Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial condition can be determined. The term ratio refers to the numerical or quantitative relationship between two variables.

It’s a tool which enables the banker or lender to arrive at the following factors :

Liquidity position

The liquidity position is the difference between the sum of liquid assets and incoming cash flows on one side and outgoing cash flows resulting from commitments on the other side, measured over a defined period, being the measure of the liquidity risk.  Related position codes are: 1. Liquidity position -spot. 2. Liquidity position – forward. The related report is the Liquidity Risk Analysis report. Two position codes are defined, one for the spot time bracket and one for the forward time brackets. See also Position, position administration tables, standard position codes, combined position code, risk management, foreign exchange risk, forex, open currency position, mismatch, interest risk, liquidity risk, forward revaluation, interest revaluation, break even.

Profitability

Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm’s cost of goods sold, but does not include other costs. It is defined as follows:

Return on assets is a measure of how effectively the firm’s assets are being used to generate profits. It is defined as:

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm’s stock. Return on equity is defined as follows:

Solvency

Solvency is the ability of a business to have enough assets to cover its liabilities. Solvency is often confused with liquidity,     but it is not the same thing. Solvency is often measured as a ratio, the “current ratio,” which is the total current assets divided by the total current liabilities. In order to be solvent and cover liabilities, a business should have a current ratio of 2/1, meaning that it has twice as many current assets as current liabilities. This ratio recognizes the fact that selling assets to obtain cash may result in losses, so more assets are needed.

Financial Stability

The firm’s ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company’s stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.