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What is financial ratio analysis?

Financial Ratio Analysis

Ratio evaluation is the quantitative evaluation of the data contained in the company’s monetary statements. Financial ratio analysis is used to evaluate various aspects of the company’s financial and operational performance, such as: its liquidity, profitability, and solvency. Financial ratio analysis includes evaluating the performance and financial health of the company by using current and historical financial data to compare the company’s performance. With the passage of time and comparing the company’s financial position to the industry average or comparison with other companies operating in the same sector, financial ratios are a great way to assess the health and position of the company before delving into its financial statements. Price-to-earnings ratios can also provide insight into the valuation and debt coverage ratios tell the investor about potential liquidity risk.
What is financial ratio analysis?
What is financial ratio analysis?

Types and types of financial ratios

Most investors know only a few basic ratios, especially those that are relatively easy to calculate. Some of the financial ratios include debt or equity ratio, current ratio, ROE, dividend payout ratio, and price ratio. There are many financial ratios, so the analysis of financial ratios can be categorized into six groups. chief:
  • Liquidity ratios: These are the ratios that measure the company's ability to pay off short-term debts at maturity using the company's current assets. They include the current ratio and the quick financial ratio as well as the working capital ratio.
  • Coverage ratios: These are the financial ratios that measure the company's ability to pay interest payments and other debt-related obligations, such as the debt service coverage ratio and the mileage-based interest rate.
  • Solvency/leverage ratios: These are the financial ratios that compare the solvency rates between the company’s debt levels with assets, equity and profits. The purpose is to assess the company’s ability to stay afloat in the long term by paying off its long-term debt and interest on debt, including the debt-to-equity ratio Equity, interest coverage ratio, and debt-asset ratio.
  • Profitability ratios: They are financial ratios that show the company's ability to achieve profits from operations, examples of which are the profit margin ratio, return on assets, return on equity, gross margin ratio, and others.
  • Efficiency/activity ratios: They are financial ratios that assess the company’s efficiency in using assets and liabilities to achieve sales and maximum profits. The ratio of asset turnover, inventory turnover, and sales days in inventory are the basic efficiency ratios.
  • Market expectations ratios: They are financial ratios used to determine what the investor may receive from investment profits and predict the direction of stocks in the future. Examples include the dividend yield ratio, price to return ratio, earnings per share ratio, and dividend distribution ratio.

profitability ratios

They are ratios of the financial ratios that determine the company’s ability to achieve profits and are derived from the comparison between revenues to the difference in expenses within the income statement. When profitability ratios are used, the company’s results for the current period are compared to the results of the same period of the previous year because many institutions have seasonal sales, which This leads to a significant difference in the profitability ratios throughout the year, and among the profitability ratios are the following:
  • Contribution Margin Ratio: It is by subtracting all variable expenses in the income statement from sales and the result is divided by sales, and is used to determine the percentage of sales that are still available after variable costs to pay for fixed costs and make a profit and then used for break-even analysis.
  • Gross Profit Ratio: Subtracts all charges associated to the price of items bought in the profits announcement from sales, then divides the end result through sales.
  • This ratio is used to determine the percentage of sales available after selling goods and services to pay selling costs and administrative costs and make a profit, and includes allocating fixed costs to the cost of goods sold.
  • Net Profit Ratio: It is by using subtracting fees in the earnings assertion from income and then dividing the end result with the aid of sales.
  • It is used to determine the net profit amount in the reporting period net of income taxes.
  • Return on assets: It is divided by the net profit by the total assets value in the balance sheet.
  • Return on equity: It is divided by the total amount in the balance sheet.

cash ratio

The money ratio, or the so-called money insurance ratio, is a ratio of liquidity ratios that measures the company's capacity to pay cutting-edge liabilities solely in money and money equivalents. The cash ratio is one of the most restrictive ratios because no other current assets can be used to pay off current cash from debt only. Whether the company maintains sufficient cash balances to pay all its current debts at maturity and the inventory and accounts receivable are excluded from the equation because the two accounts are not guaranteed, the inventory may take a long time to sell and the collection of receivables may also take a long period and an explanation of this ratio as follows:
  • The equation
The cash ratio equation is by calculating the cash coverage ratio by adding cash and cash equivalents and dividing it according to the total current liabilities of the company:
Cash Ratio = (Cash + Cash Equivalents)/Total Current Receipts
  • Analysis
This ratio shows cash and its equivalent as a percentage of current liabilities. If the ratio is 1, this means that the company has the same amount of cash and current debts, i.e., in order to pay off the current debts, the company must use all the money and quick-transfer assets, and if the ratio is more than 1, it can Paying all current liabilities in cash and equivalents, and if the ratio is less than 1, the company needs more than its cash reserves to pay off the current debt, as well as the higher cash coverage ratio, the company is more liquid, and any ratio higher than 1 is considered a good liquidity measure.
  • Example:
Company X wants to buy land and the company asks the bank for a loan in the amount of $100,000. In the company’s balance sheet, the following appears: Cash: $10,000 Cash equivalents: $3,000 Accounts payable: $5,000 Current long-term liabilities: $10,000 The company’s liquidity ratio is as follows:
(10000 + 3000) / (5000 + 10000) = 0.866
The cash ratio is 0.866 and this means that the company has cash and cash equivalents to pay off 86% of the current obligation.

P/E Ratio

Price-to-earnings ratio, multiple-price or earnings-to-earnings multiplier, which is the ratio for estimating the value of the company and measures its current share price relative to the earnings per share. He is expected to invest in a company in order to get one dollar of the company's profits and that's why it is referred to as the multiple price because it shows how much investors are willing to pay each dollar of profits, for example if the company is currently trading at a multiple of 20 please means that the investor is willing to pay 20 dollars for 1 dollar of current earnings.
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