Ratio analysis definition
/What is 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. It is particularly useful when employed in the following two ways:
Trend line analysis. 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.
Related AccountingTools Courses
Categories of Ratio Analysis
Financial ratios can be grouped into the following clusters of ratios, where each cluster is targeted at a different type of analysis.
Coverage Ratios
Coverage ratios are used to evaluate the ability of a business to meet its debt obligations. These ratios are most commonly used by lenders and creditors to review the finances of a prospective or current borrower. Examples of coverage ratios are the interest coverage ratio, debt-service coverage ratio, and asset coverage ratio.
Efficiency Ratios
Efficiency ratios measure the ability of a business to use its assets and liabilities to generate sales. A highly efficient organization has minimized its net investment in assets, and so requires less capital and debt in order to remain in operation. Examples of efficiency ratios are accounts receivable turnover, inventory turnover, fixed asset turnover, and accounts payable turnover.
Leverage Ratios
Leverage ratios are used to determine the relative level of debt load that a business has incurred. These ratios compare the total debt obligation to either the assets or equity of a business. Examples of leverage ratios are the debt ratio and debt to equity ratio.
Liquidity Ratios
Liquidity ratios are measurements used to examine the ability of an organization to pay off its short-term obligations. Liquidity ratios are commonly used by prospective creditors and lenders to decide whether to extend credit or debt, respectively, to companies. Examples of liquidity ratios are the cash ratio, current ratio, and quick ratio.
Market Value Ratios
Market value ratios are used to evaluate the current share price of a publicly-held company's stock. These ratios are employed by current and potential investors to determine whether a company's shares are over-priced or under-priced. Examples of market value ratios are book value per share, earnings per share, and market value per share.
Profitability Ratios
Profitability ratios are a set of measurements used to determine the ability of a business to create earnings. Profitability ratios are derived from a comparison of revenues to difference groupings of expenses within the income statement. Examples of profitability ratios are the contribution margin ratio, gross profit ratio, and net profit ratio.
Examples of Ratios Used in Financial Analysis
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 the following:
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.
Advantages of Ratio Analysis
There are multiple advantages to using ratio analysis. First, it shows how efficiently a business is operating, especially when the analysis is compared to the results of other comparable businesses. Second, it can provide crucial information about the liquidity and solvency of a business, which is of considerable interest to lenders and creditors. Third, ratio analysis is a good way to compare the financial results and financial position of two or more companies - usually operating within the same industry. Finally, ratio analysis can be incorporated into a firm’s budget model, so that the budget for future periods contains roughly the same performance and financial position ratios of prior periods; this is useful for constructing budgets that are aligned with the operating performance and financial structure of a business.
Disadvantages of Ratio Analysis
Ratio analysis is a widely used tool for evaluating financial performance, but it comes with several disadvantages. Here are some limitations:
Lack of context. Ratios provide numbers but lack qualitative information. Without considering the broader context, they can be misleading. For instance, a high current ratio might suggest good liquidity but could also mean excessive idle cash or inventory.
Comparison challenges. Comparisons across industries or companies can be problematic, because different industries have unique operating conditions. Even companies within the same industry might have varying accounting policies, making ratio comparison less reliable.
Historical nature. Ratios are based on historical financial statements, which might not reflect current or future conditions. This limits their usefulness in predicting future performance or in rapidly changing environments.
Accounting differences. Different accounting policies (e.g., depreciation methods, inventory valuation) can distort ratios, reducing their comparability across companies. Further, companies may engage in window-dressing to make their financials appear better.
Inflation impact. Financial statements often don't adjust for inflation, leading to distorted ratios over time.
Non-quantifiable factors. Ratios ignore qualitative factors like management quality, brand strength, market conditions, or competitive advantages. These non-quantifiable factors can have a significant impact on a company’s success.
Overemphasis on ratios. Focusing too much on ratios might cause analysts to overlook other important financial or strategic aspects of a business. For instance, a company might have poor profitability ratios but strong long-term growth prospects.
Single-year focus. Ratios typically analyze a single year, which might not represent long-term trends or cyclical fluctuations. Seasonal businesses, for example, might show distorted ratios during off-peak periods.
Potential for misinterpretation. Misunderstanding the significance of certain ratios or relying on a single ratio can lead to incorrect conclusions. For example, a low debt-to-equity ratio might indicate low risk, but it could also imply underutilization of leverage.