When deciding which investment opportunity to pursue or assessing how a company’s financial performance has improved over the years, ratio analysis is a key way for external stakeholders to assess the financial performance and viability of a company.
Continue reading below to see how analysts use ratio analysis to evaluate companies and the common types of ratios you can use.
What is ratio analysis?
Ratio analysis is a method for evaluating a company’s financial performance. It compares two or more metrics from an organization’s financial statements to help uncover insights about its profitability, liquidity, and efficiency.
As we’ll explore in further detail below, there are several types of ratio analysis that teams can prepare. However, the general steps and calculations used to complete each are relatively the same.
Importance of ratio analysis in financial decision-making
Internal teams and external stakeholders can perform ratio analysis on a company to get a better understanding of its financial positioning.
Ratio analysis can compare a company’s current performance against historical data. This might help internal teams determine whether they are improving in certain areas or underperforming to drive high-level strategy decisions.
However, a more common application is for external analysts to compare a company’s ratios against those of comparable firms in the industry. If they’re considering investing in a company, performing a ratio analysis helps them assess its market positioning and determine whether it’s a worthwhile investment.
Types of ratio analysis
As previously mentioned, there are a few main types of ratios that are used to assess a company’s financial health, including:
Liquidity ratios
Liquidity ratios are used to determine a company’s ability to meet its current obligations with the assets it possesses.
In other words, preparing these ratios should demonstrate whether a company has enough cash or cash equivalents on hand to pay off debts and liabilities in the near term.
Common liquidity ratios include:
- Current ratio
- Quick ratio (Acid test ratio and cash ratio)
- Interest coverage ratio
Profitability ratios
Profitability ratios help determine how efficiently a company operates. Internal and external stakeholders use them to assess the company’s ability to turn sales into profits and returns for shareholders.
Some of the typical profitability ratios are:
- Gross profit margin
- Operating margin
- Return on equity (ROE)
- Return on assets (ROA)
Working capital ratios
Working capital ratios provide clarity around a company’s financial stability. Analysts prepare these ratios to see how efficiently a company is managing its working capital, like how long it takes to collect accounts receivable or how quickly inventory is sold.
- Accounts receivable turnover ratio
- Accounts payable turnover ratio
- Working capital turnover ratio
- Inventory turnover ratio
How to perform ratio analysis
The calculations involved in a ratio analysis are generally straightforward and simple. The challenge of effective ratio analysis is selecting the proper financial data that are comparable to previous periods or other companies’ reporting. Here are the steps to perform a ratio analysis:
Gather necessary financial data
The first step is to gather the appropriate financial data. The exact metrics needed will vary depending on the specific ratio being prepared.
The good news is that the figures are typically found on the company’s income statement or balance sheet.
This data should be readily available for publicly traded companies. However, it can be a bit trickier for external analysts to find this data on private companies.
Calculate the ratio
With the gathered information, analysts can calculate the ratio in one or two steps.
The specific formula will differ for the ratio being prepared. Typically, the ratio is found by dividing one metric by the other to find the relationship between them.
For example, the current ratio is calculated by dividing current assets by current liabilities. Likewise, the gross profit margin is calculated by dividing profits by revenues.
Assess and compare ratios
Once the ratios have been calculated, they can be compared against the company’s historical values, industry benchmarks, or competitors' to evaluate performance. This comparison will show how the company performs relative to itself and its competitors.
The advantage of ratio analysis is that it puts companies on a level playing field, even if their gross performance data varies significantly from past periods or industry peers. Ratios make the data much more comparable and easier to identify financial trends, strengths, and weaknesses.
Benefits of ratio analysis
As discussed throughout, performing a ratio analysis provides important insights into a company’s financial health. Here are some of the specific advantages:
Identifying financial strengths and weaknesses
Comparing a company’s financial ratios to those of its competitors helps reveal what the company does well and where it can improve.
Evaluating the company’s financial data alone may not tell the full story of how well (or poorly) it manages operations. However, comparing it against industry benchmarks and peers is much more straightforward and easily points to its strengths and weaknesses.
Assessing business performance and trends
In addition, ratio analysis is an effective tool for monitoring company trends and performance improvements over time.
Even if the company earns much higher sales in the current period than last year, it may not generate the same profitability. Analysts can assess this by comparing the gross profit margins for the two periods.
In this scenario, analysts may determine that the company’s sales growth is not sustainable, even if it is generating record revenues.
Supporting informed decision-making
Ratio analysis can help drive informed decision-making for stakeholders, particularly external parties.
Internal teams often have more data available than what’s reported on their financial statements. However, external analysts, investors, and creditors can use this information to calculate various ratios and gauge the company’s solvency, efficiency, and profitability to inform lending or investment decisions.
Limitations of ratio analysis
Ratio analysis is a straightforward way to identify trends in a company’s financial performance and assess the business against others in its industry.
However, there are some limitations to this method of financial analysis that are worth noting.
Industry variations
Analysts should be aware that ratios can vary significantly between industries. The differences in operating models, capital requirements, and other nuances between industries mean they’re not always universally comparable.
For example, a software business likely doesn’t have inventory, so finding the inventory turnover ratio is not insightful for companies in this industry. However, it is a highly useful metric for evaluating e-commerce businesses.
Focuses on historical data
One of the main limitations of ratio analysis is that it focuses on a company’s historical performance rather than its real-time positioning.
The data used to calculate ratios come from the company’s finalized financial statements, which summarize performance data from the previous period.
Investors or other external stakeholders may want more real-time insights into the company’s finances than what a ratio analysis can provide.
Seasonality
It’s also important to note that ratios can vary throughout the year for seasonal businesses. For instance, a ski resort likely will not perform as well financially in the summer as it does in the winter.
Thus, it’s more insightful to compare a company to the same period in previous years to account for this seasonality. Otherwise, the company could appear to be significantly under- or overperforming compared to non-seasonal periods.
Financial ratio analysis examples
To better understand how analyzing financial ratios can provide important information about a company’s financial health and performance, here are a few common examples of how it might look in practice:
Analyzing liquidity using the current ratio formula
The current ratio formula is as follows:
A company’s balance sheet shows that it has $20,000 in inventory, $40,000 in cash and cash equivalents, and $12,000 in accounts receivable. Thus, its current assets total $72,000.
The balance sheet also shows the total current liabilities of $60,000, which include $35,000 in accounts payable, $15,000 in wages payable, and $10,000 in short-term notes payable.
Using these two values, we can calculate the company’s current ratio as:
Current ratio = $72,000 / $60,000
= 1.2
From this calculation, we can see that the company has enough liquidity to cover its short-term liabilities completely with its current assets, though it’s relatively tight.
Evaluating profitability with return on investment ratio
The formula for return on investment is:
So, if an investor initially purchased 40 shares of a company’s common stock at $20 per share and sold them at $32 per share, the investor would earn the following return:
Return on investment = ((40 * $32) – (40 * $20)) / (40 * $20)
= ($1,280 – $800) / $800
= $480 / $800
= 0.6
In summary, the investment was profitable, and the investor would have earned a 60% return. For every dollar they invested, they earned $0.60.
Assessing financial leverage through debt-to-equity ratio
Find a company’s debt-to-equity ratio with the following formula:
The company’s balance sheet shows total liabilities of $65,000 and total equity of $130,000, so we can calculate the ratio as:
Debt to equity = $65,000 / $130,000
= 0.5
This means the company has $0.50 of debt for every dollar of equity and is less reliant on debt to finance operations. This may appear less risky to potential investors and show that it receives a large amount of funding from shareholders.
Assessing risk of default through debt-to-asset ratio
A company can calculate its debt-to-asset ratio with this formula:
If the balance sheet shows total assets of $80,000 and total debts of $25,000, the debt-to-asset ratio would be as follows:
Debt to assets = $25,000 / $80,000
= 0.3125
In this case, the company has 31.25 cents of debt for every dollar in assets. In other words, less than one-third of its assets are financed by debts, which helps give stakeholders confidence that the company is not overleveraged and is in a good place to continue servicing debt payments.
A ratio closer to one might signal that the company is at a greater risk of defaulting on debt, as it would show that it is more reliant on debt to fund asset purchases.
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