Definition, Function and Types of Financial Ratio Analysis

Analysis of the company’s financial ratios is very important for a potential investor to determine how much investment can be given. The results of the analysis can also be used as a reference for business development. Actually what is the analysis of financial ratios and how do they function? For more details, see the explanation below.

What is Financial Ratio Analysis?

According to Harvarindo (2010), the ratio is one number compared to other numbers as a relationship. Jonathan Golin (2001) argues that a ratio is a number depicted in a pattern compared to other patterns and expressed as a percentage.

While finance is something related to accounting such as financial management and financial reports. So the financial ratio is an index that connects two accounting numbers and is obtained by dividing one number by another (James Carter Van Horne quoted from Kasmir (2008)).

After knowing the meaning of financial ratios , analysis is an attempt to observe in detail on a thing or object by outlining its constituent components or compiling these components for further study. Analysis can also be called a process to break things into deeper parts and unite with one another.

So, financial ratio analysis is the process of observing indexes related to accounting on financial statements such as balance sheets, income statements and cash flow statements with the aim of assessing the financial performance of a company. This analysis is used to provide information about the company’s financial position and performance that can be used as a guide in making business decisions.

Financial ratio analysis is used by two main users, namely investors and management. Investors use financial ratios to see whether a company is a good investment or not. By comparing financial ratios between companies and between industries, investors can determine which investment is best.

Whereas management uses financial ratios to determine how well the company’s performance evaluates where the company can improve. For example, if a company has low gross margins, managers can evaluate how to increase their gross margins.

Financial Ratio Analysis Function

The general function of financial ratio analysis is beneficial for management and investors as mentioned above. Of course the function is not that simple. The following explanation.

  • Useful for someone / company who wants to invest in shares.
  • Give credit to a company.
  • Determine the level of health of the suppliercompany .
  • Determine the level of health of the customercompany / customer.
  • Determine the level of company health in terms of employees.
  • Determine the amount of tax that is charged by the company to the government or determine the reasonable level of profit of an industry.
  • Determine the level of development of the company for the sake of evaluation.
  • Determine the level of financial strength of competitors / competitors (positioning).
  • Determine the level of damage faced by the company.

Types of Financial Ratios

To better understand the function of corporate financial ratio analysis, you will be introduced to other types of financial ratios. Budi Raharjo in the book Finance and Accounting (2007) grouped the company’s financial ratios into five, namely:

1. Liquidity Ratio or Liquidity Ratio

Liquidity ratio is a ratio that measures a company’s short-term liquidity capability by looking at the company’s current assets relative to its current debt. In liquidity ratios, analysis can be done using the following ratios:

  • Or the Current Ratio Current Ratiois a ratio to measure a company’s ability to pay short-term obligations or debt that is due soon with liquid assets available. The greater the ratio of current assets to current debt, the higher the company’s ability to cover its short-term liabilities. If a current ratio of 1: 1 or 100% means that current assets can cover all current debts. So it is said to be healthy if the ratio is above 1 or above 100%. This means that current assets must be far above the amount of current debt (Harahap, 2002)
  • Quick ratio or Quick Ratio / Acid Test Ratiois the ratio that indicates the company’s ability to pay current liabilities or debts with current assets without taking into account the value of inventories. This ratio shows the ability of the most liquid current assets able to cover current debt. The greater this ratio the better. This ratio figure does not have to be 100% or 1: 1. Although the ratio does not reach 100%, but close to 100% has also been said to be healthy (Harahap, 2002).
  • Cash Ratiocompares cash and current assets which can immediately become cash with good debt. Cash in question is company money held in offices and banks in the form of checking accounts. Meanwhile, cash equivalent assets ( near cash ) are current assets that can easily and quickly be cashed back, can be influenced by the economic conditions of the country that become the domicile of the company concerned. This ratio shows the portion of the amount of cash + cash equivalents compared to total current assets. The bigger the ratio the better. Just like Quick Ratio , it does not have to reach 100% (Harahap, 2002: 302).

2. Activity Ratio

This ratio looks at some assets and then determines what level of activity these assets are at a certain level of activity. Low activity at a certain level of sales will result in an increase in excess funds that are embedded in these assets. The excess funds will be better if invested in other assets that are more productive.

  • Receivables turnover, is a way to measure the number of times, on average the receivables collected in one year. This ratio measures the quality of receivables and the efficiency of the company in the collection of receivables and credit policies. This ratio measures the effectiveness of receivables management. The higher the turnover rate, the more effective the management of its receivables (Sutrisno, 2001).
  • Inventory Turnover,describes the company’s liquidity, that is by measuring the company’s efficiency in managing and selling the inventory owned by the company. This ratio measures the effectiveness of inventory management. The higher the rotation rate, the more effective the management of its supplies (Sutrisno, 2001).
  • Turnover of Fixed Assets, is a way to measure the extent of the company’s ability to generate sales based on the company’s fixed assets. This ratio shows the extent of the effectiveness of the company using its fixed assets. The higher this ratio means the more effective the proportion of fixed assets.
  • Total Asset Turnover, aratio that calculates the effectiveness of the use of total assets. A high ratio usually indicates good management, on the contrary a low ratio must make management evaluate its strategy, marketing, and investment or capital expenditure (Hanafi and Halim, 2000).

3. Ratio of Solvency or Solvability Ratio

Activity ratio shows the level of effectiveness of the use of assets or wealth of the company to you. The ratio used is:

  • Debt to Asset Ratioor Total Debt to Asset Ratio is a measure of how much a company’s assets are financed by debt or how much the company’s debt affects the management of assets. This ratio shows the extent to which debt can be covered by assets. The smaller the ratio the safer ( solvable ). The portion of debt to assets must be smaller (Harahap, 2002).
  • Debt-to-Equity Ratioor Total Debt to Equity Ratio shows the relationship between the amount of long-term debt with the amount of own capital provided by the owner of the company which is useful to know the amount of funds provided by the creditor and the owner of the company. For companies, the amount of debt cannot exceed their own capital so that the fixed burden is not too high. The smaller the portion of debt to capital, the safer.

4. Profitability and Profitability Ratios

It is a ratio that shows the level of return or gain (profit) compared to sales or assets. This analysis can be done using the following ratios:

  • Gross Profit Margin or Gross Profitargin a percentage of each outcome measure sales after the company pays the rest of the cost of sales.
  • Margin Operating Income or Operating Profit Marginis a measure of the percentage of each sale of the rest of the proceeds after all costs and other expenses reduced except for interest and taxes, or the net profit generated from each sale rupiah.
  • Net Profit Marginor Net Profit Margin is a percentage measure of each remaining sales after deducting all costs and expenses, including interest and taxes.
  • Return On Investment(ROI)  is the company’s ability to generate profits that will be used to cover the investment incurred. Profit used to measure this ratio is net income after tax or EAT (Sutrisno, 2001).
  • Economic Rentability or Return On Assetsis the company’s ability to generate profits with all assets owned by the company. This ratio measures the rate of return (EBIT) of the assets used. The bigger the ratio the better (Sutrisno, 2001)

5. Investment Ratio

Investment ratio is a ratio that measures a company’s ability to provide returns or rewards to funders, especially investors who are in the capital market within a certain period. The ratio has the value of benefits for investors according to the function of financial statements for investors to assess the performance of stock securities in the capital market.

Also read:  Contribution Margin as a Financial Analysis Tool

To be able to do ratio analysis , you must have clear financial statements consisting of balance sheets, income statements and cash flow statements that you can easily. Therefore, you can use the help of accounting software that can facilitate the calculation process. One accounting software that you can use is Journal.

Journals can help you have various financial reports with accurate and fast results. In addition, the Journal also provides reports in graphical form that makes it easy for you to analyze business finances in a short amount of time. Get all the valuable information about the Journal here , and start making an analysis of your company’s financial ratios now.


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