Financial analysis is the analysis of financial statements for decision making purposes. Financial statements serves
dual purpose: First it’s used to evaluate a company’s performance by internal staffs. Secondly it’s used to evaluate
the performance of company by outsiders. Internal staffs appraise financial indicators to improve the performance
of a company whereas external people evaluate financial indicators to decide for investment. If the financial ratios
are promising, investors will be willing to invest in a company.
For internal control process, the relationship between financial statements(Income Statement, Balance sheet and
Cash Flow Statement) should be evaluated. Additionally financial ratios should also be evaluated. Together these
statements serve as an indicator of performance of a company. Also they serve as a benchmark about how
competitors are performing in the market. If the ratio is higher, then it may mean that the competitors are doing
better and vice versa. Thus a company gets a chance to improve itself in time.
Financial ratios are the major tool of financial analysis. They help to find out the systematic strength or weakness
of a company. Thus they are highly important.
Financial ratios can be grouped into following five types:
Liquidity ratios
Assets management or efficient ratios
Debt management ratio or leverage ratios
Profitability ratios
Market value ratios
We will now deal one by one with these ratios. Firstly we will understand about liquidity ratios.
1. Liquidity ratios: Liquidity ratios are the major part of financial ratio analysis.The purpose of these ratios is to
find out the solvency position of an organization. This means whether a company is able to pay its short term
liabilities or not. Being able to pay short term liabilities is crucial for an organization because it helps to build an
environment of trust in the eyes of investors. This is important for the smooth running of an organization. The major
liquidity ratios are:
1.a) Current ratio: Current ratio is one of the major financial ratios. It measures the extent to which current
liabilities is met by current assets. It is calculated by dividing current assets by current liabilities. Current assets are
liquid and they can generate money in a relatively short period of time. Thus if the ratio of current assets with current
liabilities is maintained, it becomes easier for payment. The major current assets are cash, Marketable securities,
saundry debtors, bills receivable and inventory. The major current liabilities are bank overdraft, saundry creditors,
bills payable and outstanding expenses.
But one thing we should be careful about! If current ratio is too high, it means a company is inefficient and
misutilizing its fund in purchasing too much current assets. But if the ratio is too low, then a company can’t fulfill
its short term obligations. The standard ratio of current assets can vary country-wise but generally a current ratio of
2:1 is considered best.
Mathematically: Current ratio = Current Assets/ Current Liabilities
1.b) Quick or Liquid or Acid Test Ratio: The purpose of this ratio is to find out the capacity of a company for
immediate payment of current liabilities.Thus Quick ratio is calculated by deducting inventories from current assets
and dividing by current liabilities. Inventories are deducted because it can be difficult to liquidate them at their full
book value, thus rendering them invaluable for payment of current liabilities.
Mathematically, Quick Ratio= (Current assets- Inventories)/ Current liabilities
We can summarize as:
The ratio of 1:1 is considered as an ideal ratio for meeting all current liabilities.
The ratio greater than 1:1 indicates that a company is in strong position to fulfill its payment
liabilities.
The ratio less than 1:1 indicates that a company isn’t in position to fulfill its short term obligations.
Quick ratio is important for investors and managers because it provides a more clear view of liquidity position than
that of Current Ratio.
1.c) Cash Ratio: This ratio gives an idea whether the most liquid assets can cover the current liabilities. These liquid
assets are cash and marketable securities. Thus its formula is:
Cash ratio= (Cash + Marketable securities)/Current Liabilities
Cash denotes free cash level which can be easily paid to fulfill liabilities. Whereas Marketable securities can easily
be sold in the stock market to convert them into cash within a short time frame of one year. Thus when the ratio is
calculated by comparing current liabilities with cash plus marketable securities, it shows the chances of payment of
current liabilities.
A cash ratio of greater than one means that a company is in better position to pay all of its current
liabilities.
A cash ratio less than one means a company may face difficulties in paying its current liabilities.
1.d) Net Working Capital (NWC) to Total Assets Ratio: It is the ratio of net working capital and total assets. Net
working capital is defined as the difference of current assets and current liabilities.
Thus first it shows how much the current assets is higher than current liabilities. Secondly it shows the ratio of this
difference with respect to total assets.
Mathematically: NWC to total assets ratio= Net working capital/ Total Assets
= (Current Assets-Current Liabilities)/ Total Assets
Positive value of NWC to total assets ratio indicates that a company is in good position to pay its
current liabilities.
Higher value of NWC to total assets mean that there is high chances that the short term obligation
be met
Lower value of NWC to total assets mean that there is less chance that the short term obligation
be met.
Negative value indicates that there will be difficulty to met the short term obligations.
Together Financial ratios are a major part of financial planning and analysis. They help in performance analysis as
well as investment analysis. Thus they are used extensively for interpretation purpose.
Further Reads
https://usefulfinanceforus.blogspot.com/2025/07/assets-management-ratio.html
https://usefulfinanceforus.blogspot.com/2025/07/debt-management-ratio-analysis.html
https://usefulfinanceforus.blogspot.com/2025/07/profitability-ratios.html
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