What is Ratio Analysis
A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.
BREAKING DOWN Ratio Analysis
When investors and analysts talk about fundamental or quantitative analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the performance and financial health of a company by using data from the current and historical financial statements. The data retrieved from the statements is used to – compare a company’s performance over time to assess whether the company is improving or deteriorating; compare a company’s financial standing with the industry average; or compare a company to one or more other companies operating in its sector to see how the company stacks up.
Most investors are familiar with a few key ratios, particularly the ones that are relatively easy to calculate. Some of these ratios include the current ratio, return on equity (ROE), the debt-equity (D/E) ratio, the dividend payout ratio, and the price/earnings (P/E) ratio. While there are numerous financial ratios, ratio analysis can be categorized into six main groups:
1. Liquidity Ratios: liquidity ratios measure a company’s ability to pay off its short-term debts as they come 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 earnings to evaluate whether a company can stay afloat in the long-term by paying its long-term debt and interest on the debt. Examples of solvency ratios include debt-equity ratio, debt-assets ratio, and interest coverage ratio.
3. Profitability Ratios: these ratios show how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratio are examples of profitability ratios.
4. Efficiency Ratios: also called activity ratios, efficiency ratios evaluate how well a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios are the asset turnover ratio, inventory turnover, and days’ sales in inventory.
5. Coverage Ratios: these ratios measure a company’s ability to make the interest payments and other obligations associated with its debts. Times interest earned ratio and debt-service coverage ratio are two examples of coverage ratios.
6. Market Prospect Ratios: e.g. dividend yield, P/E ratio, earnings per share, and dividend payout ratio. These are the most commonly used ratios in fundamental analysis. Investors use these ratios to determine what they may receive in earnings from their investments and to predict what the trend of a stock will be in the future. For example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the majority of companies having a P/E between 15 and 25, a stock with a P/E ratio of 7 would be considered undervalued, while one with a P/E of 50 would be considered overvalued. The former may trend upwards in the future, while the latter will trend downwards until it matches with its intrinsic value.
Use by Analysts
Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s financial situation or performance. Analysts engage in extensive number-crunching of the financial data in a company’s quarterly financial reports for any such hints. Successful companies generally have solid ratios in all areas, and any hints of weakness in one area may spark a significant sell-off in the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, as for instance inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies.
Of course, using any ratio in any of the categories listed above should only be considered as a starting point. Further ratio analysis using more ratios and using qualitative analysis should be incorporated to effectively analyze a company’s financial position.
Ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one industry may be regarded as too high in another. For example, companies in sectors such as utilities typically have a high debt-equity ratio, but a similar ratio for a technology company may be regarded as unsustainably high.
Putting Ratio Analysis in to Practice
Ratios can be used to determine a number of things about a companies performance. Analyzing these ratios can be an excellent premise for choosing stocks and other investments. In fact, not knowing certain ratios, such as price-earnings ratio (P/E), before making an investment decision would be considered unwise to some.
To make use of ratios for the purpose of building an investment portfolio, one would need a brokerage account. Investopedia has put together a list of the best online brokers for those looking to get started with investing and trading.