Describe the purpose of ratio analysis and provide a specific business example describing how it would be used. Do the same for breakeven analysis.
Examples of Ratios Used in Financial Analysis
There are several hundred possible ratios that can be used for analysis purposes, but only a small core group is typically used to gain an understanding of an entity. These ratios include the following:
- Current ratio. Compares current assets to current liabilities, to see if a business has enough cash to pay its immediate liabilities.
- Days sales outstanding. Determines the ability of a business to effectively issue credit to customers and be paid back on a timely basis.
- Debt to equity ratio. Compares the proportion of debt to equity, to see if a business has taken on too much debt.
- Dividend payout ratio. This is the percentage of earnings paid to investors in the form of dividends. If the percentage is low, it is an indicator that there is room for dividend payments to increase substantially.
- Gross profit ratio. Calculates the proportion of earnings generated by the sale of goods or services, before administrative expenses are included. A decline in this percentage could signal pricing pressure on a company’s core operations.
- Inventory turnover. Calculates the time it takes to sell off inventory. A low turnover figure indicates that a business has an excessive investment in inventory, and therefore is at risk of having obsolete inventory.
- Net profit ratio. Calculates the proportion of net profit to sales; a low proportion can indicate a bloated cost structure or pricing pressure.
- Price earnings ratio. Compares the price paid for a company’s shares to the earnings reported by the business. An excessively high ratio signals that there is no basis for a high stock price, which could presage a stock price decline.
- Return on assets. Calculates the ability of management to efficiently use assets to generate profits. A low return indicates a bloated investment in assets.
