# Introduction to Ratio Analysis

In many ways, the Financial Statements of a company represent a company's data in raw form.

Without subjecting the data to a deeper analysis, many false conclusions might be drawn concerning the companies financial condition.

The measuring of company performance and analysis can be done by calculating ratios using the data from Financial Statements and is called "Ratio Analysis."

A Ratio Analysis is one of the most common and widespread tools used to analyze a businesses Financial standing.

# Who uses Ratio Analysis?

Financial Ratios are used by Managers of firms, by current and potential shareholders (owners) of a firm and by a firm's creditors.

# Breaking Down Ratio Analysis

Ratios are easy to understand and simple to compute.

When we do a Ratio Analysis, each calculated ratio presents a number.

The number represents the relationship between the two items used to calculate the Ratio.

The number can be a decimal value, such as 0.10, a percent value, such as 10% or a multiple, such as 10 times (represented by 10x).

For example, a company could have a current ratio of 2x (calculated as Current Assets/ Current Liabilities) which means that the company holds 2 time more Current Assets then Current Liabilities.

OR

If a companies Debt to Equity Ratio (calculated as Total Debt/ Total Equity) is 3x - This means that the company has 3x more Debt then Equity.

As you can see, the calculated ratio gives a quick and simple indication of a firms financial performance in a key area.

# Key Areas in which Ratio Analysis is used

Determining Firm performance is of great interest to any decision maker. There are many ratios that can be calculated, based on what type of Business you would like to analyze.

Different Financial Ratios measure and analyze different parts of a Business.

The key areas measured using Financial Ratios are

- Liquidity
- Solvency
- Performance
- Activity
- Value

You can find a list of Ratios related to each area below.

While the list provided for each area is quite comprehensive, experienced users calculate and analyze only the ratios which are relevant and important to them.

Important

Please keep in mind that there is no Universal Agreement as to HOW many of these ratios should be calculated.

You may find that different books and articles use slightly different formulas for the computation of many of these ratios.

Therefore, if you are comparing a ratio that you calculated with a published ratio or an Industry average, make sure you compare "Apples to Apples" i.e. you use the same formula as used in the calculation of the published ratio.

## Liquidity Ratios

Liquidity Ratios measure the ability of a company to repay its short-term debts and meet any unexpected cash needs in the short term.

They are particularly useful for creditors and lenders to check the short term credit worthiness of a business.

These ratios measure the companies ability to convert it's Current Assets into Cash quickly and pay its obligations without any significant difficulty (i.e. delay in loss of value).

Important Liquidity Ratios are:

- Current Ratio
- Quick Ratio (also called Acid Test Ratio)
- Cash Ratio
- Cash Conversion Cycle

## Solvency Ratios

The term Solvency means the capability of a Business to meet it's long term Financial obligations and that's exactly what the Solvency Ratios measure.

Solvency Ratios assess the long term Financial viability of a business i.e. its ability to pay off it's long term obligations such as bank loans, bonds payables etc.

The information is critical to banks considering giving the company long term loans, investors planning to purchase a Business etc.

Key Solvency Ratios are:

- Debt Ratio
- Debt to Equity Ratio
- Debt to Capital Ratio
- Interest Coverage Ratio
- Fixed Charge Coverage Ratio
- Equity Multiplier

## Profitability Ratios

While Liquidity and Solvency Ratios are great at measuring a business from a risk perspective, profitability ratios are paramount in measuring a business from a performance perspective.

Important Profitability Ratios include:

- Operating Profit Margin
- Gross Profit Margin
- Net Profit Margin
- Return on Assets
- Return on Equity
- Return on Invested Capital
- Earnings per Share

## Activity Ratios

Activity Ratios are typically used to analyze how well a company is using it's assets.

Business Managers use Activity Ratios as a tool to compare their performance with industry standards and the higher the ratio, the more likely the company is using it's assets efficiently.

Key Activity Ratios are:

- Inventory Turnover Ratio
- Days Inventory Outstanding
- Receivables Turnover Ratio
- Days Sales Outstanding
- Payables Turnover Ratio
- Total Asset Turnover Ratio
- Working Capital Turnover Ratio

## Valuation Ratios

Valuation Ratios guide users on how much a companies worth.

Of course, these ratios are typically only considered a starting point, with further analysis required to identify a companies value.

These Ratios are very commonly used by Stock Pickers who purchase shares in a company through the Stock Market.

Common Valuation Ratios are:

- Price to Earnings (P/E) Ratio
- Price to Book (P/B) Ratio
- Price to Sales (P/S) Ratio
- Dividend Payout Ratio
- Dividend Yield Ratio
- Retention Ratio

# Taking Ratios a Step Further

Though useful, the knowledge that a user can gain from standalone ratios is limited.

For example, if you calculate a firm's debt ratio (total liabilities/total assets) for one time period (let's say a year) and it's 50%.

What does that really mean?

While you can take from that is 50% of the firm's assets are financed by debt, the utility of this ratio would MAGNIFY when compared with something.

For Example, if you observed that the Debt Ratio of the firm was 40% last year and 50% this year, that would tell you that the overall debt levels of the company have gone up when compared to Assets.

Comparison of Ratios helps

1. Measure Performance

By comparing the Ratios between two periods, a user can easily determine if performance in the key area being studied has improved or deteriorated.

2. Spot Trends

Spotting Trends is helpful in forecasting future performance.

Financial Ratios tracked for several years may indicate any trends that have developed.

For example, a trend of consistent increase in Revenue can lay the foundation to estimate a future trend in revenue and thus be used for budget planning for internal company management. This trend can also let the CEO of the company determine the course of action for the growth and development of the business.

Caution

All of the information used in ratio analysis is derived from HISTORICAL RESULTS.

This does not mean that the same results will carry forward into the future.

Always be careful while making inferences about the Future!

3. To compare company performance with the Industry performance

Just as important as trend analysis is industry analysis.

Ratios can be used to compare a firm's financial performance with industry averages.

If the standard industry ratios are much different than the firm being analyzed, further examination may be required.

For example, if the average P/E Ratio of all companies in the S&P 500 index is 20.

Now, while the majority of companies you see will have a P/E between 15 and 25, a stock with a single-digit P/E would mean that the stock is undervalued.

Important

Ratios are usually only comparable across companies in the same Sector/Industry since an acceptable ratio in one industry may be regarded as too high in another.

For example, companies in sectors such as utilities typically have a high debt-equity ratio, but a similar ratio for a technology company may be regarded as unsustainably high.

It is also important to realize that an impressive financial ratio in one industry might be viewed as less than impressive in a different industry.

# Strengths and Weaknesses of Ratio Analysis

## Strengths

1. Ratios are simple to understand and easy to compute

2. The computation of ratios facilitates the comparison of firms which differ in size.

## Weaknesses

1. Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. For example, while most public companies in the U.S. use Generally Accepted Accounting Principles, many large multi-national corporations outside the U.S. may use International Financial Reporting Standards to produce their financial statements.

There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.

2. A ratio analysis comparison between two firms that are pursuing different strategies may not always be accurate.

For example, one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market share. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and gross margins are higher, but it will never attain the revenue levels of the first company.

# Final Thoughts

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