable

If COGS is ₹300 crore and average payables are ₹60 crore:

Payables Turnover Ratio = 300 ÷ 60 = 5

Interpretation: The organization disburses the payments to its suppliers five times in a year. In contrast to receivables, lower isn't always the best here. Extremely fast payments can lead to the loss of cash flow benefits, while very slow payments may cause a rift in the supplier relationship.

Days Payable Outstanding (DPO)

This shows how many days a company takes to pay its suppliers.

Formula: 365 ÷ Payables Turnover Ratio

DPO = 365 ÷ 5 = 73 days

Interpretation: The average time the company takes to settle accounts with its suppliers is 73 days. A longer DPO can be beneficial (maintaining cash for a longer time) but it is necessary to be cautious—extremely long DPO may signal cash flow issues or hurt supplier relations.

Cash Conversion Cycle (CCC)

It is very important to monitor working capital turnover to see how long your final cash is tied up in operations.

Formula: DSI + DSO - DPO

CCC = 61 + 73 - 73 = 61 days

Interpretation: From the moment the company spends cash to cash back, it takes 61 days. Shorter cycles are more advantageous since, in this way, cash is not tied up for a long time.

Negative CCC (as Amazon has) indicates that the company receives money from customers before it pays suppliers that's the utmost efficiency!

I repeatedly check CCC trends throughout times. A shortening (improving) CCC is a sign of better cash management.

Fixed Asset Turnover

It showcases how successful a firm is at utilizing its fixed assets - buildings, plant, machinery, and office equipment - to create sales value.

Formula: Net Sales ÷ Net Fixed Assets

If net sales are ₹500 crore and net fixed assets are ₹400 crore:

Fixed Asset Turnover = 500 ÷ 400 = 1.25

Interpretation:The firm earns ₹1.25 from sales for each ₹1 put into fixed assets. The ratio is especially beneficial when comparing companies in capital-intensive sectors such as production.

Working Capital Turnover

This shows how efficiently a company uses its working capital to generate sales.

Formula: Net Sales ÷ Working Capital

If working capital is ₹50 crore:

Working Capital Turnover = 500 ÷ 50 = 10

Interpretation: The company earns a revenue of ₹10 for every ₹1 of working capital. If the ratios are high, it means that working capital is being used efficiently; however, extremely high ratios might signal that the company has very little working capital to absorb any shocks.

4. Solvency Ratios

Solvency ratios represent the coverage of the long-term liabilities through the asset management of a company, thus the risk of the long-term existence. The ratios show the level of debt of the company and its ability to deal with this burden. 

I watch solvency ratios very carefully because high debt can lead to the collapse of even the most profitable companies during recessions.

This is, without a doubt, the leverage ratio that is observed the most. It relates the entire debt of a company to the equity of the shareholders.

Debt-to-Equity Ratio (D/E)

It is probably the most-watched leverage ratio, which calculates a company's total debt to that of its shareholders' equity.

Formula: Total Debt ÷ Total Equity

If the company's total liabilities amounted to ₹300 crore while its total equity reached ₹400 crore, then the Debt-to-Equity ratio would be calculated as follows: 300 ÷ 400 = 0.75.

Interpretation:The 0.75 ratio points out that the firm owns ₹0.75 worth of debt per ₹1 worth of equity. In general, a lower ratio indicates a safer situation. Ratios over 2.0 are looked at with some concern, but still, it is mostly dependent on the type of release. The banks usually exhibit very high D/E ratios (5-10), and that would be a risk factor for most other companies.

Debt-to-Assets Ratio

As indicated by it, the same percentage of debt has been financed-the assets.

Formula: Total Debt ÷ Total Assets

In the case of total assets being ₹1000 crore, the Debt-to-Assets Ratio shall be 300 ÷ 1000 = 0.3 or 30%.

Interpretation:The company has used 30% of its assets to borrow money and 70% to raise capital through issuing shares. The lower the ratios, the less financial risk is present. For the majority of industries, I like to see this ratio lower than 0.5 (50%).

Equity Ratio

This indicates the percentage of assets which are financed by shareholders' equity.

Formula: Total Equity ÷ Total Assets

Equity Ratio = 400 ÷ 1000 = 0.4 or 40%

Interpretation: 40% of assets are financed by equity. This is the flip side of the debt-to-assets ratio. Together, these two should add up to close to 100% (accounting for minor items).

Debt Ratio

This measures the proportion of a company's assets that are financed by debt.

Formula: Total Liabilities ÷ Total Assets

If total liabilities are ₹600 crore:

Debt Ratio = 600 ÷ 1000 = 0.6 or 60%

Interpretation: 60% of assets are financed by liabilities (both short-term and long-term). This is similar to debt-to-assets but includes all liabilities, not just formal debt.

Financial Leverage Ratio

This shows how much assets the company has relative to equity.

Formula: Average Total Assets ÷ Average Shareholders' Equity

Financial Leverage Ratio = 1000 ÷ 400 = 2.5

Interpretation: The company has ₹2.50 in assets for every ₹1 of equity. This ratio is part of the DuPont analysis (which we'll cover later). Higher leverage can amplify returns but also increases risk.

Gearing Ratio

This is similar to the D/E ratio but sometimes calculated slightly differently.

Formula: (Long-term Debt + Short-term Debt) ÷ Equity

Gearing Ratio = 300 ÷ 400 = 0.75 or 75%

Interpretation: The company has debt equal to 75% of its equity. In the UK and some other places, this is expressed as a percentage rather than a decimal. High gearing means high financial risk.

Interest Coverage Ratio (Times Interest Earned)

This is crucial for understanding if a company can afford its debt.

Formula: EBIT ÷ Interest Expense

If EBIT is ₹120 crore and interest expense is ₹20 crore:

Interest Coverage Ratio = 120 ÷ 20 = 6

Interpretation: The company earns 6 times its interest expense. This means even if profits dropped by 80%, it could still pay interest. Generally, a ratio above 2.5 is considered safe, but I prefer to see 4 or higher. Ratios below 1.5 are red flags.

Debt Service Coverage Ratio (DSCR)

This measures a company's ability to service all its debt (both principal and interest).

Formula: Net Operating Income ÷ Total Debt Service

If net operating income is ₹100 crore and total debt service is ₹50 crore:

DSCR = 100 ÷ 50 = 2.0

Interpretation: The company generates twice the cash needed to service its debt. Banks typically want to see DSCR of at least 1.25 before approving loans. Higher ratios mean safer debt levels.

Fixed Charge Coverage Ratio

This is similar to interest coverage but includes other fixed charges like lease payments.

Formula: (EBIT + Fixed Charges) ÷ (Fixed Charges + Interest)

If fixed charges are ₹15 crore:

Fixed Charge Coverage = (120 + 15) ÷ (15 + 20) = 135 ÷ 35 = 3.86

Interpretation: The company can cover all its fixed financial obligations almost 4 times over. This gives a more complete picture than interest coverage alone, especially for companies with significant lease obligations.

5. Market Value Ratios (Valuation Ratios)

Market value ratios connect a company's stock price to its financial performance. These ratios help investors determine if a stock is overvalued, undervalued, or fairly priced.

In my experience, these are the ratios that get the most attention from stock market investors, and for good reason they directly impact investment returns.

Price-to-Earnings Ratio (P/E)

This is probably the most famous ratio in stock market investing.

Formula: Market Price Per Share ÷ Earnings Per Share

If the stock price is ₹120 and EPS is ₹6:

P/E Ratio = 120 ÷ 6 = 20

Interpretation:A P/E ratio of 20 signifies that investors are ready to invest ₹20 for each ₹1 of the company's yearly profit. The answer to whether this is expensive or cheap is determined by the firm's growth potential and sector. Rapidly growing tech firms can have P/E ratios of 30-50, whereas, in the case of slowly growing utilities, it will be in the range of 10-15.

I consistently evaluate P/E ratios against the company's past average and also against the competitors. An increasing P/E might express an optimistic view, whereas a decreasing P/E would be a sign of discontent.

Price-to-Book Ratio (P/B)

It gives a comparison between share price and book (accounting value) per share.

Formula: Market Price Per Share ÷ Book Value Per Share

If book value per share is ₹40:

P/B Ratio = 120 ÷ 40 = 3.0

Interpretation: The stock is priced at three times its book value. This signifies that the investors are caring for the company threefold considering the value of its assets according to the balance sheet. The P/B multiplier greater than 3 might suggest that the market anticipates the company to grow significantly in the future. P/B ratios are usually applied for the valuation of banks and financial companies.

Price-to-Sales Ratio (P/S)

Many companies are making decisions today based on hypothetical revenue instead of real "net profits."

Formula: Market Capitalization ÷ Total Revenue

If market cap is ₹1200 crore and revenue is ₹500 crore:

P/S Ratio = 1200 ÷ 500 = 2.4

Interpretation: The company gets its foundation put at 2.4 times its yearly sales. A P/S ratio that is lower could signal that the company is undervalued, but this depends a lot on the industry. The P/S of software firms may exceed 10 and that of retailers may be below 1.0.

Price-to-Cash Flow Ratio (P/CF)

This compares stock price to operating cash flow per share.

Formula: Market Price Per Share ÷ Operating Cash Flow Per Share

In case the operating cash flow per share stands at ₹8:

P/CF Ratio = 120 ÷ 8 = 15

Interpretation: A number of investors consider this measure more reliable than P/E since cash flow 

is somewhat more difficult to manipulate than earnings. A P/CF of 15 means you are paying ₹15 for each ₹1 of cash flow that the firm produces.

Dividend Yield

In case the operating cash flow per share stands at ₹8:

P/CF Ratio = 120 ÷ 8 = 15

Interpretation: A number of investors consider this measure more reliable than P/E since cash flow is somewhat more difficult to manipulate than earnings. A P/CF of 15 means you are paying ₹15 for each ₹1 of cash flow that the firm produces.

Dividend Payout Ratio

The dividend payout ratio indicates what part of the profit is given to the shareholders in the form of dividends, showing thus the company's dividend policy.

Formula: Dividends Per Share ÷ Earnings Per Share × 100

Dividend Payout Ratio = (3 ÷ 6) × 100 = 50%

Interpretation: The firm distributes half of its profits as dividends and keeps the other half for reinvestment. Typically, mature firms have payout ratios around 50-70%, whereas growing firms might have lower ratios of 20-30% as they need cash for their expansion activities.

Enterprise Value (EV)

This is the price that might be demanded for the company at least according to the above formula.

Formula: Market Cap + Total Debt - Cash & Cash Equivalents

In case capitalisation of the company is ₹1200 crore, loans taken are ₹300 crore, and the company has income of ₹40 crore:

Enterprise Value = 1200 + 300 - 40 = ₹1460 crore

Interpretation: The whole company would cost you ₹1460 crore at the very minimum. You pay market cap's amount for the stocks, then you add the debt to your cost, and last of all, you subtract the cash that you now own since the company is selling it to you. EV is a more suitable metric than market cap for valuation purpose.

EV/EBITDA Ratio

This popular metric of valuation is considered as being less influenced by differences in accounting practices.

Formula: Enterprise Value ÷ EBITDA

Let us assume EBITDA is ₹150 crore:

EV/EBITDA = 1460 ÷ 150 = 9.73

Interpretation: Roughly 10 times EBITDA value has been assigned to this company. This ratio is very useful for comparing companies with different capital structures. In general, an EV/EBITDA ratio below 10 might indicate a cheap valuation, while a ratio above 15 might indicate an expensive valuation, but this is highly dependent on the industry.

Market Capitalization

Formula: Current Market Price × Total Outstanding Shares

So if we have ₹120 paid for each of the 10 crore shares:

Market Cap = 120 × 10 = ₹1200 crore

Interpretation: The entire market value of the company's shares is ₹1200 crore. Market cap is the factor that usually determines the categorization of companies: small-cap (under ₹5000 crore), mid-cap (₹5000-20,000 crore), and large-cap (above ₹20,000 crore).

6. Cash Flow Ratios

Cash flow ratios are very vital since, to put it another way, cash is the thing that maintains a company’s survival. Bills are paid with cash, not paper profits.

Operating Cash Flow Ratio

We already discussed this in connection with liquidity but it’s still very important to emphasize: the ratio reflects the situation where operating activities generate an amount of cash that is more than enough to settle current liabilities.

Free Cash Flow

Free Cash Flow = ƒOperating Cash Flow - Capital Expenditures

If operating cash flow is ₹80 crore and capital expenditures are ₹30 crore:

Free Cash Flow = 80 - 30 = ₹50 crore

Interpretation: The firm has ₹50 crore in cash remaining after the upkeep and expansion of its asset base. This cash can be distributed as dividends, used for debt repayment, or taken over. I am very fond of positive and growing free cash flow.

Cash Flow to Debt Ratio

Formula: Operating Cash Flow ÷ Total Debt

Cash Flow to Debt = 80 ÷ 300 = 0.267 or 26.7%

Interpretation: The firm is able to produce cash which is equivalent to 26.7% of its total debt annually. It is a sign of a company's good creditworthiness when the cash flow to debt ratio goes upwards. It is also said that a ratio of more than 0.2 (20%) is a sign of good financial health.

Cash Return on Assets

Formula: Operating Cash Flow ÷ Total Assets

Cash Return on Assets = 80 ÷ 1000 = 0.08 or 8%

Interpretation: The firm creates ₹8 in running cash per ₹100 of assets. It is same as ROA but is based on cash flow rather than net income, therefore, it is more difficult to manipulate.

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Applications of Financial Ratio Analysis

Now let's talk about how to actually use all these ratios in practical situations.

Trend Analysis (Time-Series Analysis)

1. Comparing ratios over multiple periods Ratios pertaining to single years cannot depict the whole situation. Ratios' changes over time are what I look at the trend which might be buried under a single view illuminates the scenario.

2. Identifying patterns and trends To illustrate, if ROE is going up steadily during three years from 10% to 12% to 15%, it is a very positive sign. Yet if it is going up and down (15%, 8%, 14%), it may point to a business that is not very consistent in its operations.

3. Year-over-year (YoY) comparison This year ratios are compared with the last year  ratios. A company where liquidity ratios are getting better, solvency ratios are remaining stable, and profitability ratios are growing is likely to be doing good.

4. Quarter-over-quarter (QoQ) comparison For situations that are moving faster, quarterly comparisons help to detect the changes quickly. This is very beneficial for companies that are seasonal.

Example: 5-year trend analysis Assume over five years, a company's net profit margin was: 8%, 9%, 10%, 11%, 12%. That's a gorgeous trend indicating that the company is consistently getting better. However, if it used debt-to-equity going from 0.5 to 0.7 to 1.2 to 2.0; thus, having large concern leverage is increasing rapidly.

Cross-Sectional Analysis (Peer Comparison)

1. Comparing ratios across companies Once I have examined the trends, I undergo the process of competitive company comparison. This makes it clear to the market if the company is a leading one or a laggard.

2. Selecting comparable companies This is very important you will require to compare apples to apples. Whilst studying an IT service company, I take into account only other IT service companies, not product companies or banks.

3. Same industry requirement Different industries must have proportionately different ratio levels. A 5% net profit could be a great margin for a grocery retailer but a very low one for a software company.

4. Similar size consideration Ratios of large companies compared to that of small companies often reveal opposite profiles. They may enjoy better margins due to economies of scale but have lower growth.

Example: Company A vs Company B If Company A shows a return on equity (ROE) of 18% and Company B presents a ROE of 12%, it is clear that Company A is more efficient in utilizing shareholders' funds. I would, however, verify—does Company A bear much more debt? If yes, the higher ROE could be synonymous with higher risk.

Benchmarking Against Industry Standards

1. Using industry averages Every industry has its peculiarities in terms of ratios. For example, IT services companies in India have an average debt-to-equity ratio of less than 0.1 (very low debt) whereas the infrastructure companies may have an average of 1.5 to 2.0.

2. Finding reliable benchmark data Industry wide average numbers are reported by industry organizations, financial data providers, and research reports. Dhanarthi's screener is one of the tools that enable users to easily and promptly trace the industry benchmarks by comparing different companies within the same sector.

3. Interpreting deviations from benchmarks The current ratio of a company could be 2.5 against an industry average of 1.5, which might imply that the company is being very conservative (the good side) or not utilizing its assets to the maximum (the bad side). Therefore, context is very important in this case.

4. Industry-specific considerations There are some industries that have a different way of operating. For instance, retailers usually have negative working capital since they get cash from customers before making the payment to suppliers. This would be a disaster for a manufacturing firm but would be normal for the retail sector.

Example: Comparing to S&P 500 averages In case of an Indian firm, I would rather compare it with Nifty 50 or BSE Sensex averages than S&P 500 as the characteristics of Indian companies are often different.

What Are the Uses of Financial Ratio Analysis?

Let me tell you who uses financial ratio analysis and why this tool is so useful for various individuals.

For Investors

• Investment decision-making
  Ratios are the main criteria of selection when I want to invest in a company. I only choose those with excellent profitability, minor debts, and good efficiency.

• Stock valuation
  Ratios such as P/E, P/B, and EV/EBITDA assist in evaluating a stock as overvalued or undervalued according to its fundamentals.

• Risk assessment
  High debt ratios, liquidity ratios going down, and inconsistent profits are indicators of a high risk investment. I have kept away from some losing investments by being careful of these red flags.

• Portfolio management
  I regularly check the financials of the companies in which I have invested through ratios. If the company's ratios begin to go down, then it may be the right time to sell.

For Company Management

• Investment decision-making
  Ratios are the main criteria of selection when I want to invest in a company. I only choose those with excellent profitability, minor debts, and good efficiency.

• Stock valuation
  Ratios such as P/E, P/B, and EV/EBITDA assist in evaluating a stock as overvalued or undervalued according to its fundamentals.

• Risk assessment
  High debt ratios, liquidity ratios going down, and inconsistent profits are indicators of a high risk investment. I have kept away from some losing investments by being careful of these red flags.

• Portfolio management
  I regularly check the financials of the companies in which I have invested through ratios. If the company's ratios begin to go down, then it may be the right time to sell.

For Creditors and Lenders

• Credit risk assessment
  The banks before giving money carefully analyze the different solvency ratios and the different cash flow ratios. I have noticed that the majority of the banks are looking for a debt-to-equity ratio of less than 2.0 and an interest coverage ratio of more than 2.5.

• Loan approval decisions
  The use of ratios in the lending process gives lenders a clear picture of the financial position of the borrower thus assisting them in making credit decisions and determining the amount to be lent.

• Setting loan terms and covenants
  Lenders often impose through loan contracts certain financial condition ratios like "current ratio to be always above 1.5" in order to make sure that the borrowers are always in good financial condition.

• Monitoring borrower health
  In the post-approval phase of the loan, the lenders use ratios to monitor the financial health of the borrower and to be able to spot problems early and take necessary actions.

For Suppliers

• Assessing Payment Capability Prior to granting credit to customers, suppliers verify through liquidity and solvency ratios that they will be receiving payments.

• Credit Terms Decisions Excellent ratios can lead to a longer payment term or a larger credit limit for customers.

For Regulatory Authorities

• Compliance monitoring Ratios are one of the tools by which regulators ascertain that the companies keep a minimum standard. An instance of this is that banks are required to maintain a specific capital adequacy ratio.

• Industry oversight The different regulatory bodies are watching the different industry ratios and thus can see any systemic problems arising.

For Competitors

• Competitive analysis Firms examine their rivals' ratios to pinpoint strengths and weaknesses in the market.

• Market positioning In case the competitors have substantially higher margins, it may imply either that they have pricing power or they are managing their costs better.

For Employees

• Job Security Assessment By evaluating the financial ratios of their company, employees are able to determine their employer's financial health. The declining ratios might indicate future layoffs.

• Compensation Planning Knowing the company's profit enables the workers to demand higher salaries or stock options.

How to Perform Financial Ratio Analysis (Step-by-Step Guide)

I'll take you through the exact process I use to conduct a ratio analysis from beginning to end.

Step 1: Obtain financial statements

Obtain the most recent annual or quarterly report of the company. In India, these reports can be found on the company's respective website, the BSE or NSE website, or the Ministry of Corporate Affairs website. However, for more convenient access, the websites like Dhanarthi.com compile this information in easy-to-read formats.

Step 2: Identify which ratios to calculate

Determine the importance of making a wellness-related decision before moving forward. Well, what can I do best to keep track—just to keep from staying hopelessly out of control?

• Current ratio and quick ratio (liquidity)  

• ROE and net profit margin (profitability)  

• Debt-to-equity ratio and interest coverage (solvency)  

• Asset turnover (efficiency)  

• P/E ratio (valuation)

Step 3: Extract relevant data from statements

Meticulously extract the necessary figures from the financial statements. Verify again that you are using the correct numbers (for instance, do not mix up operating profit with net profit).

Step 4: Calculate the ratios using formulas

Yes, of course! What we talked about can be done immediately; the few lines of text only took around a minute.

Step 5: Compare ratios over time

Calculate the same ratios spanning the last 3-5 years. Were there any trends in the figures - improvement, static, worsening?

Step 6: Compare with industry benchmarks

Calculate industry average ratios and analyze the difference between your company and the industry. In case of using the tools provided by Dhanarthi.com, the comparison can be viewed automatically because of the financial analysis features.

Step 7: Compare with competitors

To do a competitive analysis, start by calculating the ratios for the two or three largest competitors. Who enjoys better profitability, lower debt, or higher efficiency?

Step 8: Interpret the results

Here is a situation where the application of analytical thinking is very crucial. Gain insight from the fact that ROE is 15%—comprehend what it signifies in the light of the industry. Is it a good figure for the sector? Is the trend upwards or downwards?

Step 9: Identify trends and patterns

Examine links among various ratios. For instance, a situation where profit margins are going down and at the same time debt is on the rise could be interpreted as a warning sign.

Step 10: Make informed decisions

Based on your analysis, make your decision—invest or not, approve the loan or not, expand operations or not.

Why Is Financial Ratio Analysis Important?

I will tell you why I think every person dealing with finance should have an idea about ratio analysis.

Simplifies complex financial data
Financial statements can sometimes be lengthy, even reaching to hundreds of pages. Ratios, on the other hand, summarize the entire data into 15-20 critical numbers that convey the narrative in a very clear manner.

Enables quick performance assessment
I can evaluate most of a company's well-being in 15 to 20 minutes by using key ratios. Without ratios, it would be close to impossible to get there in a matter of hours.

Facilitates comparison (time and peers)
The comparison of absolute numbers for different companies is absolutely meaningless, on the other hand, making use of ratios allows for an easy and meaningful comparison.

Identifies strengths and weaknesses
Where a company shines and where it does not are quickly uncovered by ratios. For instance, if the profit margin is excellent but the cash flow is tight, you will be able to point out the main concern.

Supports decision-making
Itmates not mater wheter you are investing 10 lakh or 10 crores; ratios are merely a form of objective data for making informed assessments besides those combined with gut dictations.

Early warning system for problems
Poor ratios frequently point to troubles even before they come to the surface some time later. I have steered clear of unprofitable investments by spotting the ratios’ red flags.

Tracks progress toward goals
An improved ROE from 12% to 15% within a specific timeline lets you measure progress through each quarter by using ratios.

Communicates financial health to stakeholders
The language in a common set of ratios is a distinct advantage. No one needs an elaborate explanation to understand what "our ROE is 18%" really means.

Industry-standard practice
The language in a common set of ratios is a distinct advantage. No one needs an elaborate explanation to understand what "our ROE is 18%" really means.

Required for compliance and reporting
Many criteria and stipulations impose ratio thresholds by way of what ratio analysis plays a required role in most of such circumstances.

Advantages of Financial Ratio Analysis

Let me give you a quick overview of the main advantages of ratio analysis:

Simplification: It simplifies thousands of numbers into metrics that are easy to digest and understandable by anyone.

Comparison: It allows you to compare companies of very different sizes or those from different periods.

Trend Identification: It brings out the patterns that might be hidden by raw numbers over time.

Early Warning: It serves as a smoke detector, indicating potential problems before they escalate to a crisis.

Performance Measurement: It furnishes objective and quantifiable measures of either success or failure.

Decision Support: It provides hard data to back up investment, lending, or management decisions.

Standardization: It establishes a universal language that is applicable in all industries and nations.

Efficiency: It provides the means of quick analysis without losing the big picture and getting caught up in details.

Forecasting Aid: The trends in historical ratios can be used to reasonably predict future performance.

Stakeholder Communication: It enables the simple and succinct communication of intricate financial matters to various audiences.

Disadvantages and Limitations of Financial Ratio Analysis

I have recently realized that ratio analyses may not practically answer all questions because the method itself might have limitations.

1. Historical Data Limitation

Looking back at previous results
Historical data is used to calculate ratios. They indicate past events, but not necessarily future ones.

Not necessarily a true representation of the present
A ratio derived from the previous year's statements might not account for the important alterations that have recently occurred. In case the firm has just lost its main client last month, past ratios would be oblivious to that fact.

Fortune-telling impediments not illuminated
Ratios are unable to foresee the unexpected events such as new regulations, disruptive technologies, or financial crises.

2. Accounting Differences

Different accounting methods (FIFO vs LIFO)
Depending on the accounting method applied, two identical companies can declare different incomes and report different stock values. This scenario makes it difficult to draw comparisons.

Different depreciation methods
The difference between straight-line and accelerated depreciation methods can result in a significant difference in profits reported by a company, although no change in economic reality has occurred.

Accounting policy variations
Companies have the freedom of choice to determine the accounting treatment for warranty costs, bad debts, and revenue recognition.

GAAP vs IFRS differences
An Indian company following Ind AS may present different figures than a US GAAP or old Indian GAAP company, making it harder to conduct international comparisons and complicating the situation.

3. Industry Variations

Ratios differ from one industry to another
What is considered a great ratio in the retail industry may be counted as a bad one in the software industry. Therefore, to rightly interpret ratios, one must consider the industry context.

Not universally comparable
It is an exercise in futility to compare the ratios of a bank with those of a manufacturing company since they are based on entirely different business models.

Different business models
Even in the same industry, different business models result in different ratio profiles. An asset-heavy manufacturer will have different ratios than a service company with no assets.

Capital intensity differences
Industries that require a lot of capital have lower asset turnover ratios. That does not mean they are not efficient; it is just the nature of the business.

4. Seasonal Factors

Seasonal businesses reveal changes in numbers.
It is a fact that a retailer's ratios would appear quite different in December i.e. after holiday sales compared to January. The comparison should be made for the same seasons.

The time of analysis is significant.
In the case of seasonal businesses, a ratio calculated on December 31st could be very different from one calculated on June 30th.

The need for comparisons of the same periods.
Always compare Q4 with Q4, not Q4 with Q1, unless you adjust for seasonality.

5. Inflation Effects

Historical costs may be distorted
Assets that were acquired two decades back are still on the books at historical cost, which possibly represents only a small part of the present replacement cost.

Inflation not reflected in ratios
In times of high inflation, the sales increase but the assets are still on the books at historical cost, and as a result, the return ratios are also inflated.

Comparisons over long periods problematic
It is hard to compare ratios from 2000 with those from 2024 because of a significant change in the value of money over that time span.

6. Window Dressing

Firms may alter their metrics
In the run-up to reporting dates, firms might resort to such maneuvers as postponing purchases in order to lower accounts payable or liquidation of assets to enhance cash flow, just to show better ratios for a short time.

Methods of accounting creativity
Permissible but bold accounting can present the ratios more favorable than the actual economic situation.

Adjustments at the end of the period
Firms would probably schedule their transactions closely around the end of the period in order to reach the intended level of the ratios.

7. Qualitative Factors Ignored

The quality of management not assessed
The ratios do not indicate whether the management of the company is excellent or poor, however, the success of the company in the future will depend on this aspect.

Employee morale not depicted
It may happen that the financial ratios are just great, but in the company, there is going on the massive layoffs of the key employees which would affect the company's progress.

Brand value not shown
Outstanding brands do bring in a lot of money but still it will not be visible on the financial statements or through the ratios.

Innovation and R&D prospects not detected
The old ratios do not capture the potential for future innovations.

Market conditions not considered
The ratios do not give any information about the competitive situation or market trends that will have an impact on the future performance.

8. Size and Scale Issues

Hard to make comparisons between companies of different sizes
Even ratios assist a lot, but still the vast size differences cause difficulties in comparison.

Ratios do not indicate absolute values
A 20% ROE on ₹1 crore equity produces a profit of ₹20 lakh. A 15% ROE on ₹1000 crore equity translates into a profit of ₹150 crore. The one with the lower ratio, in fact, gives better absolute returns.

9. One-Dimensional View

One ratio doesn't tell the whole story
It is very dangerous to rely on only one ratio. A great P/E ratio is not very helpful if the company has heavy debts.

Various ratios for a full view
I always analyze liquidity, profitability, efficiency, and solvency ratios concurrently in order to get the whole story.

10. External Factors Not Considered

Economic situations
The ratios do not indicate whether we are in a boom or a recession.

Regulatory circumstances
Changes in regulations or political instability might have significant impacts on the company's performance but still, such influences will not appear in the historical ratio.

The introduction of disruptive technology
A business may report excellent ratios just before a transformative technology renders its business model out of date.

Rivalry scenario
The arrival of new rivals or shifts in the competitive landscape do not get reflected in the ratios until they have a consequence on the results.

Best Practices for Financial Ratio Analysis

Based on years of experience, here are my recommended best practices for doing ratio analysis properly:

Use multiple ratios, not just one
I typically calculate at least 10-15 ratios to get a complete picture. Relying on one or two is dangerous.

Always compare with benchmarks
Never evaluate ratios in isolation. Compare with industry averages, competitors, and the company's own history.

Analyze trends over time
I always look at 3-5 years of data to see trends. A single year might be an anomaly.

Consider industry context
What's normal in one industry is abnormal in another. Always keep industry characteristics in mind.

Understand accounting policies
Check the notes to financial statements to understand accounting policies that might affect ratios.

Look beyond the numbers
Read management commentary, news articles, and industry reports to understand the story behind the numbers.

Use both absolute and relative analysis
Look at both the absolute numbers and the ratios to get complete understanding.

Verify data accuracy
I always double-check that I've extracted the right figures from financial statements before calculating ratios.

Update analysis regularly
Don't do one analysis and forget about it. I review key ratios quarterly for my investments.

Combine quantitative and qualitative analysis
Numbers alone aren't enough. Consider management quality, competitive position, and industry trends too.

Document your methodology
Keep notes on how you calculated ratios and what assumptions you made. This helps when reviewing your analysis later.

Be aware of seasonality
For seasonal businesses, make sure you're comparing equivalent periods.

Common Mistakes to Avoid

Give two shout-offs when recommendations speak to having more significant meanings.

Relying on a single ratio
Always do not make decisions using a single ratio. I was about to invest in the company with good P/E ratio and I realized that the debt-to-equity of this company was greater than 3.0. Disaster avoided.

Disregard of differences in industries
It is futile comparing the ratios of a tech company with that of a steel company. Remain within the boundaries of the industry.

Not considering context
A decreased current ratio could be a bad thing or could be that the company is becoming more efficient with the current assets. Context matters.

Comparing companies not comparable
Comparing a startup that is in growth mode with a mature and paying dividend-bearing company is not a good idea. They are at varying stages of life.

Ignoring accounting disparities
When one company aggressively recognizes its revenue under the basis of aggressive recognition, and the other company is conservative, then their margins, they are not really comparable.

Disregard of qualitative aspects
Figures do not speak the truth. A firm whose ratio is ideal and yet the management is awful will not perform in the long run.

Failure to update analysis on a regular basis
Business conditions change. The one-year analysis may be totally obsolete.

Ratio values are misinterpreted
The current ratio of 0.8 is alarming in most companies, yet there are retail giants who work with negative working capital.

Picking of desirable ratios
Do not merely put initial focus on the good ratios and leave aside the bad ones. See everything impartially.

Not verifying data sources
Reliable sources of official financial statements should be used. I would also rather find the data in company websites or in their regulatory filings than on third parties which could be erroneous.

Financial Ratio Analysis vs Other Analysis Methods

Ratio analysis is powerful, but it's not the only tool in the toolbox. Let me explain how it compares to other analysis methods.

Ratio analysis vs fundamental analysis
Fundamental analysis is the broad term for analyzing a company's intrinsic value. Ratio analysis is actually a component of fundamental analysis, along with studying business models, competitive advantages, management quality, and industry dynamics.

I use ratios as the quantitative backbone of fundamental analysis, then add qualitative judgment.

Ratio analysis vs technical analysis
Technical analysis studies stock price movements and trading volumes to predict future prices. It completely ignores financial statements and ratios.

In my approach, I use ratios to select fundamentally sound companies, then might use technical analysis to time my entry and exit points.

Ratio analysis vs cash flow analysis
Cash flow analysis digs deep into the cash flow statement to understand exactly how cash moves through the business. Some analysts prefer this over ratio analysis because cash is harder to manipulate than accounting profits.

I use both. Cash flow ratios (like operating cash flow ratio) bridge the two approaches.

Complementary nature of different methods
The best analysis combines multiple approaches. I use ratio analysis for quantitative assessment, qualitative analysis for business model understanding, cash flow analysis for operational reality, and sometimes technical analysis for timing.

When to use which approach
For long-term investing, I rely heavily on ratio analysis and fundamental analysis. For short-term trading, technical analysis becomes more relevant. For lending decisions, cash flow analysis and solvency ratios take priority.

Conclusion

Financial ratio analysis is regarded as a potent method to gain insights into the comprehensive financial standing of a company. The combined use of liquidity, profitability, efficiency, solvency, and market value ratios helps to create a performance view that is both clear and balanced.

The not-well-acquainted ones with the subject may concentrate their attention on the current ratio, net profit margin, ROE, debt-to-equity, and P/E as the key ratios. Ultimately, through frequent practice, ratio analysis will transform into an intuitive and greatly useful tool for assessing businesses efficiently.

Disclaimer : This analysis is for educational purposes and not financial advice. Please consult a financial advisor before making investment decisions.

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