What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by comparing information contained in its financial statements. Ratio analysis is a cornerstone of fundamental analysis.
Outside analysts use several types of ratios to assess companies, while corporate insiders rely on them less because of their access to more detailed operational data about a company.
What Does Ratio Analysis Tell You?
When investors and analysts talk about fundamental or quantitative analysis, they are usually referring to ratio analysis. Ratio analysis involves evaluating the performance and financial health of a company by using data from the current and historical financial statements.
The data retrieved from the statements is used to compare a company's performance over time to assess whether the company is improving or deteriorating, to compare a company's financial standing with the industry average, or to compare a company to one or more other companies operating in its sector to see how the company stacks up.
Ratio analysis can be used to establish a trend line for one company's results over a large number of financial reporting periods. This can highlight company changes that would not be evident if looking at a given ratio that represents just one point in time.
Comparing a company to its peers or its industry averages is another useful application for ratio analysis. Calculating one ratio for competitors in a given industry and comparing across the set of companies can reveal both positive and negative information.
Since companies in the same industry typically have similar capital structures and investment in fixed assets, their ratios should be substantially the same. Different ratio results could mean that one firm has a potential issue and is underperforming the competition, but they could also mean that a certain company is much better at generating profits than its peers. Many analysts use ratios to review sectors, looking for the most and least valuable companies in the group.
- Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
- Ratio analysis can be used to look at trends over time for one company or to compare companies within an industry or sector.
- While ratios offer several types of insight, other types of information and analysis are usually needed to form a complete picture of a company's financial position.
Examples of Ratio Analysis Categories
Most investors are familiar with a few key ratios, particularly the ones that are relatively easy to calculate and interpret. Some of these ratios include the current ratio, return on equity (ROE), the debt-equity (D/E) ratio, the dividend payout ratio, and the price/earnings (P/E) ratio. While there are numerous financial ratios, they can be categorized into six main groups based on the type of analysis they provide.
1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they come due using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.
2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings to evaluate whether a company can stay afloat in the long-term by paying its long-term debt and interest on the debt. Examples of solvency ratios include debt-equity ratio, debt-assets ratio, and interest coverage ratio.
3. Profitability Ratios
These ratios show how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratio are all examples of profitability ratios.
4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how well a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios are the asset turnover ratio, inventory turnover, and days' sales in inventory.
5. Coverage Ratios
These ratios measure a company's ability to make the interest payments and other obligations associated with its debts. The times interest earned ratio and the debt-service coverage ratio are both examples of coverage ratios.
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis and include dividend yield, P/E ratio, earnings per share, and dividend payout ratio. Investors use these ratios to determine what they may receive in earnings from their investments and to predict what the trend of a stock will be in the future.
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 P/E ratio of 7 would be considered undervalued, while one with a P/E of 50 would be considered overvalued. The former may trend upwards in the future, while the latter will trend downwards until it matches with its intrinsic value.
Examples of Ratio Analysis in Use
Ratio analysis can provide an early warning of 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 of the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, such as inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies.
Using any ratio in any of the categories listed above should only be considered as a starting point. Further analysis using additional ratios and qualitative analysis should be incorporated to effectively analyze a company's overall financial position.
Ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one industry may be regarded as too high to too low in another. For example, companies in sectors such as utilities typically have a high debt-equity ratio which is normal for its industry, while a similar ratio for a technology company may be regarded as unsustainably high.