What is Ratio Analysis?

Ratio analysis provides investors with tools to analyze a company's financial statements as it relates to risk, reward (profitability), solvency, and how well a company operates. Investors generally use ratios to evaluate companies and make comparisons between companies within an industry. Ratio analysis simplifies the process of comparing the financial statements of multiple companies. There are five basic types of financial ratios used: profitability ratios (e.g., net profit margin and return on shareholders' equity), liquidity ratios (e.g., working capital), debt or leverage ratios (e.g., debt-to-equity and debt-to-asset ratios), operations ratios (e.g., inventory turnover), and market ratios (e.g. earnings per share (EPS)). Some key ratios investors use are the net profit margin and price to earnings (P/E) ratios.

Key Takeaways

  • Ratio analysis is a method of analyzing a company's financial statements or line items within financial statements.
  • There are many different ratios available, but some, like price to earnings (P/E) ratio and net profit margin, are used more frequently by investors and analysts.
  • The price to earnings (P/E) ratio compares a company's share price to its earnings per share (EPS).
  • Net Profit Margin compares net income to revenues.

Net Profit Margin

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. 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 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

Using one metric will not give a complete and accurate picture of how well a company operates (e.g., many analysts believe that the cash flow of a company is more important than the net profit margin ratio).

Price to Earnings Ratio

Another ratio an investor often use is the price to earnings (P/E ratio). This is a valuation ratio that compares a company's current share price to its earnings per share. It measures how buyers and sellers price the stock per $1 of earnings. The ratio gives an investor an easy way to compare one company's earnings with those of other companies. Using 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 are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.