Financial ratio analysis refers to a quantitative analysis of the ratios that reflect the financial performance of a company. By calculating the ratios of certain items in the company’s financial statements, it is possible to compare the performance of two or more companies in the same industry. By this comparison of ratios, investors can determine which companies would be good investments.
There are many calculations used in financial ratio analysis, but they can be loosely categorized into four groups: leverage, liquidity and solvency, operating, and profitability. Leverage ratios are indicators of how a company finances its operations. Debt to equity is the key leverage ratio, and it indicates how much debt the company has compared to its equity. A company with a high debt-to-equity ratio might be a riskier investment than one with a lower ratio.
Liquidity ratios measure how quickly a company can pay off its short term debt. If a liquidity ratio is high, it means that the company is easily able to cover short-term debts. The current ratio, which is current assets divided by current liabilities, is a commonly-used liquidity ratio. The solvency ratio measures a company’s ability to meet its long term debt. A higher solvency ratio means that it is more likely that a company will be able to meet its debts and will remain solvent.
Operating efficiency is measured by the operational ratio, also called the operating ratio. This ratio is calculated by dividing operating expense by net sales. A small ratio means that the company is better able to continue to be profitable even if revenues decline. A firm’s profitability can be analyzed by looking at its profitability ratios. These ratios show how well a company can generate a profit relative to its expenses. Profitability ratios include return on equity, return on assets and profit margin.
In order to perform financial ratio analysis, the information used for the calculation of ratios is gleaned from the firm’s financial statements. These statements include the balance sheet, the income statement and the statement of cash flows. These statements are updated each quarter, and can be found on the company’s website and in its annual report.
When performing financial ratio analysis, it is important to compare companies that are in the same industry. Ratios can vary widely among industries. For example, a retail company will have much lower profit margin than a technology company. This would result in very different profitability ratios, making a comparison ineffective.
