When investors wish to compare the financial performance of different companies, a highly valuable tool at their disposal is ratio analysis. Ratio analysis can provide insight into companies' relative financial health and future prospects. It can yield data about profitability, liquidity, earnings, extended viability, and more. The results of such comparisons can mean more powerful decision-making when it comes to selecting companies in which to invest.
It's important that investors understand that a single ratio from just one company can't give them a reliable idea of a company's current performance or potential for future financial success. Use a variety of ratios to analyze financial information from various companies that interest you in order to make investment decisions.
- Ratio analysis is a method of analyzing a company's financial statements or line items within financial statements.
- Many ratios are available, but some, like the price-to-earnings ratio and the net profit margin, are used more frequently by investors and analysts.
- The price-to-earnings ratio compares a company's share price to its earnings per share.
- Net profit margin compares net income to revenues.
- It's useful to compare various ratios of different companies over time for a reliable view of current and potential future financial performance.
What Is Ratio Analysis?
Ratio analysis is the analysis of financial information found in a company's financial statements. Such analysis can shed light on financial aspects that include risk, reward (profitability), solvency, and how well a company operates. As a tool for investors, ratio analysis can simplify the process of comparing the financial information of multiple companies.
There are five basic types of financial ratios:
- 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)
- Market ratios (e.g. earnings per share (EPS))
Some key ratios that investors use are the net profit margin and price-to-earnings (P/E) ratios.
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 measures the amount of net profit (gross profit minus expenses) earned from sales. 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. They have 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%.
One metric alone will not give a complete and accurate picture of how well a company operates. For example, some analysts believe that the cash flow of a company is more important than the net profit margin ratio.
Price-to-Earnings Ratio (P/E)
Another ratio investors often use is the price-to-earnings 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 P/E 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 that ABC generates and only $10 per $1 of earnings that DEF generates.
A high P/E ratio can indicate that a company's stock is overvalued or that investors may be expecting high future earnings growth. A low P/E ratio can indicate that a stock is undervalued or that future earnings are in doubt.
Other Factors to Consider
As mentioned, it's important to take into account a variety of financial data and other factors when doing research on a possible investment.
- The return on assets ratio can help you determine how effectively a company is using its assets to generate profit. The higher the ratio, the more profit each dollar in assets produces. It's calculated by dividing net income by total assets.
- The operating margin ratio uses operating income and revenue to determine the profit a company is getting from its operations. This ratio, along with net profit margin, can give investors a good feel for the profitability of a company as a whole. The operating margin ratio is calculated by dividing net operating income by total revenue.
- The return on equity ratio is another way to gauge profitability. It measures how well a company generates profit using money that's been invested in it (shareholder equity). It's calculated by dividing net profit by total equity.
- Inventory ratios can show how well companies manage their inventories. Inventory turnover and days of inventory on hand are often used. Bear in mind that the inventory method that a company employs can affect the financial data that underlie ratios. So, when comparing companies be sure that they use comparable methods.
- Take note of ratio analysis results over time to spot trends in company performance and to predict potential future financial health.
- Compare companies not just in the same industry, but with similar product types, years in operation, and location, as well. These factors can affect financial results.
What Are the 5 Categories of Ratio Analysis?
Ratio analysis includes these five types of financial ratios: profitability ratios, liquidity ratios, debt or leverage ratios, operations ratios, and market ratios.
How Do You Compare the Ratios of 2 Companies?
Start by choosing companies in the same industry. Narrow this down to companies with similar products, inventory methods, business longevity, and location. Then, compare the same financial ratios for both. Consider looking at a big picture of results over time rather than just one year-end snapshot.
Where Can You Find a Company's Financial Information?
Company information is available in many places, including news and financial publications and websites. However, to be sure of its credibility, look for financial information in audited company annual reports. In addition, the Securities and Exchange Commission (SEC) maintains financial and business information about publicly held companies in the online database called EDGAR. Access is free of charge.