Ratio Analysis: How it Helps Determine A Company’s Financial Health

Tally Solutions |Updated on: April 25, 2023

Determining the financial health of your business depends on several aspects. One of them is ratio analysis which draws a clear comparison of line items in the financial statements of a business.

What is Ratio Analysis?

Ratio analysis is a powerful tool for financial analysis. The report indicates the health of the business using the defined formula. The higher / lower ratio indicates good /poor liquidity position of the business. This report is not just useful for the stakeholders outside of a firm who do not have direct access to other crucial financial statements like balance sheet, profit and loss statement, etc, but also for internal management. Ratio analysis report permits the stakeholder of an entity to make better sense of the accounts and better understanding of the current fiscal scenario.

Objective of Ratio Analysis

Ratio Analysis is a powerful tool for financial analysis. The analysis of a financial statement is made possible by the use of financial ratios.

Ratio Analysis in TallyPrime helps you compare different sets of financial data. This comparison gives an understanding of the financial position of a business unit. The Ratio Analysis report consists of Principal Groups and Principal Ratios. The Principal Groups are the key figures that give meaning to the ratios. Principal Ratios compare two pieces of financial data to for a meaningful comparison. You can view this report in the browser.

Profitability measurement

Profit is always the ultimate motive behind running a business. If a company is selling goods on a large scale, that does not necessarily mean that it’s making profits. The crucial part is drawing a comparison of two numbers with respect to each other and calculate the net profit. Ratio analysis also helps a company in determining the use of its assets and how these assets are incurring profits. To measure profitability, you must get adequate information on Gross Profit Ratios, Net Profit Ratio, Expense ratio etc which measure the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.

Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is crucial that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses and prevent cash blockages. Turnover Ratios will point out any mismanagement of assets. A single ratio may sometimes give some information, but to make a comprehensive analysis, a set of inter-related ratios are required to be analysed and that’s exactly what ratio analysis does.

Ensure Suitable Liquidity

Every firm must ensure that some of its assets are liquid, in case of emergencies when cash is required. Thus, the liquidity of a firm is measured by ratios such as Current Ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.

Determine Long-Term Solvency

There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is highly in debt. The management will need to immediately address and rectify the situation to avoid liquidation in the future.

Working Capital Ratios

Like the Liquidity ratios, it also analyses if the company can pay off the current debts or liabilities using the current assets. This ratio is crucial for the creditors to establish the liquidity of a company, and how quickly a company converts its assets to bring in cash for resolving the debts.

With Tally Prime’s Ratio Analysis report you can get a clear picture between the principal groups and key figures in detail instantly without any added efforts. From determining the efficiency ratio to sundry debtors and sundry creditors to the inventory turnover, get information about all the crucial aspects which impact the financial health of a business in a single shot.

TallyPrime's detailed view helps you get a clear picture of:

• Working Capital: The Net Working Capital is calculated by subtracting Current Liabilities from Current Assets. Financial analysts often consider the total Current Assets as the Working Capital. This serves as a measure of how far the firm is protected from liquidity problems.
• Cash in Hand and Bank Balances: This data provides another view on the liquidity position.
• Sundry Debtors (due till today): This is the list of all the debtors and total debts due as on the date of the statement.
• Sundry Creditors (due till today): This is the list of all the creditors and total credits due as on the date of the statement.
• Sales and Purchase Accounts: The Sales and Purchase Accounts, which represent the trading activity for the period, are displayed.
• Stock-in-Hand: The Stock-in-Hand is displayed as on the date of the report. Together with Cash and Bank Balances and Debtors, this completes the Current Assets aspect of the Working Capital.
• Net Profit: This is derived from the Profit & Loss Account, and is the profit that remains after direct and indirect expenses.
• Working Capital Turnover (Sales Accounts/Working Capital): This is an activity or efficiency ratio that shows the number of times the working capital has been rolled over during a particular period. It depicts how effectively the firm is using its working capital.
• Inventory Turnover (Sales Accounts/Closing Stock): This is an activity or efficiency ratio that shows the number of times the stock has been rolled over during the period of the report. It depicts how effectively the firm is using its inventories.

Another important lever which regulates regular cashflow in your business, payment performance of debtors is also detailed out in ratio analysis. Both the receivable turnover in days and the customer's actual payment performance is displayed in the report which helps you take appropriate decision to avoid blockage of cash.

Simply drill down from the required group and you can view the party ledgers under the selected group. The Ledger Payment Performance statement displays the receivable turnover in days. This is the balance outstanding in relation to the total sales made, multiplied by the total number of days in the period. This ratio should be used in combination with the Average Performance of actual payments and the payment history of the customer to assess how long they might take to pay the outstanding balance.

Categories of Financial Ratios

There are mainly 5 categories of financial ratios, namely - Liquidity Ratios, Solvency Ratios, Profitability Ratios, Efficiency Ratios, and Coverage Ratios. 

Liquidity ratio

Liquidity ratio analyzes an organization's current or quick assets to measure the capacity to pay off short-term debt as they become due. It incorporates the current, quick and working capital ratio.

Solvency ratio

Solvency ratio refers to the process of comparing the debt level of a company with its assets, equity, and earnings to assess the probability of an organization's ability to stay afloat in the long-term by paying off its debt and associated interest.

Profitability ratio

Profitability ratio depicts the amount of profit an organization can generate through its operations. Some of the examples of profitability ratio are profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.

Efficiency ratio

The efficiency ratio assesses how effectively a company can utilize its assets and liabilities to churn sales and increase profit margins. Also known as activity ratio, efficiency ratio consists of turnover ratio, inventory turnover, and days' sales in inventory.

Coverage ratio

Coverage ratios gauge an organization's capability to pay interest and other liabilities associated with its debts.

To get a better understanding of how ratio analysis will help you get a clear picture of your company’s finances, take a free trial now.

FAQs

What is ratio analysis? 

Ratio analysis refers to the process of analyzing a company's financial statements to gain insight into a its liquidity, operational efficiency, and profitability. 

What are the types of ratio analysis?

Some of the types of ratio analysis include Liquidity Ratios, Solvency Ratios, Profitability Ratios, Efficiency Ratios, and Coverage Ratios.