Financial ratio analysis involves interpretation and analysis of the income statement, balance sheet, and cash flow statement. Ratios are calculated by dividing one financial statement item by another. Here are the top 15 techniques:
Vertical Analysis
Vertical analysis involves calculating the proportion of each item on your company’s financial statement to a base figure, usually sales revenue or total assets. The purpose here is to determine the relative weight of each item and to identify any trends or changes that may affect your company’s financial health.
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Profitability Analysis
Profitability analysis involves measuring your company’s ability to generate profits from its operations. By calculating key profitability ratios such as gross profit margin, net profit margin, and return on equity, you can assess your company’s financial performance and compare it to industry benchmarks.
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Leverage Analysis
Leverage analysis, also known as financial risk analysis, involves measuring your company’s use of debt to finance its operations and assessing your ability to meet financial obligations, such as debt payments and other liabilities. By calculating key leverage ratios such as debt-to-equity (D/E) ratio and interest coverage ratio, you can understand your company's risk profile and ability to service its debt obligations. Your D/E is calculated by dividing your company’s total amount of debt by the total amount of shareholder's equity. Total debt is the sum of all your company’s short-term and long-term debts, including loans, bonds, and other liabilities. Total equity is the sum of all your company’s common stock, preferred stock, and retained earnings.
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Growth Analysis
Growth analysis involves assessing your company’s growth potential and identifying opportunities for expansion. Analyzing key growth metrics such as revenue growth, market share, and customer acquisition rates, helps you determine whether your company is likely to grow or decline in the future.
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Liquidity Analysis
Liquidity analysis involves measuring your company’s ability to meet its short-term financial obligations. Analyzing liquidity and stability ratios such as current ratio and quick ratio, helps you assess your company’s ability to pay its bills and avoid financial distress. The current ratio is calculated by dividing your current assets by your current liabilities and a good current ratio is between 120% and 200%, which means that your business has 2 times more current assets than liabilities to cover debts.
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Solvency Analysis
Solvency analysis, such as the debt-to-asset ratio, measures your company’s ability to meet its long-term obligations and ability to weather economic downturns or other challenges. Your debt-to-asset ratio is calculated by dividing your company’s total amount of debt, including loans, bonds, and other liabilities, by the total amount of assets, including cash, inventory, property, plant, and equipment.
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Efficiency Analysis
Efficiency analysis involves measuring a company's efficiency in using its resources to generate revenue. By analyzing key efficiency ratios such as asset turnover ratio and inventory turnover ratio, investors and analysts can assess the company's ability to optimize its operations and maximize profitability. Asset turnover ratio indicates how many dollars of revenue your company generates per dollar of assets. It’s calculated by dividing your company's revenue by its total assets. In general, asset turnover ratios in the range of 0.5 to 2.0 are considered typical for most industries.
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Cash Flow Analysis
Cash flow analysis involves examining your company's cash inflows and outflows to determine its ability to generate cash and manage its cash flow. It is important to note that your company’s profitability does not necessarily equate to a positive cash flow.
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Rates of Return Analysis
Rates of return analysis involves measuring your company’s rates of return on its investments. By analyzing key return metrics such as return on investment and return on assets, investors and analysts can assess your company’s ability to generate profits from its investments.
This Cash Flow Valuation Analysis example displays various cash flow-related key performance indicators (KPIs) including the internal rate of return (IRR) by region compared to a target IRR, investment count by type, and a detailed cash flow table. Additionally, real-time indicators like the cash conversion cycle and working capital ratio could be incorporated. To aid in cash flow management, regression analysis can be utilized to forecast cash flow.
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Valuation Analysis
Valuation analysis involves determining your company’s intrinsic value based on its financial performance and other relevant factors. By using valuation models such as the price-to-earnings (P/E) ratio and discounted cash flow analysis, you can understand the price investors are willing to pay for your company's earnings per share (EPS) and assess if your company's stock is overvalued or undervalued. Your P/E is calculated by dividing your current market price per share by your company's EPS. A P/E ratio between 10 and 20 is considered to be a reasonable range for many companies.
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Scenario and Sensitivity Analysis
Scenario and sensitivity analysis involves modeling different scenarios and assessing the impact of changes in key variables on your company’s financial performance. This allows you to assess your company’s risk exposure and identify potential areas of concern.
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Variance Analysis
Variance analysis involves comparing actual financial results to budgeted or forecasted results to identify areas where the company may be falling short. By analyzing variances, you can help the company adjust its financial projections and identify potential areas of concern.
This Actual vs Forecast Analysis example compares between actual expenses and forecasts for a specific time frame, as well as the trend of expenses over time for each expense category. With a modern and integrated financial dashboard, you can easily explore this data in greater detail and extract actionable insights.
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Trend Analysis
Trend analysis involves looking at your company’s financial statements over a period of time to identify patterns and trends in your company's financial performance. This can help you assess your company’s financial health and predict future performance.
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Turnover Ratio Analysis
Turnover ratio analysis looks at how effectively your company is using its assets to generate revenue. By analyzing turnover ratios such as accounts receivable turnover and inventory turnover you can assess how efficiently your company is managing its resources. Inventory turnover is calculated by dividing the cost of goods sold by your average inventory for the period. The ideal inventory turnover ratio varies across industries, but a ratio between 5 and 10 is often considered a good range.
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Coverage Analysis
Coverage analysis involves assessing your company’s ability to meet its financial obligations, such as debt payments and interest expenses. By analyzing coverage ratios such as the interest coverage ratio (ICR) and the debt service coverage ratio, you can assess your company’s ability to pay its debts and avoid financial distress. ICR is calculated by dividing your company's earnings before interest and taxes (EBIT) by its interest expenses. Generally, a higher ICR indicates that a company is better able to meet its interest obligations and has a lower risk of defaulting on its debt. A company with an ICR below 1 may struggle to meet its interest payments and may be considered to have a higher risk of default.
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