Ratio analysis is a method of analyzing a company’s financial strength by calculating ratios from its balance sheets and income statements. These ratios are useful only in comparison to other ratios, and the type of analysis used depends on the purpose of the analysis. Balance sheet ratios determine creditworthiness, while income statement ratios determine profitability. Management ratios measure efficiency in terms of collecting accounts receivable and managing inventory.
Ratio analysis is a method of data analysis to determine the overall financial strength of a company. Financial analysts remove information from a company’s balance sheets and income statements and calculate ratios that can then be used to assess that company’s operating capacity and future prospects. These ratios are useful only in comparison to other ratios, such as comparable ratios for similar companies or the historical trend for a single company over various business cycles. There are various ratios that measure the efficiency, soundness, profitability and solvency of a company in the short term.
The type of relationship analysis that is most effective depends on who needs the information. Credit analysts are concerned with risk assessment and will therefore focus on ratios that measure whether a company can meet its financial obligations and how much debt is involved in the capital structure. At the opposite end of the spectrum, analysts looking at a business in terms of an investment opportunity will use ratios that determine whether a company is efficient and how great its potential profitability is.
For example, knowing that a company has a particular profit margin determined by a corresponding relationship is meaningless in itself. Financial analysts know that it’s more important to determine what that relationship looks like in terms of other similar companies, or even what that relationship looks like compared to that same company’s previous levels of profitability. Furthermore, these relationships need to be studied over a suitable period of time, allowing important changes within the company to be taken into account.
Balance sheet ratio analysis is useful in determining the creditworthiness of a business and the amount of trust it has in its creditors. The specific ratios included in this group are the current ratio, which measures financial strength by dividing a company’s assets by its liabilities, and the quick ratio, which takes the gist of the current ratio but excludes inventory. By focusing on a company’s liquid assets, a quick relationship can gauge its strength even in the worst case scenario where all its funding was suddenly cut.
In contrast, the analysis of the income statement is more related to the profitability of a business. Among this type of ratio analysis, the gross margin ratio measures the profit on sales available to pay overhead expenses, while the net profit margin ratio is an indicator of the financial performance of the company’s sales. Ratios known as management ratios can also be calculated from balance sheet information. These ratios measure efficiency in terms of collecting accounts receivable and managing inventory, the ability to turn assets into profit, and the return business owners get on their investment.
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