Ratio Analysis

Loading the player...

What is the 'Ratio Analysis'

A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items in financial statements like the balance sheet, income statement and cash flow statement; the ratios of one item – or a combination of items - to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis.

BREAKING DOWN 'Ratio Analysis'

While there are numerous financial ratios, 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, the debt-equity ratio, the dividend payout ratio and the price/earnings (P/E) ratio.

For a specific ratio, most companies have values that fall within a certain range. A company whose ratio falls outside the range may be regarded as grossly undervalued or overvalued, depending on the ratio.

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 single-digit P/E would be considered undervalued, while one with a P/E of 50 would be considered overvalued. Of course, this ratio would typically only be considered as a starting point, with further analysis required to identify if these stocks are really as undervalued or overvalued as the P/E ratios suggest.

As well, 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.

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.  

 

RELATED TERMS
  1. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  3. Accounting Ratio

    A way of expressing the relationship between one accounting result ...
  4. Combined Ratio

    A measure of profitability used by an insurance company to indicate ...
  5. Activity Ratios

    Accounting ratios that measure a firm's ability to convert different ...
  6. Capitalization Ratios

    Indicators that measure the proportion of debt in a company’s ...
Related Articles
  1. Investing Basics

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  2. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  3. Trading Strategies

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  4. Stock Analysis

    Big Movers on the Technology Sector Today, Including BIDU

    The morning has been good for the market. The Nasdaq is trading up 1%; the S&P 500 is up 0.5%; and the Dow has increased 0.6%. The technology sector is a category of stocks relating to the ...
  5. Stock Analysis

    Sysco and Other Big Movers In Services

    The market has been slipping so far today. The Nasdaq has fallen 0.3%; the S&P 500 has fallen 0.4%; and the Dow has declined 0.5%. The Services sector (IYC) is currently lagging behind the ...
  6. Active Trading

    5 Must-Have Metrics For Value Investors

    These quick-and-dirty ratios will help you find the most undervalued stocks on the market.
  7. Forex Education

    How To Use The P/E Ratio And PEG To Tell A Stock's Future

    While the price-to-earnings ratio is commonly used for assessing stock prices, the price/earnings-to-growth ratio offers forecasting advantages that investors need to know.
  8. Active Trading Fundamentals

    Wal-Mart's 5 Key Financial Ratios (WMT)

    Identify the five key financial ratios that fundamental analysts use to evaluate Wal-Mart's financial position and determine if its stock is a good buy.
  9. Fundamental Analysis

    Efficiency Ratio

    There are many types of efficiency ratios, but all measure how well a company utilizes its resources to make a profit. Business managers use these ratios to determine how well they are operating ...
  10. Stock Analysis

    Big Movers on the Semiconductors Sector Today, Including INVN

    So far today, the Nasdaq has fallen 0.8%, the S&P 500 is down 0.2% and the Dow is trading up 0.4%. The Semiconductors sector (XLK) is up 0.5% so far today and here are its biggest movers: ...
RELATED FAQS
  1. How do stock dividends affect the retained earnings account?

    Understand the difference between financial ratio analysis and accounting ratio analysis. Learn why ratio analysis is important ... Read Answer >>
  2. What role does ratio analysis play in valuing a company?

    Learn about the role of ratio analysis in determining company value, including some of the most common ratios used by modern ... Read Answer >>
  3. How does ratio analysis make it easier to compare different companies?

    Learn what ratio analysis is, how investors can compare companies within the same sector using ratio analysis and how ratios ... Read Answer >>
  4. Which financial metrics are best for analyzing companies in the chemicals sector?

    Learn about some of the key financial metrics that investors and market analysts commonly use to evaluate companies in the ... Read Answer >>
  5. How do I use ratios to perform a financial analysis?

    Learn which ratios are used in fundamental analysis. Find out how analysts measure company performance and financial health ... Read Answer >>
  6. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
Hot Definitions
  1. Reverse Mortgage

    A type of mortgage in which a homeowner can borrow money against the value of his or her home. No repayment of the mortgage ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  6. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
Trading Center