Ratio Analysis

Defining Ratio Analysis

Ratio Analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by comparing information contained in its financial statements.
This involves comparing different figures from the balance sheets, income statements, and cash flow statements.
To understand the result, these ratios are often compared to previous periods of the same organisation, or to ratios of similar organisations.

Ratios are used by managers to help plan operations, by lenders to decide whether to make a loan, and by investors to understand if a company is a good investment.
They can highlight issues such as solvency, stability, and profitability, making it easier to make critical decisions.

Profitability Ratios: These ratios measure how well a company generates earnings. E.g. Return on Capital Employed (ROCE) and Gross Profit Margin.
Liquidity Ratios: Measure a company’s ability to pay off its short-term liabilities as they are due. E.g. Current Ratio and Quick Ratio (also known as Acid Test Ratio).
Efficiency Ratios: Measure how efficiently a company uses its assets and liabilities internally. E.g. Asset Turnover and Inventory Turnover.
Leverage Ratios: Measures the degree to which a company uses borrowed funds. E.g. Debt Ratio and Equity Ratio.

Ratio analysis is merely a ‘snapshot’ of a company’s performance, at a particular point in time, which could be significantly affected by seasonal factors.
It primarily involves the use of historical data, and past performance might not always accurately predict future business performance.
Different companies may use different accounting methods, which means ratios may not always be comparable between companies.

The meaning of a ratio varies widely depending on the industry and the specific business context.
Always interpret ratios by comparing them to benchmarks such as industry standards, competitor ratios, or the company’s previous ratio values.
In other words, a single ratio by itself does not say much, you need to compare it to something.