Learn What Is Ratio Analysis

The Financial Ratios: What Do They Tell Us?

Ratio. This term conjures up complicated and frustrating high school math problems. However, this is not the case when it comes to investing. Properly understood and applied can make you a better investor.

The Key Takeaways

• To compute different ratios, fundamental analysis is based on financial statements from corporations.
• Fundamental analysis is used to determine the intrinsic value of a security so that it can be compared to its market value.
• Six basic ratios are used to select stocks for investment portfolios.
• These include the working capital and quick ratios, earnings per share, price-earnings, debt-to-equity, earnings per share (EPS), and return on equity.
• For a complete picture of your company's financial health, it is best to use most ratios in conjunction with others.

What are Financial Ratios (or financial ratios)?

Financial ratios can be created by using numerical values from financial statements to gain useful information about a company. The numbers on a company's financial statements, such as balance sheet, income, and cash flow, are used for quantitative analysis. They can be used to assess the company's liquidity and growth, leverage, margins, profitability rates of return, valuation, rate of return, and other factors.

The following groups are used to group financial ratios:

• Ratios of liquidity
• Leverage ratios
• Efficiency ratios
• Ratios of profitability
• Market value ratios

What is Ratio Analysis?

Ratio analysis studies different pieces of financial information within financial statements. Analysts outside the business use these to assess various aspects such as profitability, liquidity, and solvency.

Analysts rely on their financial statements to evaluate a company's financial performance. The data is used to assess a company's financial health and draw comparisons with other firms.

Ratio Analysis: What are the uses?

1. Comparisons

Ratio analysis can assess a company's financial performance against similar companies in the same industry. This will help to determine the company's market position. Management can use financial ratios such as Price/Earnings from competitors to help identify market gaps and evaluate its competitive advantages and weaknesses. Management can then use this information to make decisions to improve their company's market position.

2. Trend line

Ratios can be used by companies to determine if there are any trends in financial performance. Companies with a history of financial performance collect data over many reporting periods. This data can forecast future financial performance and identify financial turbulences that are unlikely to be predicted using ratios from a single period.

3. Operational efficiency

Financial ratio analysis can be used to assess the efficiency of the company's management in managing its assets and liabilities. Unnecessary expenses such as motor vehicles, land, or buildings should be avoided. Financial ratios are a way to see if financial resources have been used properly or not.

Ratio Analysis – Categories of Financial Ratios

Numerous financial ratios can be used to analyze ratios. They are divided into the following categories.

1. Ratios of liquidity

Suppose a company is in financial difficulty and cannot pay its debts. In that case, it may convert its assets to cash and use the money to repay any outstanding debts. The company's liquidity ratio measures its ability to pay its debts using its assets.

The quick ratio, cash ratio, and current ratio are all common liquidity ratios. Banks, creditors, and suppliers use liquidity ratios to determine whether clients can pay their financial obligations.

2. Solvency ratios

Solvency ratios measure a company's long-term financial viability. These ratios compare the company's debt levels with its assets, equity, or annual earnings.

The debt to equity and interest coverage ratios are important solvency ratios. Governments, banks, employees, and institutional investors are the main users of solvency ratios.

3. Profitability Ratio

The profitability ratio measures a company's ability to make profits relative to its expenses. To determine the profitability of a business relative to its peers, it can be compared with a comparable firm's ratio. A higher profitability ratio in the current financial reporting period indicates that the business' finances are improving.

You can see some examples of important profitability ratios: the Return on Equity, Return on Assets, Profit Margin, and Return on Capital Employed ( ROCE) are all examples.

4. Efficiency ratios

The efficiency ratios measure how efficiently a business uses its assets and liabilities to generate revenue and profit. These ratios include inventory, machinery utilization, and turnover of liabilities. They also calculate the equity used. These ratios are vital because a business with higher efficiency ratios will generate more revenue and profit. 

Asset Turnover, Inventory Turnover, and Payables Turnover are some of the most important efficiency ratios.

5. Coverage ratios

The coverage ratio measures a company's ability to pay its debts and other obligations. Analysts can draw trends from the coverage ratios over several reporting periods to predict the company's future financial position. Higher coverage ratios mean businesses can pay off their debts and other obligations more easily.

The key coverage ratios are debt coverage, interest coverage, and fixed charge coverage.

6. Market prospects ratios

Earnings can come from future dividends or a higher stock price. Investors can use their current earnings and future dividends to determine what the stock price will be and how much they might expect to receive. Market prospect ratios allow investors to forecast how much they can earn from certain investments.

The key market prospect ratios are the dividend yield, earnings, the Price to Earnings (P/E) ratio, and the dividend payout rate.

What is Fundamental Analysis?

Fundamental analysis involves the study of a security to determine its true value. This consists in studying economic, industry, or company data. An investor can use fundamental analysis to determine whether a security is fairly priced, overvalued, or undervalued by comparing its true value to its market price.

Fundamental analysis is different from technical analysis. It focuses on determining the price action and uses different tools such as chart patterns or price trends.

Which is better, a higher or lower P/E ratio?

It depends on your investment goals. The P/E ratio measures the stock's value relative to its earnings per share. A stock with a lower P/E ratio could indicate that it is undervalued and may be worth purchasing. It could also suggest that the company is not financially sound.

Higher P/E could indicate that stock is more expensive. However, this could also be because the company's performance is good and could continue to improve.

The best way to use the P/E as a tool for comparing relative values of stocks you are interested in is often a comparison tool. You might also want to compare P/E between stocks and an industry average.

The bottom line

Financial ratios are a way to help you choose the right stocks for your portfolio and increase your wealth. Fundamental analysis can use dozens of financial ratios. Six of the most commonly used and easy-to-calculate financial ratios have been briefly highlighted.

A company can't be evaluated by one ratio alone. For more confidence in investment decisions, make sure you use a variety of ratios.