What is ratio analysis?
Ratio analysis is a quantitative method for obtaining insight into a company’s liquidity, operational efficiency and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
Key points to remember
- Ratio analysis compares individual data from a company’s financial statements to reveal information about profitability, liquidity, operational efficiency, and solvency.
- Ratio analysis can mark a business’s performance over time, while also comparing one business to another in the same industry or industry.
- While ratios provide useful information about a business, they should be combined with other metrics to get a broader picture of a business’s financial health.
What does ratio analysis tell you?
Investors and analysts use ratio analysis to assess the financial health of companies by examining past and current financial statements. Comparative data can demonstrate how a business is performing over time and can be used to estimate likely future performance. This data can also compare a company’s financial position with industry averages while measuring how a company compares to others in the same industry.
Investors can easily use ratio analysis, and every number needed to calculate ratios is found in a company’s financial statements.
Ratios are benchmarks for businesses. They value stocks within an industry. Likewise, they measure a business today against its historical numbers. In most cases, it is also important to understand the variables that determine ratios, as management has the ability, at times, to change their strategy to make their equity and company ratios more attractive. In general, ratios are generally not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four categories mentioned earlier will give you a big picture of the business from different angles and help you spot potential red flags.
Examples of report analysis categories
The different types of financial ratios available can be roughly grouped into the following six silos, depending on the datasets they provide:
1. Liquidity ratios
Liquidity ratios measure a company’s ability to repay short-term debts as they fall due, using the company’s current or quick assets. Liquidity ratios include current ratio, quick ratio, and working capital ratio.
2. Solvency ratios
Also called financial leverage ratios, solvency ratios compare a company’s debt levels with its assets, equity and profits, to assess the likelihood that a company will stay afloat over the long term, paying off long-term debt as well as interest on its debt. Examples of solvency ratios include: debt ratios, debt-to-asset ratios, and interest coverage ratios.
3. Profitability ratios
These ratios indicate how much profit a business can generate from its operations. Profit margin, return on assets, return on equity, return on capital employed and gross margin ratios are all examples of profitability ratios.
4. Efficiency reports
Also called activity ratios, efficiency ratios evaluate the efficiency with which a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover rate, inventory turnover, and days of sale in inventory.
5. Coverage ratios
Coverage ratios measure a company’s ability to pay interest and other obligations associated with its debts. Examples include the ratio multiplied by the interest earned and the debt service coverage ratio.
6. Market Outlook Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend yield, P / E ratio, earnings per share (EPS) and dividend payout ratio. Investors use these metrics to predict future earnings and performance.
For example, if the average P / E ratio of all companies in the S&P 500 Index is 20 and the majority of companies have a P / E between 15 and 25, a stock with a P / E ratio of seven would be considered undervalued. On the other hand, one with a P / E ratio of 50 would be considered overvalued. The former may move higher in the future, while the latter may move lower until each aligns with its intrinsic value.
Examples of report analysis in use
Ratio analysis can predict a company’s future performance–For the best or for the worst. Successful companies typically have strong ratios across areas, where any sudden sign of weakness in one area can trigger a large stock sell-off. Let’s look at some simple examples
Net profit margin, often referred to simply as profit margin or bottom line, is a ratio that investors use to compare the profitability of companies in the same industry. It is calculated by dividing the net profit of a business by its income. Instead of dissecting financial statements to compare company profitability, an investor can use this ratio instead. For example, suppose Company ABC and Company DEF are in the same industry with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its income into profit, while DEF only converted 10%.
Using the companies in the example above, suppose ABC has a P / E ratio of 100, while DEF has a P / E ratio of 10. An average investor concludes that investors are willing to pay $ 100 per $ 1 of income generated by ABC and only $ 10 per $ 1 of income generated by DEF.
The ratios are generally only comparable between companies in the same sector. For example, a debt ratio that might be normal for a utility company might be deemed too high for a tech game.