Ratio Analysis Formula: Definition, Categories, Limitations

Ratio analysis plays an essential role in understanding a business's financial condition. Business owners and accountants use this technique to determine profitability, operational efficiency, and liquidity by studying its financial reports, like the income statement and balance sheet. This technique does not only help business owners to understand their financial conditions but also helps them to understand where they stand in the market. Knowing financial conditions also helps business owners to make the right decisions for business growth. Not only this, but it also helps them to understand which of their services are beneficial for their business growth. In this article, the student will learn how the ratio analysis formulas work and take a handful of examples to better understand ratio analysis and its types.

Key Takeaways: Ratio analysis, Liquidity ratios, Activity ratio, Solvency ratio, Limitations of Ratio Analysis, Profitability, Operational efficiency, Liquidity

Also read: Isosceles Triangle Theorems

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What is Ratio Analysis?

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Regarding business financial health, ratio analysis is a vital tool that can help interpret and determine the relationships between the items of financial statements. The primary purpose of ratio analysis is to provide an understandable report of an enterprise's performance and financial position by using ratio analysis formulas. These accounting and financial formulas help find out the information related to the asset and cash flows of the company. 

As these formulas are specially designed to showcase the genuine picture of the company's working with accuracy. After preparing a financial report, many formulas, including ratio analysis, a quantitative formula is applied to assess all financial conditions of the business. These formulas help determine the operational efficiency, profitability, and the liquidity by observing all financial reports and statements. Now, let’s move to the types of ratio analysis to better understand the formulas.

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Types of Ratio Analysis

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The ratio analysis is divided into four parts. They are:

• Liquidity Ratios

Liquidity is a form of assets or security. The liquidity can be converted into money without consequences on the market outlay. A firm can sell or buy an asset for productivity without getting through a drastic change in the asset price. Moreover, the liquidity ratio applies ratio analysis equations to find out a business's short-term cash flow. The liquidity ratio has two sub ratio formulas. 

They are:

Current Ratio: Current ratio provides an idea of the short-term liquidity of a company. The formula is:

Quick Ratio: The quick ratio helps to find out the company's liquidity for up to six months. The formula of the quick ratio is: 

• Profitability Ratio

The profit is an essential part of every business. Every person seeks profit in his/her business. And the profitability ratio helps to determine whether the company is fetching any profit or not. It provides the data of the business success rate over the time. The primary beneficiaries of these ratios are the business owners, stakeholders, government and the tax holders. The profitability ratio does not only help to get to know the success rate but also helps the entrepreneur to get loans. Because when it comes to granting the loan, all bank officials prefer to check out the company's profitability status to determine whether the business will be able to return the loan amount or not.

• Activity Ratio

Activity Ratio, also known as turnover ratio formula, is applied for the estimation of a company's efficiency by converting the goods and services into cash. This ratio works on the basis of time period. The activity ratio has two sub formulas. They are:

Inventory turnover ratio: Inventory turnover ratio always updates on the conversion frequency of product to cash. 

Receivable turnover ratio: The receivable turnover ratio helps to update the supply frequency of credits.

• Solvency Ratio

The solvency ratio helps check the business's facts to determine the capability to pay the long-term deficit of a firm. The solvency ratio has two sub ratio formulas. They are:

Debt Equity Ratio: Debt Equity Ratio helps to consider the steadiness of the long-term economic approaches of a company. 

Proprietary Ratio: Proprietary Ratio helps to determine the firmness of the business's capital structure.

Also read: First Order Differential Equation

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Limitations of Ratio Analysis

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Ratio analysis comes in handy when a person needs to derive the essential information for business finance. Still, some limitations come with ratio analysis. These limitations are:

• If the person does not have adequate or old data, it can induce a misreading of ratio analysis.
• In ratio analysis, we use the data or trends from the past to predict future growth that can not always be correct or reliable. 
• In ratio analysis, you need to be knowledgeable to proceed without mistakes.
• As mentioned above, you can not rely on ratio analysis because it does not always show a factual basis. Because when you proceed with ratio analysis, you use historical data.
• You can not use ratio analysis to compare distinct companies because each firm uses other accounting techniques to determine their financial health.

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Things to Remember

• Ratio Analysis is the best way to compare the financial statements of various businesses. It can be a valuable source for outside critics. 
• Ratio analysis facilitates and outlines the statement on economic reports. 
• Critics can acquire an opinion about the efficiency of a company by reading the data on ratio analysis statements.
• It can also assist in understanding past flaws and future trends. 
• Ratio analysis is not valuable for inner surveillance, but investors and stakeholders utilize it. 
• The abilities of a critic specify the precision of a Ratio Analysis information since it does not always characterize an authentic portrait. 
• The tool for estimating any business's financial situation is comprehended as Ratio Analysis, and it can be utilized for any business, whether it is small scale or large scale.