Ratio Analysis: Introduction

Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. Ratio analysis helps creditors solve these issues.

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by comparing information contained in its financial statements. Ratio analysis is a cornerstone of fundamental 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.

Ratio analysis can provide an early warning of potential improvement or deterioration in a company’s financial situation or performance. Analysts engage in extensive number-crunching of the financial data in a company’s quarterly financial reports for any such hints.

Successful companies generally have solid ratios in all areas, and any hints of weakness in one area may spark a significant sell-off of the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, such as inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies. 

Using any ratio in any of the categories listed above should only be considered as a starting point. Further analysis using additional ratios and qualitative analysis should be incorporated to effectively analyze a company's overall financial position.

Ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one industry may be regarded as too high to too low in another. For example, companies in sectors such as utilities typically have a high debt-equity ratio which is normal for its industry, while a similar ratio for a technology company may be regarded as unsustainably high.

What are Financial Ratios ?

• Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios helps investors shortlist companies that meet their criteria.
• Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
• Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the forefront the inter-relationship between ratios and how they help a company become more profitable.

Sources of Data

Here is where the investors get the data they require for ratio analysis:

• Financial Statements: The financial data published by the company and its competitors is the prime source of information for ratio analysis.
• Best Practices Reports: There are a wide range of consulting firms that collate and publish data about various companies. This data is used for operational benchmarking and can also be used for financial data analysis.
• Market: The data generated by all the activity on the stock exchange is also important from ratio analysis point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow and such other metrics to check if it is fairly priced.