Definition of Ratio Analysis
Ratio Analysis helps the internal and the external stakeholders in understanding and comparing the numbers presented in the Income Statement, Balance Sheet and the Cash flow statement thereby drawing conclusions on the performance of the company in a given period of time, so as to develop company strategy for the upcoming period and the investment strategy from the perspective of a given investment policy statement.
Explanation of Ratio Analysis
When the management, shareholders, creditors or the board of directors look at the financial statements, each of these stakeholders attempts to understand and prepare a viewpoint of the company’s performance in the given time and its future approach. For example, if the company is altering the capital structure to be debt-free, it is aiming at a more equity-driven approach and such information is reflected in the debt ratios.
When prospective investors look at the financial statements, they want to know how well the company’s securities fit in their investment portfolio. They look at ratios such as the P/E ratio and try to figure out whether the stock is over or undervalued and what should be their strategy for including the stock in the portfolio.
Advantages of Ratio Analysis
There are multiple kinds of ratios, each explaining various aspects of the company performance and therefore they have their own advantages. Together, several ratios help in determining an overall stronghold of the company and also the areas of improvement.
1. Efficiency
Ratios such as the inventory turnover or sales turnover ratios help in understanding how well the company is using its assets and resources to generate sales or using up inventory. If these ratios are higher, that means the company is highly efficient, however, if these ratios are falling over time, then it could imply that the inventory is building up, the product is getting obsolete, marketing or sales strategy is lacking and so on.
2. Solvency
These ratios are helpful in analyzing whether the assets owned by the company are sufficient to meet the short and long term viability of the company. These are looked by the debt rating agencies such as the S&P and the Moody’s to present how risky is the company for investment. These include coverage ratios, current ratio, quick ratio and so on.
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3. Liquidity
This is the ratio that implies how much a company has invested in cash and near-cash securities and is helpful in analyzing how much money could the company generate at a short notice to fulfill an unforeseen event. However, a very high investment in liquid assets can also imply that the company is missing out on greater interest from the investment in less liquid securities. Therefore a right level of liquidity is desired.
4. Market Performance
Ratios such as the P/E ratio, P/Sales ratio, P/BV ratio, EV/EBITDA and so on help in understanding whether the company is over or undervalued in comparison with its peer group and should an investor include the stock at the given level of risk involved. Further, it also helps the management to understand how a company’s performance reflects the share price and what kind of future strategy should it adopt.
5. Profitability
Ratios such as the Gross Profit Margin, Net Profit Margin, Return on Equity help in understanding how much is it worth investing in the company. If the Net Profit margin is very low but the Gross Profit Margin is very high, this implies that the overheads of the company are a little on the higher side and the company should look into these to find out if there is an area of improvement.
6. Planning
Once the management has the ratios in front of them, they can develop future strategies such as capital expansion related investments or whether leasing is a better option than buying a fixed asset. Combining the information with the future market expectations helps the management in developing a long term expansion plan which is executed in phases over time.
7. Budgeting
Operating expenses and other annual expenses and investments are also planned based on the ratios, for example, if the inventory turnover ratio is very high, the management can place bulk orders and build up inventory to reduce ordering cost if the expectation of demand remains unchanged
8. Cross-Sectional Comparison
After bringing various company ratios on the same page by recalculating them based on the same accounting principles and assumptions, a good within sector or industry comparison can be made and seen how well a company is performing with respect to its competitors.
9. Time Series Analysis
Over time, if a company’s return on equity or the net profit margin is increasing then it is a good sign for investors who seek higher returns. Further ratios such as the dividend payout ratio help in assessing the growth opportunities available with the company. For example, if the company is giving out very high dividends, certain growth-seeking investors may not want to continue their investments assuming that the capital gain will be lower in the future, however, value-oriented investors would prefer such stock whose dividend flow is constant.
10. Cohesive Approach to look at Financial Statements
Certain ratios have inputs from various financial statements and these help in combining them and informing a complete analysis without missing out information due to data being available in different statements. An example could be the Return on equity. The net income that goes into the numerator comes from the Income statement and the Equity that goes into the denominator comes from the balance sheet. Therefore, we combine both the statements together in the analysis of this ratio.
Conclusion
We can conclude by saying that ratio analysis is a popular tool used by investors and internal stakeholders alike and it helps in making strategic decisions by the management and the investment decisions by the investing community. It gives a quick summary of the company performance which can be elaborated upon by delving deeper into the financial statements and therefore act as a starting point of the analysis
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