Performance Analysis: Ratio Analysis

For performance analysis a widely used tool is ratio analysis. It’s an age old method which represents relationship between two variables. For business organization, financial ratio represents significant relationship among different financial statement components and shows how one component is related to another. Thus, ratio helps to identify the liquidity, profitability, and operational efficiency of a firm. It also facilitates the comprehension of the financial statements and the comparative analysis among firms in the same industry.

Five types of financial ratios are commonly used i.e. liquidity ratios, activity ratios, leverage ratios, profitability ratios, and market ratios. Different ratio under these major categories are shown in the table.  

Category	Ratio
Liquidity Ratios	Current Ratio, Quick Ratio, Cash Ratio, Net Working Capital
Activity Ratios	Inventory Turnover, Days Sale Outstanding, Average Payment Period, Total Asset Turnover, Fixed Asset Turnover
Leverage Ratios	Debt Ratio, Debt/Equity Ratio, Time Interest Earned Ratio, Fixed Payment Coverage Ratio
Profitability Ratios	Gross Profit Margin, Operating Profit Margin, Net Profit Margin, Operating Return on Assets, Earnings Per Share, Return on Total Assets, Return on Equity
Market Ratios	Price/Earnings Ratio, Market/Book Value Ratio

For effective decision making these ratios are mostly put in Cross Sectional Analysis where at same point in time a ratio is compared among firms of the same industry. For example, comparing the current ratio of Beximco Pharma and Square Pharma for 2015. This helps the financial manager to understand the companys’ position in relation to other firms in the industry.  In another case, Time Series Analysis is conducted where same ratio is compared over a period of time like comparing the current ratio of Beximco Pharma for 2015 with the same ratio in 2010, 11, 12, 13 and 14. It helps to identify the direction of the companys’ position over the periods.  In practice, both of these techniques are simultaneously used by financial manager.  

Though ratios are simple to calculate and good measures of financial performance, the user must be careful about the drawbacks of ratio analysis. Firstly, Single ratio is not self-sufficient rather group of ratios should be used for decision making. Secondly, Ratio doesn’t provide any conclusive evidence rather only indication of potential problem area. Thirdly, the data from the audited financial statement should be preferred. And, fourthly, the data used and compared should be prepared in same way.