What is ‘Ratio Analysis’
A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items in financial statements like the balance sheet, income statement and cash flow statement; the ratios of one item – or a combination of items – to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency. The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations. Ratio analysis is a cornerstone of fundamental analysis.
BREAKING DOWN ‘Ratio Analysis’
While there are numerous financial ratios, most investors are familiar with a few key ratios, particularly the ones that are relatively easy to calculate. Some of these ratios include the current ratio, return on equity, the debt-equity ratio, the dividend payout ratio and the price/earnings (P/E) ratio.
For a specific ratio, most companies have values that fall within a certain range. A company whose ratio falls outside the range may be regarded as grossly undervalued or overvalued, depending on the ratio.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the majority of companies having a P/E between 15 and 25, a stock with a single-digit P/E would be considered undervalued, while one with a P/E of 50 would be considered overvalued. Of course, this ratio would typically only be considered as a starting point, with further analysis required to identify if these stocks are really as undervalued or overvalued as the P/E ratios suggest.
As well, ratios are usually only comparable across companies in the same sector, 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.
Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s financial situation or performance. Analysts engage in extensive number-crunching of the financial data in a company’s quarterly financial reports for any such hints.
Successful companies generally have solid ratios in all areas, and any hints of weakness in one area may spark a significant sell-off in the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, as for instance inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies.