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.

The types of financial ratios can be summarized as follows:

Liquidity Ratios: Assess a company's ability to meet short-term obligations. Examples include the
current ratio, quick ratio, and working capital ratio.

Solvency Ratios: Measure a company's long-term financial stability and its ability to meet long-term
debt obligations. Examples include the debt-equity ratio, debt-assets ratio, and interest coverage ratio.

Profitability Ratios: Evaluate a company's ability to generate profits from its operations. Examples
include profit margin, return on assets (ROA), return on equity (ROE), and gross margin ratios.

Efficiency Ratios: Assess how efficiently a company uses its assets and liabilities to generate sales and
maximize profits. Examples include turnover ratio, inventory turnover, and days' sales in inventory.

Coverage Ratios: Measure a company's ability to cover its interest payments and other obligations
associated with its debts. Examples include the times interest earned ratio and the debt-service
coverage ratio.
 Market Prospect Ratios: Provide insights into a company's market value and prospects. Examples
include dividend yield, price-to-earnings (P/E) ratio, earnings per share (EPS), and dividend payout ratio.

These ratios serve as valuable tools for analyzing a company's financial performance,
assessing its operational efficiency, and determining its financial health and market position.

1. Net Profit Margin: A ratio used to compare the profitability of companies within the
same sector by dividing net income by revenues.
2. P/E Ratio: Stands for price-to-earnings ratio, used to assess investor willingness to pay
for earnings generated by a company.
3. Types of Ratio Analysis: Financial ratio analysis can be categorized into profitability,
solvency, liquidity, turnover, coverage, and market prospects ratios. Non-financial
metrics may also be used in specific departments or industries.
4. Uses of Ratio Analysis: Ratio analysis is used to track changes in a company over time,
compare performance with competitors, and strive for specific benchmarks.
5. Importance of Ratio Analysis: Ratio analysis provides a more accurate representation
of a company's operational state, as static numbers alone may not fully explain its
performance.
6. Example of Ratio Analysis: The inventory turnover ratio measures how quickly a
company converts inventory into sales, allowing for analysis of efficiency in converting
goods to cash.

Ratio analysis enables companies to gain insights into their performance, competition,
and internal goals by comparing and analyzing multiple financial and non-financial
metrics.

SUMMARY:

In summary, ratio analysis is a valuable tool used to assess a company's financial performance and
make informed decisions. It involves analyzing various financial ratios to evaluate profitability,
solvency, liquidity, turnover, coverage, and market prospects. Ratio analysis has several uses,
including tracking changes over time, comparing performance with competitors, and striving for
specific benchmarks. It helps provide a more accurate understanding of a company's operations and
can identify areas of strength or weakness. Examples of ratio analysis include net profit margin, P/E
ratio, and inventory turnover ratio. By examining these ratios, investors and analysts can gain insights
into a company's profitability, market value, and efficiency.