Ratio Analysis is a way to get an objective idea of a company's efficiency, profitability and liquidity by going through its financial statements such as profit & loss statement and balance sheet. It plays an instrumental role in fundamental analysis of the company’s shares.
The ratio analysis is a financial tool used by investors to assess the performance of a company by evaluating its past and present financial statements. By comparing the data of two or more years can give evidence of a company's performance over a period of time. The ratio analysis can compare the company’s performance in relation to its industry peers to show evidence of where the company stands in terms of its profitability, efficiency and stock prices, among other factors.
It is an objective assessment and is based on hard data shared by the company in its audited financial statements.
Ratio analysis helps analyse a company's performance in the industry. As a matter of fact, the ratio analysis is not used in isolation but in relation to several other ratios. To understand the ratios in perspective, it is imperative to also understand a number of variables which drive the ratios.
These are the following broad categories of ratios:
1. Solvency Ratios: These ratios show the company’s debt level in relation to equity, assets and earnings to gauge the possibility of the company staying afloat after having paid its loans and interest. Some of the solvency ratios include debt-asset ratios, debt-equity ratios and interest coverage ratios. These ratios are also known as financial leverage ratios.
2. Liquidity Ratios: These ratios show the company’s ability to clear its short term dues by using the short term assets such as cash. These ratios include current ratio and working capital ratio.
3. Efficiency Ratios: These ratios show how the company uses its assets as well as liabilities to generate revenue and earn profit. They are also known as activity ratios and include inventory turnover ratio, turnover ratio, among others.
4. Profitability Ratios: These ratios indicate how efficiently a company can make profits from its day-to-day operations. Some of the profitability ratios include return on equity, return on capital employed, gross margin ratio.
It is vital to note that financial ratios help calculate a company’s operational efficiency. However, one must compare different ratios amongst each other and also against the industry average to put them in perspective.