What Is Ratio Analysis?

What Is Ratio Analysis?

Let me tell you directly: ratio analysis is a way to dig into a company's balance sheet and income statement to figure out its liquidity, how efficiently it operates, and its profitability. It's not just one number—it's a whole approach to looking at various financial data points about the business. This is a key part of fundamental equity analysis, and that's something you need to know if you're evaluating stocks.

You'll find plenty of different ratios that investors and experts use to predict a company's financial stability and growth potential. You can apply them to see how the company's performance has shifted over time or how it stacks up against others in the same industry.

Key Takeaways

Here's what you should remember: ratio analysis looks at line-item data from financial statements to check profitability, liquidity, efficiency, and solvency. It tracks how a company performs over time or compares it to others in the same sector. Sometimes external groups, like lenders, require it and set benchmarks linked to risk. Ratios give useful insights, but pair them with other info for a full picture of financial health. Common examples include the current ratio, gross profit margin, and inventory turnover.

How Ratio Analysis Works

As an investor or analyst, you use ratios to assess a company's financial health by reviewing its past and current statements. For instance, you compare price per share to earnings per share to get the P/E ratio, which helps determine stock value.

These ratios let you evaluate performance over time, estimate future results, compare with industry averages, or see how the company measures up against peers in the sector. All the numbers you need come from the balance sheet, income statement, cash flows, and shareholders' equity statements.

Ratios aren't meant to stand alone—they're comparison tools. You look at them against past ratios for the same company or similar ones from competitors. Investors use them, but companies do too, to see how changes affect sales, growth, and overall performance.

Limitations of Ratio Analysis

Ratio analysis can show you a company's current state and potential growth, but companies might tweak things to make ratios look better without real changes to fundamentals. You have to understand the variables, what ratios reveal or hide, and how they can be manipulated.

Don't rely on ratios by themselves—combine them with other metrics for a complete view of the company's finances and how it compares to industry peers.

Types of Ratios for Ratio Analysis

You can group financial ratios into six main types based on the data they use and what they tell you. Using ratios from each gives a full view from different angles and helps spot issues.

Application of Ratio Analysis

When you do ratio analysis, you get figures that don't mean much alone—you compare them to other data to judge if the company's health is strong, weak, improving, or worsening.

Over time, tracking the same ratio shows performance trends, future risks, and growth paths. Pick a ratio, calculate it regularly, like quarterly, and see how it changes. Watch for seasonality that might skew monthly results.

For comparisons across companies, use ratios to see how one stacks up against similar firms in the industry. A 10% gross profit margin might be fine if peers are at 5%, but bad if they're at 25%. Compare only similar companies, consider capital structures, sizes, and product differences. Industries have different norms—a high debt-equity ratio might be okay for utilities but not for tech.

Companies set their own benchmarks to maintain or improve ratios, like boosting liquidity. Lenders might require certain levels, like debt service coverage, or else recall loans or raise rates.

Examples of Ratio Analysis in Use

Ratio analysis helps predict future performance. Strong ratios overall with one weak spot can trigger sell-offs. Take net profit margin: divide net income by revenues to compare profitability. If ABC has 50% and DEF 10% in the same sector, ABC is converting more revenue to profit.

Combine with P/E: if ABC's is 100 and DEF's 10, investors pay more for ABC's earnings, suggesting higher expectations.

What Are the Types of Ratio Analysis?

Financial ratio analysis breaks into six types: profitability, solvency, liquidity, turnover, coverage, and market prospects. Non-financial ratios, like marketing conversion rates, exist too but vary by department.

What Are the Uses of Ratio Analysis?

It has three main uses: track financial health over time to predict performance, compare with competitors, and meet internal or external benchmarks.

Why Is Ratio Analysis Important?

It helps understand a company's health beyond static numbers. A $1 billion revenue might hide negative margins or declining liquidity, showing underperformance.

What Is an Example of Ratio Analysis?

Look at inventory turnover to see how fast inventory turns to sales. Track it yearly to spot monthly trends and reasons for variations.

The Bottom Line

There's a ton of data out there, but comparing numbers through ratios gives better insights into performance over time, against competitors, and toward goals. It's mostly financial, but can include non-financial data too.