how ratio analysis works
investors and analysts use ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements for example comparing the price per share to earnings per share allows investors to find the price to earnings p e ratio a key metric for determining the value of a company s stock the ratios of these different financial metrics from a company can be used to every figure needed to calculate the ratios used in ratio analysis is found on a company s financial statements a ratio is the relation between two amounts showing the number of times one value contains or is contained within the other ratios are comparison points for companies and are not generally used in isolation instead they are compared either to past ratios for the same company or to the same ratio from other companies for example if the average p e ratio of all companies in the s p 500 index is 20 and the majority of companies have p es between 15 and 25 a stock with a p e ratio of seven is probably undervalued in contrast one with a p e ratio of 50 likely is overvalued the former may trend upwards in the future while the latter may trend downwards until each aligns with its intrinsic value ratio analysis is often used by investors but it can also be used by the company itself to evaluate how strategic changes have impacted sales growth and performance limitations of ratio analysisratio analysis can help investors understand a company s current performance and likely future growth however companies can make small changes that make their stock and company ratios more attractive without changing any underlying financial fundamentals to counter this limitation investors also need to understand the variables behind ratios what information they do and do not communicate and how they are susceptible to manipulation ratios also can t be used in isolation instead they should be used in combination with other ratios or financial metrics to give a fuller picture of both a company s financial state and how it compares to other companies in the same industry types of ratios for ratio analysisthe financial ratios available can be broadly grouped into six types based on the kind of data they provide using ratios in each category will give you a comprehensive view of the company from different angles and help you spot potential red flags liquidity ratios measure a company s ability to pay off short term debts as they become due using the company s current or quick assets liquidity ratios include also called financial leverage ratios solvency ratios compare a company s debt levels with its assets equity and earnings these are used to evaluate the likelihood of a company staying afloat over the long haul by paying off both long term debt and the interest on that debt examples of solvency ratios include these ratios convey how well a company can generate profits from its operations examples of profitability ratios are also called activity ratios efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits key efficiency ratios include coverage ratios measure a company s ability to make the interest payments and other obligations associated with its debts examples include market prospect ratios are the most commonly used ratios in fundamental analysis investors use these metrics to predict earnings and future performance these ratios include most ratio analysis is only used for internal decision making though some benchmarks are set externally discussed below ratio analysis is often not a required aspect of budgeting or planning application of ratio analysisusing ratio analysis will give you multiple figures and values to compare however those values will mean very little in isolation instead the values derived from these ratios should be compared to other data to determine whether a company s financial health is strong weak improving or deteriorating comparing how the same ratio changes over time provides a picture of how a company has performed during that period what risks might exist in the future and what growth trajectory growth it is likely to follow to perform ratio analysis over time select a single financial ratio then calculate that ratio at set intervals for example at the beginning of every quarter then analyze how the ratio has changed over time whether it is improving the rate at which it is changing and whether the company wanted the ratio to change over time 