Ratio analysis

Ratio analysis is the comparison of line items in the financial statements of a business. Ratio analysis is used to evaluate a number of issues with an entity, such as its liquidity, efficiency of operations, and profitability. This type of analysis is particularly useful to analysts outside of a business, since their primary source of information about an organization is its financial statements. Ratio analysis is less useful to corporate insiders, who have better access to more detailed operational information about the organization. Ratio analysis is particularly useful when used in the following two ways:

  • Trend line. Calculate each ratio over a large number of reporting periods, to see if there is a trend in the calculated information. The trend can indicate financial difficulties that would not otherwise be apparent if ratios were being examined for a single period. Trend lines can also be used to estimate the direction of future ratio performance.
  • Industry comparison. Calculate the same ratios for competitors in the same industry, and compare the results across all of the companies reviewed. Since these businesses likely operate with similar fixed asset investments and have similar capital structures, the results of a ratio analysis should be similar. If this is not the case, it can indicate a potential issue, or the reverse - the ability of a business to generate a profit that is notably higher than the rest of the industry. The industry comparison approach is used for sector analysis, to determine which businesses within an industry are the most (and least) valuable.

There are several hundred possible ratios that can be used for analysis purposes, but only a small core group is typically used to gain an understanding of an entity. These ratios include:

  • Current ratio. Compares current assets to current liabilities, to see if a business has enough cash to pay its immediate liabilities.
  • Days sales outstanding. Determines the ability of a business to effectively issue credit to customers and be paid back on a timely basis.
  • Debt to equity ratio. Compares the proportion of debt to equity, to see if a business has taken on too much debt.
  • Dividend payout ratio. This is the percentage of earnings paid to investors in the form of dividends. If the percentage is low, it is an indicator that there is room for dividend payments to increase substantially.
  • Gross profit ratio. Calculates the proportion of earnings generated by the sale of goods or services, before administrative expenses are included. A decline in this percentage could signal pricing pressure on a company's core operations.
  • Inventory turnover. Calculates the time it takes to sell off inventory. A low turnover figure indicates that a business has an excessive investment in inventory, and therefore is at risk of having obsolete inventory.
  • Net profit ratio. Calculates the proportion of net profit to sales; a low proportion can indicate a bloated cost structure or pricing pressure.
  • Price earnings ratio. Compares the price paid for a company's shares to the earnings reported by the business. An excessively high ratio signals that there is no basis for a high stock price, which could presage a stock price decline.
  • Return on assets. Calculates the ability of management to efficiently use assets to generate profits. A low return indicates a bloated investment in assets.