## What Is Ratio Analysis?

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.

### Key Takeaways

- Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
- Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
- Ratio analysis may also be required by external parties that set benchmarks often tied to risk.
- While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.
- Examples of ratio analysis include current ratio, gross profit margin ratio, inventory turnover ratio.

## What Does Ratio AnalysisTell You?

Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company's financial standing with industry averages while measuring how a company stacks up against others within the same sector.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.

Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make it's stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.

A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.

## Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

### 1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

### 2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

### 3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of** profitability ratios**.

### 4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

### 5. Coverage Ratios

**Coverage ratios **measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio.

### 6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a required aspect of budgeting or planning.

## Application of Ratio Analysis

The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. By itself, that value may hold little to no value. Instead, ratio analysis must often be applied to a comparable to determine whether or a company's financial health is strong, weak, improving, or deteriorating.

### Ratio Analysis Over Time

A company can perform ratio analysis over time to get a better understanding of the trajectory of its company. Instead of being focused on where it is today, the company is more interested n how the company has performed over time, what changes have worked, and what risks still exist looking to the future. Performing ratio analysis is a central part in forming long-term decisions and strategic planning.

To perform ratio analysis over time, a company selects a single financial ratio, then calculates that ratio on a fixed cadence (i.e. calculating its quick ratio every month). Be mindful of seasonality and how temporarily fluctuations in account balances may impact month-over-month ratio calculations. Then, a company analyzes how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).

### Ratio Analysis Across Companies

Imagine a company with a 10% gross profit margin. A company may be thrilled with this financial ratio until it learns that every competitor is achieving a gross profit margin of 25%. Ratio analysis is incredibly useful for a company to better stand how its performance compares to similar companies.

To correctly implement ratio analysis to compare different companies, consider only analyzing similar companies within the same industry. In addition, be mindful how different capital structures and company sizes may impact a company's ability to be efficient. In addition, consider how companies with varying product lines (i.e. some technology companies may offer products as well as services, two different product lines with varying impacts to ratio analysis).

Different industries simply have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies more heavily on private investor funding.

### Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios. These calculations may hold current levels steady or strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.

Benchmarks are also frequently implemented by external parties such lenders. Lending institutions often set requirements for financial health as part of covenants in loan documents. Covenants form part of the loan's terms and conditions and companies must maintain certain metrics or the loan may be recalled.

If these benchmarks are not met, an entire loan may be callable or a company may be faced with an adjusted higher rate of interest to compensation for this risk. An example of a benchmark set by a lender is often the debt service coverage ratio which measures a company's cash flow against it's debt balances.

## Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance*—*for better or worse. Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off. Let's look at a few simple examples

Net profit margin, often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

## What Are the Types of Ratio Analysis?

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries. For example, a marketing department may use a conversion click ratio to analyze customer capture.

## What Are the Uses of Ratio Analysis?

Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes to a company over time to better understand the trajectory of operations. Second, ratio analysis can be performed to compare results with other similar companies to see how the company is doing compared to competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.

## Why Is Ratio Analysis Important?

Ratio analysis is important because it may portray a more accurate representation of the state of operations for a company. Consider a company that made $1 billion of revenue last quarter. Though this seems ideal, the company might have had a negative gross profit margin, a decrease in liquidity ratio metrics, and lower earnings compared to equity than in prior periods. Static numbers on their own may not fully explain how a company is performing.

## What Is an Example of Ratio Analysis?

Consider the inventory turnover ratio that measures how quickly a company converts inventory to a sale. A company can track its inventory turnover over a full calendar year to see how quickly it converted goods to cash each month. Then, a company can explore the reasons certain months lagged or why certain months exceeded expectations.

## The Bottom Line

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.

**Expert Introduction**

As an expert in financial analysis and business strategy, I have extensive experience in utilizing ratio analysis to gain insights into a company's financial health and performance. I have worked with various organizations to assess their liquidity, operational efficiency, and profitability by studying their financial statements and employing ratio analysis techniques. My expertise extends to applying ratio analysis to compare companies within the same industry, track changes in financial health over time, and set internal benchmarks for financial ratios. I have also conducted in-depth research on the application of ratio analysis in strategic decision-making and have practical experience in using various types of financial ratios to evaluate companies' performance.

#### What Is Ratio Analysis?

Ratio analysis is a quantitative method used to gain insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. It compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency. Ratio analysis can also be used to compare a company's financial standing with industry averages and to measure how a company stacks up against others within the same sector.

#### Types of Ratio Analysis

**Liquidity Ratios**: Measure a company's ability to pay off its short-term debts using current or quick assets. Examples include the current ratio, quick ratio, and working capital ratio.**Solvency Ratios**: Compare a company's debt levels with its assets, equity, and earnings to evaluate the likelihood of a company staying afloat over the long haul. Examples include debt-equity ratios, debt-assets ratios, and interest coverage ratios.**Profitability Ratios**: Convey how well a company can generate profits from its operations. Examples include profit margin, return on assets, return on equity, and gross margin ratios.**Efficiency Ratios**: Evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Examples include turnover ratio, inventory turnover, and days' sales in inventory.**Coverage Ratios**: Measure a company's ability to make interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio.**Market Prospect Ratios**: Include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. These metrics are used to predict earnings and future performance.

#### Application of Ratio Analysis

The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. Ratio analysis can be applied to track changes in a company over time, compare results with other similar companies, and strive for specific internally-set or externally-set benchmarks. It is important because it may portray a more accurate representation of the state of operations for a company.

#### Ratio Analysis Over Time

Performing ratio analysis over time allows a company to understand the trajectory of its operations, analyze changes in financial ratios, and make long-term decisions and strategic planning. It involves selecting a single financial ratio and calculating it on a fixed cadence to analyze how the ratio has changed over time.

#### Ratio Analysis Across Companies

Ratio analysis is incredibly useful for a company to better understand how its performance compares to similar companies within the same industry. It is important to consider only analyzing similar companies within the same industry and to be mindful of how different capital structures and company sizes may impact a company's ability to be efficient.

#### Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios and external parties such as lending institutions often set requirements for financial health as part of loan covenants. If benchmarks are not met, companies may face consequences such as loan recall or adjusted higher rates of interest.

#### Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance and is important for portraying a more accurate representation of the state of operations for a company. For example, the net profit margin and P/E ratio are commonly used in ratio analysis to compare the profitability and valuation of companies within the same sector. Additionally, the inventory turnover ratio can be used to measure how quickly a company converts inventory to sales.

#### Conclusion

In conclusion, ratio analysis is a powerful tool for gaining insights into a company's financial health and performance. By comparing multiple figures and deriving calculated values, companies can make better decisions, understand their performance over time, and strive for specific benchmarks. Ratio analysis is essential for evaluating a company's liquidity, operational efficiency, and profitability, and it plays a crucial role in strategic decision-making and financial planning.