How to do financial analysis by ratios?

Financial analysis using ratios is an essential tool for assessing the financial health of a company. This approach is different from the functional approach of financial analysis. By examining various financial ratios, investors, managers and analysts can gain valuable insights into a company's performance, profitability, solvency and operational efficiency.

In this article, we will explore in detail how to use financial ratios to interpret a company's financial statements and make informed decisions.

Whether you're a finance professional or an entrepreneur looking to better understand your business numbers, this in-depth exploration of financial ratio analysis will provide you with practical, actionable knowledge.

????Liquidity analysis

Liquidity analysis assesses a company's ability to meet its short-term obligations using ratios such as current ratio, reduced liquidity ratio, and quick liquidity ratio. This analysis provides insights into a company's ability to meet its short-term debts using its liquid assets.

✔️ Liquidity ratios

Liquidity is a measure of a debtor's ability to repay its debts assuming business continuity. It differs from solvency, which is based on the assumption of cessation of activities.

To measure the liquidity of a company, we evaluate the importance of its funds available for its disbursements. This is based on the ratio of general liquidity, reduced liquidity and immediate liquidity. The current ratio measures a company's ability to pay its short-term debts.

When it is greater than 1, the current assets make it possible to finance at least the current liabilities. The company can then be considered as "solvent" in the short term.

The reduced liquidity ratio is equivalent to the ratio of current assets (the most liquid assets on a balance sheet) less inventories, to current liabilities. short term (debts at less than one year).

The immediate liquidity ratio is more restrictive than the other two ratios. It indicates the ability of a company to meet its short-term commitments without resorting to its current assets. illiquid (including inventory).

✔️ Financial analysis by stable employment coverage ratios

The coverage ratio of stable jobs measures the rate of coverage of assets held at LT by liabilities.

This ratio must be at minus equal to 1 (100%). It is even better if it is greater than 1 because this means that the company's stable resources allow it to release excess liquidity which can be used to finance working capital requirements.

✔️ The obsolescence ratio

The obsolescence ratio measures the level of wear and tear of a company's production equipment. It is expressed as a percentage.

The closer it gets to 1, the more recent it indicates that the tool is in production. Otherwise, it indicates aging.

✔️ The financial independence ratio

The financial independence ratio highlights the state of the company's financial debt in relation to its equity.

A ratio that is too low risks complicating the possibilities of finding external financing because it indicates that the company is dependent on the entities that finance it and has very little room for maneuver generated by its own funds.

✔️ Financial autonomy ratio

Of the ratios calculated so far, that of financial autonomy (RAF) is particularly important.

The financial rule is that capital contributors must intervene for at least half of the financing of the investment in order to ensure the company's autonomy vis-à-vis third parties. According to the financial approach, financial autonomy is expressed as follows:

Si RAF < 1, then the company always has the possibility of going into debt in the long and medium term.

In the case where  RAF > 1, then the company is unable to take on more debt. In other words, it must reconstitute its capital or increase it in order to obtain a new margin for indebtedness and insurance for its financial partners.

???? Profitability analysis

The interpretation of profitability ratios actually corresponds to the last step of the analysis financial of the company. The idea is to bring out the main ratios from the economic analysis in order to be able to make comparisons with other companies in the same sector. 

In fact, a company's profitability is an essential component of its overall performance. It can be defined as its ability to generate results (beneficiaries) at from the capital invested.

Given the different levels of results, three levels of profitability analysis exist: operating profitability, economic profitability and financial profitability.

Profitability ratios measure results in relation to: activity (operating profitability); means of production or investments (economic profitability); and financial means (financial profitability).

✔️ Analysis of operating profitability

Among the operating profitability ratios, we have:

👉 The commercial margin rate TMC

The TMC concerns companies with an essentially commercial activity. The examination of this ratio makes it possible to appreciate the commercial margin of the company and consequently its commercial strategy. Indeed, a high margin makes it possible to incur expenses without concern and better business service.

This indicator allows the company to compare itself against competitors of the same. The monitoring of this indicator over time makes it possible to assess the company's commercial policy. Mathematically, the gross margin rate is obtained by the following formula:

👉 The value added rate (VAT)

This ratio used in industrial companies measures the degree of integration of the company. It makes it possible to distinguish between the costs of the external and internal factors of production of the company. It is equal to:

👉 The gross operating surplus (EBITDA) rate

The EBITDA ratio measures the margin generated by each unit of turnover regardless of the company's different policies. It is expressed by the following ratio:

EBITDA is the primary indicator of the company's industrial and/or commercial performance. It is obtained by the following relation:

Once its value has been calculated, two cases can arise:

If EBE > 0,  then the enterprise is profitable from the operating point of view;

If EBITDA<0, this is referred to as “gross operating insufficiency”. In other words, the turnover of the company does not cover its expenses.

👉The operating rate of return (ERR)

This ratio measures the level of operating profit generated by each unit of turnover. This ratio is expressed by the ratio:

👉 The commercial rate of return (TRC)

The last ratio of this family is the one that determines the level of net profit generated for each unit of turnover. It is expressed by the ratio:

👉 The inventory turnover ratio

The inventory turnover ratio measures the number of times the inventory has been turned over during the year. This ratio is a good indicator of the quality of goods in stock (degree of disuse) and the effectiveness of purchasing and inventory management practices.

It is calculated by dividing the cost of goods sold by the average value of inventory during a given period. It is important to evaluate inventory turnover because each turnover generates gross profits. This ratio can reveal where you could improve your purchasing practices and inventory management.

For example, you could analyze your buying habits and those of your customers to determine how you could minimize your inventory. You could monetize some of the obsolete inventory by selling it at a discount to certain customers.

In order to calculate the inventory turnover ratio over a year, we must first calculate the average inventory of the company.

Too low a ratio can express different situations. Either lcompany encounters commercial difficulties or it is oversupplied.

An overstocked stock is an element to monitor which can, for example, lead to additional storage costs; in the case of perishable goods where the value decreases over time, too much stock can significantly impact the financial health of the company.

On the contrary, a high ratio means that the stock is optimally managed in relation to the sales volume achieved by the company during the year.

👉 Trade receivables turnover ratio

The turnover ratio of trade receivables provides information on the average time elapsed between the date of issue of an invoice and that of its effective payment. This ratio is calculated from the following ratio:

This ratio makes it possible to outline a trend concerning the time that your customers take to discharge debts. An average delay that is too long can express several things. Let vour clients are experiencing financial difficulties or that thehe deadlines you give to your customers are too short.

Conversely, a short average customer payment period means that your customers are reliable, respect the deadlines imposed or that they benefit from good financial health.

👉Trade payables turnover ratio

Substantially close to the previous ratio, the turnover rate of supplier debts expresses the average time taken by the company to settle the debts it has contracted with its suppliers. It is calculated as follows:

A short average payment term is a characteristic highly appreciated by your suppliers. This means that you are reliable and that you respect the commitments you have made with your partners.

However, paying your suppliers too quickly can cause cash flow difficulties depending on the company's resources. It is advisable to respect the recommended deadlines and pay your suppliers on the pre-agreed due date.

In addition, leaving enough time for your company to collect sales allows you to fill your cash flow and subsequently pay your suppliers more quietly.

????Analysis of economic profitability (ER)

The ratios for measuring economic profitability make it possible to judge the ability of the company to generate results (beneficiaries) by mobilizing just the capital necessary for the exercise of its activity.

Economic profitability arises from the company's ability to sell and generate margins and results that allow the company's capital to be renewed and remunerated. The net economic rate of return is expressed by the ratio:

Overall economic profitability is measured in relation to net economic assets.

This indicator of economic profitability makes it possible to enlighten investors on the remuneration of the capital necessary for operation. However, this indicator is not meaningful for all users of financial analysis. This is why, for example, capital providers are interested in financial profitability, in particular the remuneration of their contributions.

???? The analysis of financial profitability (FR)

Financial ratios are the most used by the manager to follow the evolution of the company. These ratios make it possible to assess the company's ability to pay dividends to its shareholders and to remunerate them in such a way as to compensate them for the risk incurred.

The importance of this ratio is assessed with reference to the average rate of return on fixed-income investments. It is expressed by the ratio:

Financial analysis using ratios is the best way to assess the financial situation of the company. You must always respect the financial analysis approach. However, if you want to take control of your personal finances in six months, I highly recommend this guide.

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