What is Ratio Analysis in Finance?

Ratio analysis is a quantitative method to analyze a company’s financial statements. This method is based on individual financial statement items such as the balance sheet, income, cash flow statements, relationships of one element, or a combination of elements. Ratio analysis assesses a company’s operational and financial performance, including efficiency, liquidity, profitability, and solvency. 

Ratios are also compared between companies in the same industry for ​​comparative valuations. The trend of these relationships over time is studied to see if they improve or deteriorate. The article discusses ratio analysis, its types and a few examples of ratio analysis in finance to better understand the concept.

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Types of Ratio Analysis

The various types of ratio analysis are –

1. Liquidity Ratio

The liquidity ratio measures the ability of a company to clear off its short-term debts using its current or quick assets. Liquidity ratios include the current ratio, the quick ratio, and the working capital ratio.

2. Solvency Ratio

Solvency ratios are also known as financial leverage ratios. They compare a company’s debt levels with its available assets, equity, and earnings to assess the likelihood that it will stay afloat over the long term. 

Examples of credit ratios include debt-to-equity ratios, debt-to-asset ratios, and interest coverage ratios.

3. Profitability Ratio

The profitability ratio conveys how well a business can generate profit from its operations. Examples of profitability ratios are profit margins, return on assets, return on capital, gross margin ratios, etc.

4. Efficiency Ratio

Also called activity ratios, efficiency ratios assess a company’s efficiency in using its assets and liabilities to maximize profits. Key efficiency ratios include turnover rate, inventory turns, and days sold in inventory.

5. Coverage Ratio

A coverage ratio measures a company’s ability to make interest payments or dividends associated with its debts. Examples include the interest earned ratio and the debt service coverage ratio.

6. Market Outlook Ratio

Market Outlook Ratio is the most popular ratio analysis method to analyze a company’s financial performance and predict future earnings.

For example, if a company’s average price-to-earnings (P/E) ratio in the Standard and Poor (S&P 500®) Index is 20, most companies have a P/E ratio between 15 and 25. A P/E ratio of 8 would be considered undervalued, while a P/E ratio of 55 would be considered overvalued. 

The former ratio may trend upward in the future, while the latter may trend downward until each aligns with its intrinsic value.

Examples of Ratio Analysis

Ratio analysis can predict a company’s future performance – for better or worse. Successful companies in all areas tend to have strong ratios, where any sudden hint of weakness in one area could trigger significant stock sales. Let’s look at some simple examples.

Net profit margin compares companies’ profitability in the same industry. You can calculate the net profit margin of a company by dividing its net income by revenues. Instead of looking at financial statements to compare the profitability of the companies, an investor can use ratio analysis. For example, ABC and DEF are probably in the same industry with 50% and 10% profit margins, respectively.

This allows an investor to quickly compare the two companies and conclude that ABC turned 50% of its revenue into profit, while DEF turned only 10%.

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Using the companies from the example above, ABC probably has a P/E of 100, while DEF has a P/E of 10. An investor concludes that investors are willing to pay $100 for every $1 profit generated by ABC and only $10 for every $1 profit generated by DEF.

Generally, the proportions are only comparable between companies in the same sector. For example, a potentially average debt-capital ratio for an unsustainable utility might be considered high in a tech drama.

BREAKING the Ratio Analysis

While there are numerous financial ratios, most investors are familiar with a few key ratios, especially ones that are relatively easy to calculate. These ratios include the current, return on equity, debt-to-equity, dividend, and price/earnings (P/E) ratios.

Most companies have values ​​within a certain range for a specific ratio. Depending on the ratio, a company whose ratio falls outside the range may be considered grossly undervalued or overvalued. Of course, this ratio is a starting point. However, further analysis is required to identify whether these stocks are genuinely undervalued or overvalued, as the P/E ratios suggest.

Furthermore, the ratios usually are only comparable between companies in the same industry, as an acceptable ratio in one industry can be too high in another. For example, companies in industries such as utilities typically have high debt-to-equity ratios, but a similar ratio for a technology company can be unsustainably high.

Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s financial condition or performance. Analysts extensively calculate economic data in a company’s quarterly financial reports for any suggestions.

Successful companies often have strong ratios in all areas, and any hint of weakness in one area can trigger a significant sell-off in the stock. Some ratios are closely scrutinized because of their importance to a given industry, such as inventory sales volume for retail and days sold outstanding (DSO) for technology companies.

Key Takeaways

• Ratio analysis compares data from line items in a company’s financial statements to reveal profitability, liquidity, operating efficiency, and solvency information.
• Ratio analysis can chart a company’s performance and compare companies within the same sector.
• Ratios help in getting helpful information about a company. However, they must be combined with other metrics to get a detailed and bigger picture of its financial health.