Ratio Analysis
What Is Ratio Analysis?
Ratio analysis is a quantitative method of acquiring understanding into a company's liquidity, operational efficiency, and profitability by concentrating on its financial statements, for example, the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
What Does Ratio Analysis Tell You?
Investors and analysts employ ratio analysis to evaluate the financial health of companies by investigating past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can likewise compare a company's financial standing with industry averages while measuring how a company stacks up against others inside the same sector.
Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.
Ratios are comparison points for companies. They evaluate stocks inside an industry. Likewise, they measure a company today against its historical numbers. By and large, it is likewise important to understand the variables driving ratios as management has the flexibility to, on occasion, alter its strategy to make its stock and company ratios more attractive. Generally, ratios are typically not used in detachment yet rather in combination with other ratios. Having a smart thought of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red banners.
Examples of Ratio Analysis Categories
The different sorts of financial ratios available might be comprehensively grouped into the accompanying six storehouses, 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 as they become due, utilizing the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.
2. Solvency Ratios
Likewise called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company remaining above water over the long take, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.
3. Profitability Ratios
These ratios convey 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 ratios are examples of profitability ratios.
4. Efficiency Ratios
Likewise called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.
5. Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio.
6. Market Prospect Ratios
These are the most usually 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 earnings and future 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 P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. Interestingly, one with a P/E ratio of 50 would be considered overvalued. The former might trend upwards from here on out, while the latter might trend downwards until each lines up with its intrinsic value.
Examples of Ratio Analysis being used
Ratio analysis can predict a company's future performance — for better or worse. Successful companies generally brag strong ratios in all areas, where any sudden touch of weakness in one area might spark a huge stock sell-off. Let's glance at a few simple examples
Net profit margin, often referred to simply as profit margin or the main concern, is a ratio that investors use to compare the profitability of companies inside the same sector. It's calculated by partitioning a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector with profit margins of half and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted half of its revenues into profits, while DEF just converted 10%.
Utilizing the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors will pay $100 per $1 of earnings ABC generates and just $10 per $1 of earnings DEF generates.
Ratios are typically just comparable across companies inside the same sector. For example, a debt-equity ratio that may be normal for a utility company may be deemed impractically high for a technology play.
Highlights
- Ratio analysis can mark how a company is performing over time, while comparing a company to another inside the same industry or sector.
- While ratios offer useful understanding into a company, they ought to be paired with other metrics, to get a broader picture of a company's financial health.
- Ratio analysis compares line-item data from a company's financial statements to reveal bits of knowledge regarding profitability, liquidity, operational efficiency, and solvency.
