What Is Ratio Analysis?

Ratio analysis is a method of examining a company's balance sheet and income statement to learn about its liquidity, operational efficiency, and profitability. It doesn't involve one single metric; instead, it is a way of analyzing a variety of financial data about a company. Ratio analysis is a cornerstone of 澳洲幸运5官方开奖结果体彩网:fundamental equity analysis.

There are many different ratios that investors and other business experts can analyze to make predictions about a company's financial stability and potential future growth. These can be used to evaluate either how a company's performance has changed over time or how it compares to other businesses in its industry.

How Ratio Analysis Works

Investors and analysts use ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. For example, comparing the price per share to earnings per share allows investors to find the 澳洲幸运5官方开奖结果体彩网:price-to-earnings (P/E) ratio, a key metric for determining the v▨alue of a company's stock.

The ratios of these different fina꧑ncial metrics from a 𒅌company can be used to:

• Evaluate a company's performance over time
• Estimate likely future performance
• 澳洲幸运5官方开奖结果体彩网:Coཧmpare a company's financial standi🌞ng with industry averages
• Measuring how a company stacks up against others within the same sector

Every figure needed to calculate the ratios used in ratio analysis is found on a company's financial statements.

Ratios are comparison poin🔯ts for companies and are not generally used in isolation. Instead, they are compared either to past ratios for the same company or to the same ratio fro𝄹m other companies.

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 is probably undervalued. In contrast, one with a P/E ratio of 50 likely is overvalued. ♛The former may trend upwards in the fᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚuture, while the latter may trend downwards until each aligns with its intrinsic value.

Ratio analysis 🧔is often used by investors, bu🐎t it can also be used by the company itself to evaluate how strategic changes have impacted sales, growth, and performance.

Limitations of Ratio Analysis

Ratio analysis can help investors understand a company's current performance and likely future growth. However, companies can make small changes that make their stock and company ratios more attractive without changing any underlying financial fundamentals. To counter this limitation, investors also need to understand the variables behind ratios, what information they do and do not communicate, and how they are susceptible to manipulation.

Ratios also can't be used in isolation. Instead, they should be used in combination with other ratios or financial metrics to give a fuller picture of both a company's financial state and how it compares to other companies in the same industry.

Types of Ratios for Ratio Analysis

The financial ratios available can be broadly grouped into six types based on the kind of data they provide. Using ratios in each category will give you a comprehensive vi꧟ew of the company from different angles and help you spot potential red flags.

1. Liquidity Ratios

Liquidity ratios measure a company's abilityౠ to pay off short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include:

• Current ratio
• Quick ratio
• Working capital ratio

2. Solvency Ratios

Also called financial leverage ratios, 澳洲幸运5官方开奖结果体彩网:solvency ratios compare a company's debt ♋🌄levels with its assets, equity, and earnings. These are used to evaluate the likelihood of a company staying afloat over the long haul by paying off both long-term debt and the interest on that debt. Examples of solvency ratios include:

• Debt-equity ratios
• Debt-assets ratios
• Interest coverage ratios

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Examples of 澳洲幸运5官方开奖结果体彩网:profitability ratios are:

• Profit margin ratio
• Return on assets
• Return on equity
• Return on capital employed
• Gross margin ratio

4. Efficiency Ratios

Also called activity ratios, 澳洲幸运5官方开奖结果体彩网:efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales a🐼nd maximize profits. Key efficiency ratios include:

• Turnover ratio
• Inventory turnover
• Day's sales in inventory

5. Coverage Ratios

澳洲幸运5官方开奖结果体彩网:Coverage ratios measure a company's ability to make the interest payments and other ob🦩ligations associated with its debts. Examples include:

• 澳洲幸运5官方开奖结果体彩网:Times interest earned ratio
• 澳洲幸运5官方开奖结果体彩网:Debt-service coverage ratio

6. Market Prospect Ratios

Market prospect ratios are the most commonly used ratios iℱn fundamental analysis. Investors use these metrics to predict earnings and future performance. These ratios include:

• 澳洲幸运5官方开奖结果体彩网:Dividend yield
• 澳洲幸运5官方开奖结果体彩网:P/E ratio
• 澳洲幸运5官方开奖结果体彩网:Earnings per share (EPS)
• 澳洲幸运5官方开奖结果体彩网:Dividend payout ratio

Application of Ratio Analysis

Using ratio analysis will give you multiple figures and values to compare. However, those values will mean very little in isolation. Instead, the values derived from these ratios should be compared to other data to determine whether a company's financ⛎ial health is strong, weak, improving, or deteriorating.

Ratio Analysis Over Time

Comparing how the same ratio changes over time provides a picture of how a company has performed during that period, what risks might exist in the future, and ღwhat growth trajectory growth it is likely to fol𓃲low.

To perform ratio analysis over ti⭕me, select a single financial ratio, then calculate that ratio at set intervals (for example, at the beginning of every quarter). Then, analyze how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).

Comparative Ratio Analysis Across Companies

Comparative ratio analysis can be used to understand how a company's performance compares to similar companies in the same industry. For example, a company with a 10% gross profit margin may be in good financial shape if other companies in the same sector have gross profit margins of 5%. However, if the majority of competitors achieve gross profit margins of 25%, that's a sign that the original company may be in financial trouble.

When using ratio analysis to comp♒are different companies, be sure to:

• Only analyze similar companies within the same industry.
• Be mindful of how different capital structures and company sizes may impact a company's ability to be efficient.
• Consider the impact of varying product lines (for example, two companies offer similar services, but only one sells physical products).

Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios. The goal may be to hold current levels steady or to strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.

Benchmarks are also frequently implemented by external parties such as lenders. Lending institutions often set requirements for financial health as part of covenants in loan document's terms and conditions. An example of a benchmark set by a lender is often the debt service coverage ratio, which measures a company's cash flow again🌌st its debt balances. If a company doesn't maintain certain levels for these ratios, the loan may be recalled or the interest rate atta🎶ched to that loan may increase.

Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance—for better or worse. When a company generally boasts solid ratios in all areas, any sudden hint of weakness in one area may spark a significant 🅷🥃stock sell-off.

For example, 澳洲幸运5官方开奖结果体彩网:net profit margin, often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues and is often used instead of dissecting financial statements to compare how profitable companies are. If company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively, an investor comparing the two companies will conclude t🎶hat ABC converted 50% of its revenues into profits, while DEF only converted 10%.

This can be combined with additional ratios to learn more about the companies in question. If ABC has a P/E ratio of 100 and DEF has a P/E ratio of ꦐ10, that means investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

The Bottom Line

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their informati𒐪on, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Rati🎀o analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.