What’s about Ratio Analysis

Hope you’re having a productive day and ready to conquer today, this month we finish up on the SMEs assessments that we start last month, we are looking at some of the reasons why that business you have might be failing despite the fact you’re pouring your blood and sweat in it, as we noted in the https://mbuguaandassociates.com/why-is-your-business-failing/ article, one of the reasons was cost management, and one thing that is key to note in this was, reduction of the cost may not be the solution but actually maximizing the benefits that are accruing in relation to this costs, some cost may not be fixed perse but you can’t get rid of them the best you can do is ensure that you maximize the benefit you stand to gain with them.

Now with that recap let us dive into today’s subject and explain the importance of understanding the various ratios and how they can be the pointers or better still indicators of trouble either about to happen or already happening,

Ration analysis is like the symptoms that indicate that an ailment is about to attack you, you know like how you start having a fever, the next a headache then next something else before they finally give you a diagnosis of malaria or whatever ailment it may be…

Same way ratio analysis can tell you when you’re about to be in a liquidity crisis, it can measure your profitability trend, the operational efficiency can be measured and monitored using ratio analysis, it is possible to also know the solvency status of the company by looking at its ratios, and the most interesting aspect of the ratios is that it cannot only be used to monitor and evaluate the internal operations of an organization but also can be used to compare the organization’s performance in the industry it plays in, the key is know how to calculate them, interpret them and have them monitored in the right intervals.

Both start-ups and established organizations cannot overlook the importance of ratio analysis in the efficient operation of their businesses.

As you may have already figured out ratio analysis is a quantitative analysis that gives insight into the company’s liquidity status, operational efficiency, and profitability status, this is achieved by taking a keen look into the financial statements of the organization, these financial statements are mostly the statement of financial position, and statement of financial performance, and some cases even the cash flow statement. Ratio analysis may not seem to look into the statement of equity perse but it actually does put a focus on it while looking into the statement of financial position, it is only that it does not single it out, in as much it has a reporting page of its own in the collection of financial statements.

There is an argument that ratio analysis is actually a cornerstone of fundamental equity analysis and actually we agree with this 100%. We, however, would also want to demystify the notion that is attached to the statement, which then implies that ratio analysis is only important to investors, or potential investors or an analyst, because in all honesty that is not the case, and that is why we introduced this subject with the simplicity of the importance that ratio analysis has to the success of the business or organization and why as the business owner or the manager understanding the ratio standing of your organization is paramount to the successful operation, liquidity and profitability status that you hope to achieve.

To an investor ration analysis will help them know if the investment is good risky or bad risky but to the management of the organization ratio analysis will help inform decision making on what needs to be done, when and even how it should be done

There are various classes of ratio analysis and each interprets a different status, let us now discuss each class, and what you should understand by it;

  1. Liquidity Ratio – this measures the company’s ability to pay off its short-term debts as they fall due, it includes the current ratio, quick ratio, and working capital ratio.
  2. Profitability Ratio – this will inform how well the organization can or will generate profits from its operations, it comprises the profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.
  3. Efficiency Ratio – this is used to evaluate how efficient the organization is using its assets and liabilities to generate sales and maximize profits, it encompasses, general turnover ratio, inventory turnover, and daily sales analysis.
  4. Coverage Ratio – this is for the company or organization that has debt inform of loan obligations, as it measures its ability to make the interest payments that come with the loans and other obligations associated with its debts, it has the time interest earned ratio and the debt-service coverage ratio.
  5. Solvency Ratio – this is very much related to the coverage ratio, the only difference is that the earlier one is mostly looked into by the management, and this is most important to potential investors, the operative word being mostly and not exclusively, this ratio compares the company’s debt levels with its assets, equity, and earnings, in an effort to evaluate the probability of the company continuing as a going concern, or if it will be unable to pay off its long-term debt as well as the interest on its debt, the solvency ratio has in it the debt-equity ratios, debt-assets ratios, and interest coverage ratios.
  6. Market Prospect Ratios – these can now be labeled as of ‘sole’ interest to investors and potential investors as the metrics used here are for the sole purpose of predicting the current and future earnings as well performance, these ratios encompass; dividend yield, price-earnings ratio (P/E), earnings per share (EPS), and dividend payout ratio.

As you can see for you to be able to understand the head ratio interpretations you must be made to understand the sub-ratios in that cluster, for example:

Profit Margin = the company’s net income by its revenues, this is interpreted to tells you how much the company is able to convert its total revenue into profits

P/E Ratio – tell you how much investors are willing to pay per earning that the company makes.

Let’s meet again here on the 17th for another subject, as we understand what is really an asset and what is not, did you that some expenses are actually assets disguised? Remember to subscribe to the newsletter either the Twitter one or the website one, but if I were you I’d do both as each publication is different and addresses a different topic.

Take-Home: understand the ratio standing of your organization and know when you’re about to be in trouble instead of waiting for trouble to be the wake-up call.

MA Financial Services Consultants

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