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Part of the Series How to Value a CompanyIntroduction to Company Valuation
Fundamental Analysis Basics
Fundamental Analysis Tools and Methods
Valuing Non-Public Companies
Ratio analysis is a method of examining a company's balance sheet and income statement to learn about its liquidity, operational efficiency, and profitability. It doesn't involve one single metric; instead, it is a way of analyzing a variety of financial data about a company. Ratio analysis is a cornerstone of fundamental equity analysis.
There are many different ratios that investors and other business experts can analyze to make predictions about a company's financial stability and potential future growth. These can be used to evaluate either how a company's performance has changed over time or how it compares to other businesses in its industry.
Investors and analysts use ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. For example, comparing the price per share to earnings per share allows investors to find the price-to-earnings (P/E) ratio, a key metric for determining the value of a company's stock.
The ratios of these different financial metrics from a company can be used to:
Every figure needed to calculate the ratios used in ratio analysis is found on a company's financial statements.
A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.
Ratios are comparison points for companies and are not generally used in isolation. Instead, they are compared either to past ratios for the same company or to the same ratio from other companies.
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 is probably undervalued. In contrast, one with a P/E ratio of 50 likely is overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.
Ratio analysis is often used by investors, but it can also be used by the company itself to evaluate how strategic changes have impacted sales, growth, and performance.
Ratio analysis can help investors understand a company's current performance and likely future growth. However, companies can make small changes that make their stock and company ratios more attractive without changing any underlying financial fundamentals. To counter this limitation, investors also need to understand the variables behind ratios, what information they do and do not communicate, and how they are susceptible to manipulation.
Ratios also can't be used in isolation. Instead, they should be used in combination with other ratios or financial metrics to give a fuller picture of both a company's financial state and how it compares to other companies in the same industry.
The financial ratios available can be broadly grouped into six types based on the kind of data they provide. Using ratios in each category will give you a comprehensive view of the company from different angles and help you spot potential red flags.
Liquidity ratios measure a company's ability to pay off short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include:
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings. These are used to evaluate the likelihood of a company staying afloat over the long haul by paying off both long-term debt and the interest on that debt. Examples of solvency ratios include:
These ratios convey how well a company can generate profits from its operations. Examples of profitability ratios are:
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:
Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include:
Market prospect ratios are the most commonly used ratios in fundamental analysis. Investors use these metrics to predict earnings and future performance. These ratios include:
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.
Using ratio analysis will give you multiple figures and values to compare. However, those values will mean very little in isolation. Instead, the values derived from these ratios should be compared to other data to determine whether a company's financial health is strong, weak, improving, or deteriorating.
Comparing how the same ratio changes over time provides a picture of how a company has performed during that period, what risks might exist in the future, and what growth trajectory growth it is likely to follow.
To perform ratio analysis over time, select a single financial ratio, then calculate that ratio at set intervals (for example, at the beginning of every quarter). Then, analyze 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).
When performing ratio analysis over time, be mindful of seasonality and how temporary fluctuations may impact month-over-month ratio calculations.
Comparative ratio analysis can be used to understand how a company's performance compares to similar companies in the same industry. For example, a company with a 10% gross profit margin may be in good financial shape if other companies in the same sector have gross profit margins of 5%. However, if the majority of competitors achieve gross profit margins of 25%, that's a sign that the original company may be in financial trouble.
When using ratio analysis to compare different companies, be sure to:
Different industries 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.
Companies may set internal targets for their financial ratios. The goal may be to hold current levels steady or to 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 as lenders. Lending institutions often set requirements for financial health as part of covenants in loan document's terms and conditions. An example of a benchmark set by a lender is often the debt service coverage ratio, which measures a company's cash flow against its debt balances. If a company doesn't maintain certain levels for these ratios, the loan may be recalled or the interest rate attached to that loan may increase.
Ratio analysis can predict a company's future performance—for better or worse. When a company generally boasts solid ratios in all areas, any sudden hint of weakness in one area may spark a significant stock sell-off.
For example, 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 and is often used instead of dissecting financial statements to compare how profitable companies are. If company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively, an investor comparing the two companies will conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.
This can be combined with additional ratios to learn more about the companies in question. If ABC has a P/E ratio of 100 and DEF has a P/E ratio of 10, that means investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.
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.
Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes within a company's financial health over time and predict future performance. Second, ratio analysis can be performed to compare results between competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.
Ratio analysis can be used to understand the financial and operational health of a company; static numbers on their own may not fully explain how a company is performing. Consider a business that made $1 billion in 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. This means the company is performing below its competitors in spite of its high revenue.
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.
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.
