Ratio analysis is a financial analysis technique that involves using financial ratios to evaluate a company’s financial performance. Financial ratios are mathematical relationships between two or more financial variables, such as revenue and expenses, that can be used to measure various aspects of a company’s financial health. Ratio analysis is a popular tool used by investors, creditors, analysts, and other stakeholders to assess a company’s liquidity, solvency, profitability, efficiency, and other key financial metrics.
Commonly used financial ratios:
Here are some of the most commonly used financial ratios along with their formulas:
Current ratio = Current assets / Current liabilities
Quick ratio (Acid test ratio) = (Current assets – Inventory) / Current liabilities
Debt-to-equity ratio = Total debt / Total equity
Debt-to-assets ratio = Total debt / Total assets
Gross profit margin = (Revenue – Cost of goods sold) / Revenue
Net profit margin = Net income / Revenue
Asset turnover ratio = Revenue / Total assets
Inventory turnover ratio = Cost of goods sold / Average inventory
Market Value Ratios:
Price-to-earnings ratio (P/E ratio) = Market price per share / Earnings per share
Dividend yield ratio = Annual dividends per share / Market price per share
Ratio Analysis steps
The following are the general steps involved in conducting ratio analysis:
- Collect financial statements: Collect the financial statements of the company for the relevant period that you want to analyze. These financial statements include the balance sheet, income statement, and statement of cash flows.
- Calculate financial ratios: Calculate the financial ratios using the formulas appropriate for the particular type of ratio being analyzed. This involves selecting the relevant data from the financial statements and performing the necessary calculations.
- Analyze the ratios: Compare the calculated ratios to industry benchmarks or to the company’s historical performance. Look for any trends or patterns that may indicate strengths or weaknesses in the company’s financial performance.
- Interpret the results: Interpret the results of the ratio analysis, taking into consideration any contextual factors that may impact the results. Use the analysis to identify areas where the company is performing well and areas where it may need to improve.
- Take action: Use the insights gained from the ratio analysis to inform decision-making and take action where necessary. This could involve making changes to the company’s operations or strategy, adjusting financial policies, or seeking additional financing.
- Easy to understand: Ratio analysis provides a simple way to analyze financial statements and can be easily understood by investors, managers, and other stakeholders.
- Provides insights into financial performance: Ratio analysis can reveal key insights into a company’s financial performance, such as profitability, liquidity, and solvency.
- Helps with decision-making: Ratio analysis can be used to inform decision-making, such as investment decisions or operational changes.
- Facilitates comparison: Ratio analysis allows for comparison of a company’s financial performance over time, as well as to competitors or industry benchmarks.
- Limited by the quality of financial statements: Ratio analysis is only as reliable as the financial statements it is based on, so inaccuracies or omissions in financial reporting can affect the results.
- Not comprehensive: Ratio analysis only provides a partial picture of a company’s financial health and should be used in conjunction with other forms of analysis.
- Limited industry comparability: Different industries have different financial norms and standards, so ratio analysis may not be directly comparable across industries.
- Can be manipulated: In some cases, companies may manipulate financial statements to improve their ratio results, so it is important to be cautious and verify the accuracy of the underlying financial statements.