Ratio Analysis


What Is Ratio Analysis?

 What Does It Tell You?
 Types
 Application
 Examples
 FAQs
 The Bottom Line
 CORPORATE FINANCE
 FINANCIAL RATIOS
Financial Ratio Analysis: Definition, Types,

Examples, and How to Use
By
ANDREW BLOOMENTHAL
Full Bio


Andrew Bloomenthal has 20+ years of editorial experience as a financial

journalist and as a financial services marketing writer.
Learn about our editorial policies

Updated March 17, 2023
Reviewed by
AMY DRURY
Fact checked by
MICHAEL LOGAN
Investopedia / Theresa Chiechi
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.
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Ratio Analysis
What Does Ratio Analysis Tell 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.

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

What Is Ratio Analysis?

Financial Ratio Analysis: Definition, Types,

Andrew Bloomenthal has 20+ years of editorial experience as a financial

Updated March 17, 2023

What Is Ratio Analysis?

 Ratio analysis compares line-item data from a company's financial

What Does Ratio Analysis Tell You?

Types of Ratio Analysis

Liquidity ratios measure a company's ability to pay off its short-term debts

Also called financial leverage ratios, solvency ratios compare a company's

Also called activity ratios, efficiency ratios evaluate how efficiently a

Coverage ratios measure a company's ability to make the interest payments

6. Market Prospect Ratios

Application of Ratio Analysis

Ratio Analysis Over Time

To perform ratio analysis over time, a company selects a single financial

Ratio Analysis Across Companies

Imagine a company with a 10% gross profit margin. A company may be

To correctly implement ratio analysis to compare different companies,

Ratio Analysis Against Benchmarks

Benchmarks are also frequently implemented by external parties such

If these benchmarks are not met, an entire loan may be callable or a

Examples of Ratio Analysis in Use

What Are the Types of Ratio Analysis?

What Are the Uses of Ratio Analysis?

Why Is Ratio Analysis Important?

What Is an Example of Ratio Analysis?

The Bottom Line

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