What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by studying its financial statements. Ratio analysis is a cornerstone of fundamental equity analysis.
What Does Ratio Analysis Tell You?
Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company’s financial standing with industry averages while measuring how a company stacks up against others within the same sector.
- 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 mark how a company is performing over time, while comparing a company to another within the same industry or sector.
- While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company’s financial health.
Examples of Ratio Analysis Categories
The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company’s ability to pay off its short-term debts as they become 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 the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.
3. Profitability Ratios
These ratios convey 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 ratios are all examples of profitability ratios.
4. Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: 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. Examples include the times interest earned ratio and the debt-service coverage ratio.
6. Market Prospect Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share, and dividend payout ratio. Investors use these metrics to predict earnings and future performance. For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.
Examples of Ratio Analysis in Use
Ratio analysis can predict a company’s future performance—for better or worse.Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off.
Ratios are typically only comparable across companies within the same sector. For example, a debt-equity ratio that might be normal for a utility company might be deemed unsustainably high for a technology play.