As an investor in the stock market, you are aware that when a share price of a company goes up, it offers an excellent opportunity to invest. But what determines the share price of a company? What goes behind the evaluation? And, how do analysts arrive upon the price they think is appropriate?
Value of shares depends on the company’s financial health. Analysts base their analysis on the company’s financial statements to determine financial stability and predict future growth. Based on this analysis, the share value of a company goes up or down.
Financial analysis is a critical part and requires expertise in evaluating the various data on a company’s balance sheet. Among the many techniques used to analyse financial statements, ratio analysis is one. It allows the management and the analysts draw a comparison between the various components of a company’s financial metrics to understand growth rate or loopholes. Traders and investors also use ratio analysis to evaluate investment opportunities in a company or to spot a potential red flag. Understanding ratio analysis will help you assess company performance from different aspects and let you pick the right stocks.
Understanding Ratio Analysis
Let’s begin our discussion with, what is ratio analysis? It is a process to analyse different components of a company’s balance sheet against each other to draw a comparative study. It is a widely used method by financial experts, used for obtaining insight on a company’s liquidity, operational efficiency, and profitability.
Key pointers
– It is a process of comparing line-item data of a company’s financial statement
– Analysts apply ratio analysis to gain insights on the company’s profitability, liquidity, solvency, and operational efficiency
– Ratio analysis reveals about company’s performance over time and even in comparison to another company from the same domain
– Ratio analysis offers useful insight, but it should be paired with other performance metrics to get the broader picture
What Is Ratio Analysis Used For?
As mentioned above, ratio analysis is critical in evaluating company’s financial performance. Management uses it for,
Comparison: One company can compare its performance against its competitors on various financial aspects to gauge its performance using ratio analysis. Obtaining financial ratio from competitors regarding pricing or earning helps the management identify market and performance gaps and formulate decisions for improvement.
Trend Line Analysis: Experts use ratio analysis to determine any trend in the company’s performance over time. Trend analysis is used for predicting progress of a company and possible loopholes in it.
Operational Efficiency: Ratio analysis helps to determine efficiency level in managing assets and liabilities, highlights abnormal expenses, and overuses or under optimal uses of resources.
Types of Ratio Analysis
For analytical purposes, financial analysts calculate various ratio analysis to draw a comparison between different components within a financial statement.
Liquidity ratio:
Computing liquidity ratio is vital to determine the solvency and financial strength of a company. It considers the company’s ability to pay its debt with its current asset. It is used by creditors, banks, and investors to determine the strength of the company to honour debt compliances when those become due.
The quick ratio, cash ratio, and current ratio are some of the commonly calculated liquidity ratios.
Solvency ratio:
It is calculated to determine company’s financial viability in the long run. Common solvency ratios calculate the debt-to-capital ratio, interest coverage ratio, and equity multiplier. Solvency ratio is used by credit agencies, government, banks, and institutional investors to determine the financial health of an organisation.
Profitability ratio:
Profitability ratio is measured to determine growth and ability to earn a profit. It estimates the company’s earning against its expenditures. Also, it is used to compare year to year growth to measure progress.
Management also uses profitability ratio analysis to compare profitability against other competitors.
Efficiency ratio:
It estimates efficiency in managing asset and liabilities to generate sales and earn profit. Management uses asset turnover ratio, inventory turnover, payable turnover, and few more to calculate efficiency quotient.
Market prospect ratio:
Prospect ratio helps investors to determine the future profitability of an investment. They use current earning on shares and dividends to determine how much their investment will receive in the future.
These are some of the broad categories of financial ratio analysis used at different stages to measure growth and stability, and eventually, investment prospects. Ratio analysis can take many forms, and accordingly, the formula will change.
Why Use Ratio Analysis?
Ratio analysis helps you understand the logic behind stock price evaluation. Since ratio analysis gives a glimpse at the company’s financial health, investors use the calculation to pick the right stocks. The comparative analysis gives you critical data regarding the past performance of a company to predict the future.
Ratio analysis gives you insights on
– Company’s comparative performance analysis over a period that can be applied to justify stock price movement in the market
– Company’s performance against sector performance metrics, which again is a critical determinant of stock price
Ratio analysis is easy to understand and apply to the analysis. As an investor, understanding it helps you get a comprehensive idea of the company’s stock performance in the market.
Conclusion
Ratio analysis is the foundation of financial analysis used to get an in-depth insight on the company’s performance. It is a quantitative method to gauge financial performance on a year-to-year basis concerning various crucial components. It lets you scrutinise the past to fix the future, compare company financials against the industry average, and more. Typically, analysts use a combination of different ratios for a complete picture. Having a good idea of ratio analysis will help you get a comprehensive view of a company from different angles and verify the merits of your investment decision.
