Ratio analysis can be used when financial information needs to be simplified to make it possible to interpret and compare the information. Banks often do ratio analysis when they need to decide whether to lend money to a client or not. If a business wants to open an account with a supplier, the suppliers often use ratio analysis to determine the financial health of the business before deciding if they will sell to the business on credit.
In Part 1 and Part 2 of this series of articles on financial ratios, the limitations of using ratios have been mentioned. However, there are also certain advantages to making use of ratio analysis. Some of these advantages are:
Financial risk ratios
Financial risk ratios, also known as solvency ratios, are used to determine the long term financial health of a business by determining whether the business carries too much or too little debt.
A business can finance its assets with capital from the owner(s) or money borrowed from a bank or similar institution. The debt ratio determines the proportion of the assets of a business that are financed through debt, e.g. a debt ratio of more than 0.5 means more than half of the business’s assets are financed through debt. A debt ratio of less than 0.5 means most of the business’s assets are financed through capital (equity).
The equity ratio is a variant of the debt ratio above. The equity ratio shows the proportion of the assets of a business that are financed through equity.
Formula: Profits before interest paid and income tax / Interest paid
This ratio indicates whether a business will be able to make the interest payments on its debts from its profits. For example, a ratio of 2.5:1 means that the business earns two and a half times the amount that is needed to cover its interest expense.
Formula: Cash flow from operating activities – Capital expenditure
The free cash flow ratio gives the amount of cash from operations that is left after a business paid for its capital expenditure. This is the amount of cash that is available to repay loans to banks and loans from the owner(s) to the business, and to make investments.
Formula: Operating cash flows / Total debt
Banks often look at this ratio when they have to decide if they will make a loan to a business as this ratio tells if a business will be able to make capital and interest payments on loans when they become due.
A ratio of 1:1 means the business is in a good liquidity position or in good financial health. A ratio of less than 1 implies that the business does not earn enough profits to be able to pay capital and interest out of its earnings. If a business has a ratio of less than 1, there is a good chance of bankruptcy within the next few years if the business does not do something to improve its financial position.
The above ratios are used to give an indication of the financial health of a business. It is important to remember that different industries have different norms and what is interpreted as a problematic ratio in one industry, can be perfectly acceptable in another industry.
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This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted. (E&OE)