Understanding Ratio Analysis
Ratio analysis refers to a method that is used to evaluate and compare the financial performance of a company over a period of time by looking at its balance sheet and income statement. Various ratios are derived from the company’s financial statements that then help in assessing different aspects of its operations, such as profitability, liquidity, efficiency, and solvency.
It serves as a key tool for investors, managers, and analysts to compare one company with another that belongs to the same industry and get a deeper understanding of the company’s value, performance over time, and future potential. Instead of working on one single metric, with the use of ratio analysis, investors can analyze a variety of financial data about a company.
Key Uses of Ratio Analysis
Investors and analysts use ratio analysis to assess a company’s financial performance by examining its financial statements from both past and present. Financial ratios can be used for the following purposes:
- Track performance over time
- Compares a company’s performance from year to year to assess changes or improvements.
- Predict future performance
- Estimate financial results based on current ratios.
- Compare with Industry Averages
- Compare the company’s ratio in relation to other companies in the same industry.
While investors commonly use ratio analysis, companies also use it to evaluate the effects of strategic decisions on their sales, growth, and overall performance.
Types of Ratios for Ratio Analysis
Liquidity Ratio:
- It assesses a company’s ability to pay short-term liabilities with short-term assets and evaluates a company’s ability to pay off short-term obligations without relying on inventory.
- Includes Current Ratio, Quick Ratio, Working Capital Ratio
Solvency Ratio:
- It compares a company’s total debt to its shareholders’ equity to evaluate financial leverage and measures its ability to meet interest payments on its debt.
- Includes Debt-Equity Ratios, Debt-Assets Ratio, and Interest Coverage Ratios.
Profitability Ratio:
- It indicates how effectively a company generates profit from its operations.
- Includes Profit Margin Ratio, Return on Assets (ROA), Return on Equity (ROE), and Gross Margin Ratio.
Efficiency Ratio:
- It evaluates how effectively a company uses its assets and liabilities to generate sales and profit.
- Includes Turnover Ratio, Inventory Turnover, and Day’s Sales in Inventory
Coverage Ratio:
- It measures a company’s ability to meet its debt obligations, including interest payments.
- Includes Times Interest Earned Ratio, Debt-Service Coverage Ratio
Market Prospect Ratio:
- It is used to evaluate a company’s stock performance and future growth potential.
- Includes Dividend Yield, P/E Ratio, Earnings Per Share (EPS), and Dividend Payout Ratio.
