Ratio analysis is a popular term in accounting, often used in comparing different items in preparing company’s balance sheet. It is also used by market analysts and traders in determining the financial health of a company while making an investment decision. But it is only a generic definition; in reality, there is more to ratio analysis that can offer critical information to investors.
So, what is ratio analysis, and how it can be used in decision making?
When investors decide to invest in stocks, ratio analysis is one of the factors that investors look up to determine the worth of shares of a company.
To put it simply, Ratio Analysis is a quantitative method of evaluating the profitability, efficiency, liquidity, solvency and potential growth of a firm by external investors using its financial statements. This is particularly important for investors since it gives you insight on company’s financial health.
It’s useful for comparing line data from a company’s financial statements over the years as well it’s standing vis a vis other firms in the industry. Combining Ratio Analysis with other data helps provide a clearer picture of the organization’s investment potential.
What are the different categories of ratio analysis?
- Liquidity Ratios: Current Ratio, Quick Ratio, Working Capital Ratio
- Solvency Ratios: Debt Equity Ratio, Debt Asset Ratio, Interest Coverage Ratio
- Profitability Ratios: Profit Margin, Return on Assets, Return on Equity, Return on Capital Employed, Gross Margin Ratio
- Efficiency Ratios: Turnover Ratio, Inventory Turnover Ratio, Day’s Sales in Inventory
- Coverage Ratios: Times Interest Earned Ratio, Debt-Service Coverage Ratio.
- Market Prospect Ratios: Dividend Yield, P/E Ratio, Earnings per Share (EPS), Dividend Payout Ratio.
There are various ratios under these categories, which can be combined in different ways to gain an image of the firm’s financial state and the potential gains and risks in making investments.
So, what aspects of a company’s financial health get reflected by ratio analysis?
There are a number of ways the data received from the analysis can be interpreted. Ratio analysis is a handy tool when you have to understand a company’s financial health in detail, as an outside investor.
- Financial Statement Analysis: These ratios can be used to understand the firm’s balance sheets and income statements concerning what sort of investment you are interested in making; as in, gathering insight on company’s future growth potential. If you plan to invest in certain equity or debt, it can help you assume dividend pay-out in the long-term.
- Trend Line: Secondly, performing ratio analysis over many reporting periods can help in detecting trends and relationships while being used to project future developments or responses to certain kinds of situations.
- Profitability & Liquidity Analysis:Ratios such as the return on assets or the return on equity can be used to understand the firm’s ability to generate earnings. In contrast, the current ratio or quick ratio can be used to understand the firm’s ability to deal with short term debts such as employee salaries and operating costs.
- Comparisons Between Firms: Ratio analysis is also used for comparing companies. Various ratio analysis definitions can be compared to ratios of other companies in the same sector to detect similarities, identify problems and compare performances based on a number of criteria.
- Risk Identification: Ratios such as the financial or operating leverages and the debt service coverage ratio can be used to weigh the firm’s ability to deal with debt while maintaining profitability.
- Functional Efficiency Analysis: Additionally, ratios such as the fixed asset turnover, inventory turnover ratio and account receivables turnover of a firm can be used in ratio analysis in comparison with those from firms within the same sector to determine which organisations are better managed as well as their relative abilities to generate income from assets.
Ratio analysis is multifaceted and can be used for various degrees of analysis. While, management takes an interest in ratio analysis to understand company’s performance, growth, PL situation, etc.; investors can analyse it to determine ROI on their investment on company’s stocks. Next time, when you make an investment choice, try to consider ratio analysis to get clarity.