In business, you need to assess how healthy or effective your finances are in the company. In the assessment, there is a term called financial ratio analysis. Therefore, we will try to provide the basic formula of financial ratio analysis for companies.
Financial Ratio Analysis
Financial ratio analysis is a form of analysis to measure company performance based on comparative data written in financial statements such as balance sheet, profit/loss, and cash flow statements in a certain period.
Therefore, financial ratio analysis is also commonly referred to as financial statement analysis.
This analysis is usually carried out by accountants at the end of the company’s period in one year. The results of the analysis are then reported to management as an information guide to determine the company’s decisions or policies in the next period.
Financial analysis is also in the balanced scorecard, a tool for measuring company performance, how effective the strategy has been used to achieve a competitive advantage.
So that the analysis of financial ratios on companies is not only addressed to the management but also investors. For them, financial ratio analysis is an assessment of how healthy the company deserves the investment injection.
The Function of Analysis of Other Financial Ratios?
In addition to being a measure of whether a company is healthy, financial ratio analysis has other benefits, namely;
- Look at trends in the company’s performance in a certain period.
- Material evaluation of company resources such as suppliers, equipment, production processes, and even the employees themselves.
- As a reference for investors to choose a company.
- For consideration of creditors.
- Assess the effectiveness of the company’s strategy in building a competitive advantage.
- Analysis of internal strengths and competitiveness of the company with competitors.
- As reference material for the company’s internal audit from the financial sector, operations, or other sectors.
- Determine the reasonableness of the profits of the company.
Based on the points above the role of financial statement analysis has basically two roles; as material for consideration and evaluation by both business owners and internal parties such as creditors or investors
Types of Financial Ratio Analysis
Like its function above, the calculation of financial ratio analysis is divided based on its function. So what are the types of analysis?
1. Liquidity Ratio
This ratio is useful for measuring how well your company can meet short-term obligations. This analysis is based on current assets that are relative to liabilities (current debt).
However, the liquidity ratio is divided into several types depending on the comparison of the condition of assets and liabilities.
1. Current Ratio
The most basic ratio calculation for measuring liquidity. The aim is to measure the company’s ability to pay short-term obligations or debt that is due soon with available current assets.
The greater the ratio of current assets to current debt, the higher the company’s ability to cover its short-term liabilities.
Here is the current ratio formula
Current Ratio = Current Assets / Current Debts X 100%
2. Quick Ratio/Acid Test Ratio
Unlike the current ratio, the fast ratio does not require a 1: 1 ratio between current assets and current debt. This is because in calculating the ratio quickly ignores the inventory factor.
So that means, the quick ratio measures the ability of a business to pay the short-term debt that is easier using liquid assets ( liquid assets ).
Fast ratio formula
Quick ratio = Cash + securities + accounts receivable / current debt x 100%
3. Cash Ratio
Not much different from fast ratios, cash ratios are useful for measuring a company’s ability to pay short-term liabilities with available cash and also securities.
The cash in question is the company’s money that is stored both in offices and banks in the form of a checking account.
While securities are cash equivalent assets that are easily cashed back. The cash ratio formula is
Cash ratio = cash + securities / current debt
For cash ratio, the same as a quick ratio where the comparison does not need to reach a perfect value or 100% to get a good level of company capability.
2. Profitability or Profitability Ratios
This ratio is useful to measure the level of the company’s ability to obtain profits based on the value of sales, assets, and capital.
There are several methods in calculating profitability ratios namely
1. Gross Profit Margin
As a measure of the company’s ability to get gross profit. The following formula
= net sales – the cost of good sold (cost of goods sold) / net sales x 100%
2. Operating income ratio
This calculation is used to measure the company’s ability to obtain operating profit before interest and taxes from sales. The following formula
= net sales – cost of good sold (HPP) – earnings before interest & taxes (EBIT) / net sales x 100%
3. Net Profit Margin
Unlike the gross profit margin, the net profit margin calculates the level of the company’s ability to get a net profit. The following formula
= Net profit after tax (EAT) / net sales x 100%
3. Earning Power of a Total Investment
Measuring the company’s ability to manage capital owned and invested in overall assets.
This calculation is used as a reference for investors or shareholders in measuring the level of investment returns invested in the company. The formula is as follows.
= profit before tax and interest / total assets x 100%
4. Return of Investment
Calculate the company’s ability to generate profits that are used to cover the investment incurred. Profit used to measure this ratio is net profit after tax or earnings after tax (EAT)
Formula = EAT / total assets x 100%
5. Return on Equity
The company’s ability to get net income based on equity. The following formula
= earnings after tax (EAT) / amount of equity x 100%
6. Return on Net Worth
Measuring the ability of invested capital to generate income for shareholders. The following formula
= earnings after tax (EAT) / amount of own capital x 100%
Solvency Ratio or Leverage Ratio
If the liquidity ratio to measure short-term liabilities, is different from the solvency ratio. This ratio aims to measure the company’s ability to meet its long-term obligations.
There are two types in this ratio, namely the ratio of liabilities to assets ( total debt to assets ratio ) and also the ratio with equity ( total debt to equity ratio ).
The total debt to asset ratio aims to calculate the effect of the amount of liability on the management of the company’s assets. Also, this ratio serves to measure how many assets/assets of the company financed by debt.
While the total debt to equity ratio shows the relationship between the amount of long-term debt with the amount of own capital provided by the company owner.
For entrepreneurs, the amount of debt should not be more than the amount of their own capital. So the smaller the ratio the safer the company.
Note: the maximum value of this ratio is 200% as a safe limit for the company to meet its long-term obligations.
The activity ratio measures how effectively a company utilizes all its resources.
In this analysis, low activity at a certain level of sales results in more funds being embedded in assets.
These more funds in which the impact of low activity becomes better if invested in more productive activities.
1. Turnover Accounts Receivable
Receivables turnover is used to measure the quality and efficiency of the company’s receivable turnover in one period by comparing sales with average receivables.
The higher the ratio, the better the quality and efficiency of the company’s receivables turnover. The following formula
= sales/accounts receivable x 100%
2. Inventory Turnover
Used to measure the level of quality and efficiency of the company’s inventory turnover against sales in a certain period.
The higher the ratio, the more efficient the inventory management by the company. The following formula
= sales/inventory x 100%
3. Turnover of Fixed Assets
This ratio is useful for measuring and evaluating the company’s ability to utilize fixed assets efficiently to increase sales.
Just like before, the greater means the company is more effective in managing its fixed assets. The formula is as follows
= sales / fixed assets x 100%
4. Total Asset Turnover
This ratio also involves current assets and fixed assets. Where the greater the ratio, the more effective the company can utilize all of its assets towards sales conversions.
The following formula
= sales / total assets x 100%
5. Average Billing Turnover
This ratio measures how long it takes a company to receive bills from consumers in one year.
The formula is as follows
= receivables x 365 / sales x 100%
6. Turnover of Working Capital
Measuring the level of networking capital turnover is the ratio between current assets and current debt to sales in one period.
The formula is as follows
= sales / (current assets – current debt) x 100%
It is a ratio to measure a company’s ability to provide returns to funders (investors). This ratio is useful as a guideline for investors to determine the level of the financial health of the company.
Financial Ratio Analysis Method
In addition to the ratio calculation method described above, there are several other methods that you can use.
The most common method used in the analysis of corporate financial ratios is the analysis of common size and time series.
Common Size Analysis
Common size analysis is comparing changes in items with total assets, liabilities, and sales. This comparison is presented as a percentage per component in the financial statements in both the balance sheet and the income statement.
In this analysis, the company will get information in the form of investment composition (assets) and capital structure (liabilities). The investment composition in question is the position of the relativity of current assets to fixed assets. While the capital structure illustrates the relativity of corporate debt to own capital.
Common size analysis is also carried out to compare the current period’s financial statement data, compare between competitors, or compare with industry.
Remember the function of financial ratio analysis: as an analysis of competitiveness in the industry
Time Series Analysis And Forecasting
This analysis is used to compare financial data for a certain period, especially as a material for forecasting or projection of financial conditions in the future.
In this analysis, several points must be considered where these points affect changes in financial structure namely; government regulations, changes in competition, changes in technology, and also acquisitions.
Usually, this time series analysis uses an index in the form of numbers. Several steps must be considered in conducting time series analysis.
First, determine the base year. Determination of the base year can be based on the year of establishment, the year of organizational structure change, the year of the project, or the years in a particular moment. The base year financial statement post will be recorded as an index of 100.
Second, calculate the other year’s index numbers using the base year financial statement postal numbers as the denominator.
Third, predict the direction and historical trends of financial statement items. Finally, provide a decision on the analysis.
Time series analysis is also based on financial data namely; the trend. Cycle, seasonal, and irregularity.
Trends are long-term time series movements. Trends can be expressed in upward or downward trends. In trend data, you need to look at patterns over a fairly long period, around 15 to 20 years.
Remember the factor of changing trends: government regulations, technology, demographics, competitors
Whereas cycle data is part of a business anomaly that usually lasts 2 to 10 years. If the trend is macro, then the cycle is micro where it can be influenced by internal factors.
There are also seasonal data, which are data anomalies based on a certain time or shorter time in a year such as Eid, Christmas holidays, or weather.
While irregular data arise due to data based on an uncertain time in an uncertain period (but relatively in a short period). For example, when a pandemic or political crisis.
Well, that’s a brief explanation of the analysis of financial ratios in companies. Remember this analysis requires or is based on financial statements. The accuracy of the financial statements will greatly affect the analysis which is also called the financial ratio analysis.
If there is an error in making financial reports, no matter how good the analysis, the results will still be an error as well and in the end might affect the forecasting and also the investor’s decision to invest in your business.