Financial ratio analysis is a sophisticated process that uses quantitative methods to give deep insights into company performance. This form of analysis can highlight a wide variety of important factors. These include, but aren’t limited to, financial liquidity, process efficiencies, and profitability.
There is a bit of controversy surrounding the use of financial ratios and financial ratio analysis. These are tools used by traders, analysts, and other outsiders who have limited public information in order to compare various companies. However, corporate insiders don’t use them as much because they can access company data more directly.
What Can a Financial Ratio Analysis Reveal About a Company?
If you’ve heard a group of investors discussing the quantitative or fundamental analysis, they were probably talking about ratio analysis. Ratio analysis uses information from a company’s historical and current financial statements to assess its financial performance.
Investors and analysts use the information found in these financial statements to examine a company’s performance over relatively long periods. These analyses help them to:
- Decide whether a particular company’s performance is improving or on the decline
- Measure a company’s financial picture relative to its industry average
- Compare the company to other companies that operate in the same industry sector
Financial ratio analysis can give a baseline for company performance. This baseline is established by reviewing the results of several different account periods. With this trend line established, analysts can spot company changes that would have remained obscure in the ratio analysis.
Comparing one company to another, or to the overall industry average, is another effective way to use ratio analysis. Isolating a specific ratio for companies in a particular industry sector and using it as a basis for comparison gives analysts a look at information that’s of great value whether it’s positive or negative.
The ratios of companies in the same industry sector should be more or less equal. If the ratios aren’t the same, it could mean that a given company is underperforming or that another is outpacing the competition. This is one of the most useful features that ratio analysis offers, largely because analysts can use the results to find the best and worst performing companies within a certain industry sector.
Four Important Features of Financial Ratio Analysis
The following four points will help frame further discussion of ratio analysis:
- The primary purpose of ratio analysis is to provide an in-depth look at a company’s levels of liquidity, solvency, process efficiency, and overall profitability.
- Ratio analysis provides these insights by comparing line-item information that appears on a company’s financial statements.
- Ratio analysis can help analysts spot trends within a single company or make comparisons between different companies in a single industry sector.
- Although ratios provide many valuable insights, additional types of analysis are also required to present the entire picture of a company’s financial performance.
Six Categories of Ratio Analysis
The typical investor is able to use only a few essential ratios, usually those that are easiest to interpret and calculate. These relatively simple examples include the price/earnings (P/E) ratio, the current ratio, the debt/equity (D/E) ratio, and the dividend payout ratio. Although there are many financial ratios investors can work with, they can be organized into six basic groups.
1. Coverage Ratios
Coverage ratios assess the ability of a company to make its debt payments. Two commonly used coverage ratios are the debt-service coverage ratio and the times interest earned ratio.
2. Efficiency Ratios
Efficiency ratios (sometimes known as activity ratios) assesses how effectively a firm manages its liabilities and assets to maximize profits and sales. The inventory turnover, day’s sales in inventory, and asset turnover ratio are three of the most commonly used efficiency ratios.
3. Liquidity Ratios
These ratios gauge the ability of a company to pay off its short-term debts as they become due by using the company’s quick or current assets. Examples of liquidity ratios include quick, current, and working capital ratios.
4. Market Prospect Ratios
Market prospect ratios are often referred to as ‘the fundamentals’, and they include many of the most common ratios that analysts and investors use. Examples include the P/E ratio, the dividend yield, and the dividend payout ratio. These ratios help investors estimate how much they’ll earn on their investments.
5. Profitability Ratios
These ratios try to answer the ultimate question: how well does a company generate profits? Do they have large profit margins or small ones? What are their return rates on labor, assets, equity, or investment? When pulling all these numbers together, how does that ratio compare to others in the industry? These are the questions that profitability ratios are designed to answer.
6. Solvency Ratios
These ratios are used to determine whether a firm can pay all the costs associated with its long-term debt and remain viable well into the future. Sometimes known as financial leverage ratios, solvency ratios make this determination by comparing the company’s equity, assets, and earnings with its debt level.
Ratio analysis can reveal many important things about a company’s financial performance, but they’re more of a starting point than an ultimate conclusion. Additional analyses (including qualitative analysis) are always required to paint a truly accurate picture of a company’s financial position.
Lastly, financial ratio analysis is most useful when it is used to compare companies in the same industry sector. This is because a ratio that’s considered to be robust in one industry might be a sign of weakness in another. This is not intended to diminish the descriptive power of ratio analysis, but their situational nature does mean you should take them in stride.
About Zach Inghram
Zach Inghram is a CPA and holds a BBA in accounting from Loyola University Chicago. He has a diverse professional background having held analyst, accountant, and audit roles within the insurance, infrastructure services, and oil & gas industries. As the sole proprietor of Inghram CPA, he provides tax and bookkeeping services locally in the Austin, TX area and remotely around the country. His clients commonly remark that he holds himself to the highest standards of honesty, integrity, and professionalism. In his free time, he and his wife enjoy being outdoors hiking, camping, gardening, and fishing.