Ratio analysis provides an investor with tools to analyze a company's financial statements. Investors use ratios to evaluate one stock in a sector in comparison to another company in the same industry. Using ratio analysis simplifies comparing financial statements of multiple companies. Some key ratios an investor can use to evaluate a company are the profit margin and price to earnings (P/E) ratios.
Profit margin is a ratio that investors can 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 trying to dissect 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 was able to convert 50% of its revenues into profits, while DEF was only able to convert 10%.
Another ratio an investor can use is the P/E ratio. This is a valuation ratio and compares a company's current share price to its earnings per share. It measures how buyers and sellers are pricing 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 investor can conclude 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.