Ratio analysis is widely used in various ways ranging from corporate planning to fundamental analysis. In fact, it is so commonplace that it is a core competency in finance and accounting.
In this post, we will cover what ratio analysis is, why it is useful, how it is used in practice, and provide some examples of the more commonly used ratios.
What Is Ratio Analysis?
Ratio analysis is an approach to evaluating financial statements relying on the use of ratios to gain an understanding of a business’ operating efficiency, profitability, and liquidity. Ratio analysis is based on the fact that a single financial figure by itself may not communicate any meaningful information, but when expressed as relative to some other line item, it will provide significant insights.
Typically, each line item on the financial statements is presented as a ratio of some other figure. For example, the balance sheet might present each line item as a percentage of equity. Ratio analysis is performed in various ways and is commonly applied when performing vertical and horizontal analysis.
Benefits of Ratio Analysis
When financial information is presented in ratios, it levels the playing field across businesses within the same sector. This allows the user to quickly and easily compare various businesses of various sizes within the same sector to see how they compare.
Additionally, ratios are an easy-to-understand financial metric. Conceptually, it is easy to understand what a ratio is conveying. For example, when performing ratio analysis, you might be interested in understanding the proportion of cost of goods sold (COGS) relative to gross income, which makes it easy to grasp the business’s ability to manage inventory and the quality of its suppliers.
Finally, ratio analysis makes it easier to compare financial performance over a set. Typically, analysts are concerned with improvement within the metrics they are monitoring. Performing ratio analysis strips away some of the noise that gets created through accounting policies or extraordinary events.
How Is Ratio Analysis Used?
It is common for both retail investors and professional analysts of various types to rely on ratio analysis to assist in the evaluation of a business’s financial health. The approach makes it easy to compare financial performance over periods of time and can be used as a way to project future performance when making financial models.
Ratio analysis essentially creates comparative metrics that make it easier to identify how good a business is at managing its assets, liabilities, equity, and various other items. The ratios are commonly used in conjunction with one another and a single ratio is rarely used on its own.
Common Examples Of Ratio Analysis
While there are many different approaches to ratio analysis there are some core concepts that most ratios attempt to address.
Ratios concerned with profitability attempt to clarify how good a business is at creating profits from its core operations. Some of the more common ratios include profit margin, gross margin, return on assets, and return on equity.
One of the most important ratios often monitored by lenders or creditors is coverage ratios and these are commonly referred to as debt coverage ratios. These ratios help to assess a business’s ability to satisfy the various covenants and interest expenses imposed by creditors. Some examples of commonly used coverage ratios include debt-service coverage ratio, asset coverage ratio, loan life coverage ratio, and interest coverage ratio.
These ratios help analysts assess a business’s ability to pay for short-term liabilities using its current assets. These are often performed by banks and lenders and some businesses, like retail banks, are required by the Federal Government to maintain certain levels of liquidity ratios. These ratios include the current ratio, working capital ratio, and the quick ratio.
Efficiency ratios sometimes are often used in profitability analysis and help to assess a business’s ability to effectively manage and use its assets and liabilities to drive profits. Some of the more common approaches to measuring efficiency are the inventory turnover ratio and days’ sales in inventory.
Additionally, retail banks have a unique definition of efficiency ratio which, for them, is the ratio of non-interest expenses to total revenue. The ratio is used in banking to identify how effective managers are at managing overhead costs.
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