Ratio Analysis
Ratio analysis is a technique used in financial analysis to gain insight into a company’s liquidity, operational efficiency, profitability, and solvency by examining and comparing specific figures from its financial statements. These ratios can be used to track a company’s performance over time and to compare its performance to that of other companies in the same industry.
Here are some key types of financial ratios and their uses:
- Liquidity Ratios: Measure a company’s ability to meet its short-term obligations.
- Current Ratio: Current Assets / Current Liabilities
- Quick Ratio (or Acid-Test Ratio): (Current Assets – Inventories) / Current Liabilities
- Profitability Ratios: Evaluate a company’s ability to generate profit.
- Efficiency Ratios: Gauge how well a company uses its assets and liabilities internally.
- Inventory Turnover: Cost of Goods Sold / Average Inventory
- Receivables Turnover: Net Credit Sales / Average Accounts Receivable
- Solvency Ratios: Measure a company’s ability to meet its long-term debts.
- Debt to Equity Ratio: Total Debt / Shareholders’ Equity
- Debt Ratio: Total Debt / Total Assets
- Market Prospect Ratios: Indicate how the market perceives the value of a company’s stock.
- Earnings Per Share (EPS): Net Profit / Number of Outstanding Shares
- Price-to-Earnings Ratio (P/E): Market Price Per Share / Earnings Per Share
Example of Ratio Analysis
Let’s use a hypothetical example to illustrate ratio analysis for two competing tech companies, TechA and TechB.
Financial Data (in USD):
| Metric | TechA | TechB |
|---|---|---|
| Current Assets | 1,000,000 | 800,000 |
| Current Liabilities | 500,000 | 600,000 |
| Net Profit | 300,000 | 250,000 |
| Revenue | 2,000,000 | 1,800,000 |
| Shareholders’ Equity | 1,500,000 | 1,000,000 |
| Market Price Per Share | 50 | 40 |
| Earnings Per Share (EPS) | 3 | 2.5 |
Ratio Calculations:
- Current Ratio:
- TechA: 1,000,000 / 500,000 = 2.0
- TechB: 800,000 / 600,000 = 1.33
- Net Profit Margin:
- TechA: 300,000 / 2,000,000 = 0.15 or 15%
- TechB: 250,000 / 1,800,000 = 0.138 or 13.8%
- Return on Equity (ROE):
- TechA: 300,000 / 1,500,000 = 0.20 or 20%
- TechB: 250,000 / 1,000,000 = 0.25 or 25%
- Price-to-Earnings Ratio (P/E):
- TechA: 50 / 3 = 16.67
- TechB: 40 / 2.5 = 16
Interpretation:
- Liquidity : TechA has a higher current ratio (2.0 vs. 1.33), suggesting it’s better positioned to meet short-term obligations using its current assets.
- Profitability : TechA has a slightly higher net profit margin, meaning it’s slightly more efficient at turning revenue into profit. However, TechB has a higher ROE, indicating it provides a higher return on the equity invested by shareholders.
- Market Valuation v: Both companies have fairly similar P/E ratios, implying the market values their earnings somewhat equally, but TechA has a slightly higher P/E ratio, which could suggest that investors expect higher growth or see slightly more value in TechA.
This simplified example showcases how ratio analysis can be used to compare the financial performance and position of two companies. When used in real-world scenarios, analysts would consider a much broader range of ratios, alongside other qualitative and quantitative factors, before drawing conclusions or making investment decisions.
