Question

Explain the various categories of ratio analysis and provide examples of at least two ratios in each category. If you were an investor, which category would you be most interested in? Why?

Answer 1

Part-1

Ratios are used by lenders and business analysts to determine a company's financial stability and standing.It's important to understand that financial ratios are time sensitive; they can only show a picture of a business at a given time. There are five catagories of Financial ratios and those are as follows :

Part-2 :

There are a large variety of ratios out there, but for an investor using financial ratios which are broken up into four major categories: profitability ratios, liquidity ratios, solvency ratios and valuation ratios. As an investor he should consider Profitability ratio because Profitability ratio is a key piece of information that should be analyzed when you're considering investing in a company. This is because high revenues alone don't necessarily translate into dividends for investors unless a company is able to clear all of its expenses and costs. In general, the higher a company's profit margin, the better, but as with most ratios, it is not enough to look at it in isolation. It is important to compare it to the company's past levels, to the market average and to its competitors.

1. Solvency Ratio : The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and other creditors selling goods on credit. These ratios indicate firm’s ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings. Example of solvency ratios are Debt-equity ratio and Proprietary ratio.

2. Profitability Ratios : The profitability ratios are just what the name implies. They focus on the firm's ability to generate a profit and an adequate return on assets and equity. They measure how efficiently the firm uses its assets and how effectively it manages its operations and answers questions like how efficiency his business and it helps to compare with other competitor. Examples of Proftitablity ratios are Gross profit ratio, Net profit ratio, Operating profit ratio and Return on investment ratio.

3. Market Value Ratios : The market value ratios can be calculated for publicly traded companies only as they relate to stock price. There are many market value ratios, but a few of the most commonly used are price/earnings (P/E), book value to share value and dividend yield .

4. LEVERAGE RATIO /Capital Structure ration : The term capital structure refers to the relationship between various long term forms of financing such as debentures (long term), preference share capital and equity share capital including reserves and surpluses. Leverage or capital structure ratios are calculated to test the long term financial position of a firm. Generally capital gearing ratio is mainly calculated to analyse the leverage or capital structure of the firm. Example of ratios are total debt ratios, the debt/equity ratio, the long-term debt ratio, the times interest earned ratio, the fixed charge coverage ratio, and the cash coverage ratio.

5. Asset Efficiency or Turnover Ratios : The asset efficiency or turnover ratios measure the efficiency with which the firm uses its assets to produce sales. As a result, it focuses on both the income statement (sales) and the balance sheet (assets).Examples of these ratios are asset efficiency ratios are the inventory turnover ratio, the receivables turnover ratio, the net working capital ratio, the fixed asset turnover ratio, and the total asset turnover ratio.

         The receivables turnover ratio is a liquidity ratio that measures a company's ability to collect on debts and    accounts owed to it. With this the investor can analyse the how capable a company will be at raising cash to purchase additional assets or to repay creditors quickly. Debt equity ratio when using this ratio to make an analysis of a company, it can be helpful to look at both the company and the industry as a whole. It's not unrealistic for a younger company to have a debt to total assets ratio closer to "1" (more assets were financed by debt), as it hasn't yet had a chance to eliminate its debt. The price-to-earnings (P/E) ratio is the most well-known valuation ratio that compares the company's stock price to the earnings it generates on a per-share basis. An easy way to think about the P/E ratio is that it's a pretty good indicator of investors' expectations of a company's future income.

There are many other ratio which helps an investor to concentrate and make decisions for investement out of all the above expalined ration to be considered majorly by the investor for good investment opportunities.