Ratio analysis is a quantitative method used to gain a deep insight into a company’s liquidity, operational efficiency, and profitability by carefully studying its financial statements such as the balance sheet and income statement. This technique is a cornerstone of fundamental equity analysis.
Key Takeaways
- Ratio analysis compares line-item data from a company’s financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
- It helps track a company’s performance over time and allows for comparisons with other companies within the same industry or sector.
- External parties, like lenders, may require ratio analysis tied to risk benchmarks.
- While ratios provide useful insights, they should be used alongside other metrics for a comprehensive view of a company’s financial health.
- Examples of ratio analysis include current ratio, gross profit margin ratio, and inventory turnover ratio.
What Does Ratio Analysis Tell You?
Investors and analysts utilize ratio analysis to gauge a company’s financial health by examining current and past financial statements. Comparative data not only highlight how a company performs over time but also serve as predictors for future performance. This data can compare a company’s financial standing with industry standards, illustrating how it measures up against peers within the same sector.
Ratios serve as comparative tools for stocks within an industry and for different time frames within the same company. Understanding the variables driving these ratios is crucial, as management can fine-tune strategies to present more attractive ratios. Typically, ratios are used in conjunction with other metrics to provide a holistic financial analysis.
Types of Ratio Analysis
The various kinds of financial ratios can be broadly grouped into six categories based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company’s ability to pay off its short-term debts using current or quick assets. Examples include the current ratio, quick ratio, and working capital ratio.
2. Solvency Ratios
Solvency ratios, or financial leverage ratios, compare a company’s debt levels with its assets, equity, and earnings to evaluate its ability to survive long-term by paying off both principal and interest. Examples include debt-equity ratio, debt-assets ratio, and interest coverage ratio.
3. Profitability Ratios
Profitability ratios evaluate how well a company can generate profit from its operations. Common examples include the profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.
4. Efficiency Ratios
Also known as activity ratios, efficiency ratios analyze how effectively a company uses its assets and liabilities to generate sales and maximize profits. Key examples include turnover ratio, inventory turnover, and days’ sales in inventory.
5. Coverage Ratios
Coverage ratios measure a company’s ability to meet interest payments and other debt-related obligations. Notable examples include the times interest earned ratio and the debt-service coverage ratio.
6. Market Prospect Ratios
These are essential for fundamental analysis and include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict future earnings and performance.
Application of Ratio Analysis
The fundamental basis of ratio analysis is the comparison of multiple figures to derive a calculated value. This value must often be applied to comparables to determine if a company’s financial health is strong, weak, improving, or deteriorating.
Ratio Analysis Over Time
Performing ratio analysis over time helps companies understand their trajectory. By calculating the same ratio periodically, companies can track performance improvements, analyze the impact of strategies, and recognize risks. Considerations should be made for seasonality, which may affect monthly variations.
Ratio Analysis Across Companies
A company might initially be pleased with its performance until it benchmarks against competitors, which may highlight areas of underperformance. Ratio analysis is crucial for gaining perspective relative to industry standards.
Ratio Analysis Against Benchmarks
Internal targets for financial ratios help companies maintain current levels or achieve growth goals. Externally, lenders and other parties often set benchmarks as loan covenant requirements. Not meeting these benchmarks can result in loan recalls or increased interest rates.
Examples of Ratio Analysis in Use
Net Profit Margin
The net profit margin, often called the bottom line, allows investors to compare the profitability of companies within the same sector. Suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can use this ratio to easily compare and conclude that ABC is converting more revenue into profits than DEF.
P/E Ratio
Using the same companies as examples, if ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10, this indicates investors are willing to pay more for ABC’s earnings than DEF’s, reflecting differing market valuations.
Why Is Ratio Analysis Important?
Ratio analysis is important because it provides a more accurate portrayal of a company’s operations than static numbers alone. For instance, high revenue figures are less insightful without an understanding of profitability, liquidity, and efficiency as presented by various ratios.
The Bottom Line
Companies face an overwhelming amount of data useful for informed decision-making. Ratio analysis offers a systematic approach to distill complex financial information into comprehensible insights. Whether it’s through internal assessments or external benchmarks, ratio analysis enhances the understanding of a company’s performance, setting the foundation for more strategic planning and long-term success.
Related Terms: Current Ratio, Profitability Ratios, Solvency Ratios, Financial Statements, Operational Efficiency.
