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Ratio Analysis Ratio analysis is the broad method by which financial data is converted into simple mathematic ratios for comparison. Since the data is widely available, calculating ratio analysis numbers can be accomplished by anyone with access to public financial statements. Calculations created from these formulas provide crucial information for decision-making. Advantages Converting financial accounting data into ratios allows for comparisons of companies to be made in spite of size. Ratios provide information that raw data cannot. Very large companies can be compared reliably to smaller companies. Using ratio analysis, companies can be evaluated even across industries. Trends of growth, increased performance, and deterioration within the firm can be evaluated against itself, as well as across the industry. Limitations While ratio analysis is valuable, there are limitations in application. All formulas are only as good at the input data. The ratios are calculated based on accounting data provided by the company, and while generally deemed reliable, accounting procedures may differ, or data may not be as reliable as another firms data. Also, when comparing past rates, for example, inflation may skew interpretations. In addition, formulas or equations for ratio analysis must be comparable for a true comparison, and therefore based on an industry standard. Calculation of Data In order to calculate the ratio analysis for a financial institution, obtain the data from the financial statements. Typically, the balance sheet and income statement will provide the data that you require for calculations. Determine the industry standard for calculation by SIC code (Standard Industry Classification Code) if doing complex analysis, and make the calculations. For a small business, gross profit margin ratios (sales cost of goods divided by cost of goods sold) may be a crucial piece of information when making decisions about growth. For example, a

small company with $500,000 in sales, at a cost of $300,000 in cost of goods would have a 40% gross profit margin, or .40 on the dollar to cover costs. Internal Usage for Ratio Analysis Managers utilize ratio analysis to gauge the overall health of a company or business unit. These ratios can be calculated and reviewed, then measured again past years to determine if supply chains need to be reviewed or point to the need for lay-offs. Significant positive changes in ratios may determine growth opportunities, and lead to identifying trends. Companies also use the information to compare across the industry standard. In the example above, a 40% gross profit margin may be competitive in textiles, but in another industry, such as technology, where GPM can be 50-80%, a small company would require major cost-cutting measures to become or stay competitive. Making Company-Level Comparisons Using Ratio Analysis External usage of the ratio analysis data is widespread. While these ratios dont tell the whole story, sharp deviations from an industry standard, can forecast growth or decline. The calculations make it easy for larger companies to review smaller companies for buyout and merger opportunities. Financial analysts and individual investors utilize ratios to help determine the core health of a business, and make investment recommendations to individual investors partially based on this data. Entire industry sectors can also be easily assessed utilizing financial ratio data. Ratio analysis has long been utilized to make educated internal and external decisions in business. Financial ratio data greatly influences decisions for growth, investment, and cost-cutting measures. Copyright 2011 Ratioanalysis.org. All Rights Reserved. Privacy Policy | Contact us
Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment.

Financial ratios are calculated from one or more pieces of information from a company's financial statements. For example, the "gross margin" is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. In isolation, a financial ratio is a useless piece of information. In context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing. A ratio gains utility by comparison to other data and standards. Taking our example, a gross profit margin for a company of 25% is meaningless by itself. If we know that this company's competitors have profit margins of 10%, we know that it is more profitable than its industry peers which is quite favourable. If we also know that the historical trend is upwards, for example has been increasing

steadily for the last few years, this would also be a favourable sign that management is implementing effective business policies and strategies. Financial ratio analysis groups the ratios into categories which tell us about different facets of a company's finances and operations. An overview of some of the categories of ratios is given below.

Leverage Ratios which show the extent that debt is used in a company's capital structure. Liquidity Ratios which give a picture of a company's short term financial situation or solvency. Operational Ratios which use turnover measures to show how efficient a company is in its operations and use of assets. Profitability Ratios which use margin analysis and show the return on sales and capital employed. Solvency Ratios which give a picture of a company's ability to generate cashflow and pay it financial obligations.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law of "Garbage In...Garbage Out!" A cross industry comparison of the leverage of stable utility companies and cyclical mining companies would be worse than useless. Examining a cyclical company's profitability ratios over less than a full commodity or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company's situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company. Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the "downside" risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company's financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder. Although financial ratio analysis is well-developed and the actual ratios are well-known, practicing financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.

Ratio Analysis
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication of a firm's financial performance in several key areas. The ratios are categorized as Short-term Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios. Ratio Analysis as a tool possesses several important features. The data, which are provided by financial statements, are readily available. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm's financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas

where performance has improved or deteriorated over time. Because Ratio Analysis is based upon Accounting information, its effectiveness is limited by the distortions which arise in financial statements due to such things as Historical Cost Accounting and inflation. Therefore, Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick indication of a firm's performance and to identify areas which need to be investigated further. The pages below present the most widely used ratios in each of the categories given above. Please keep in mind that there is not universal agreement as to how many of these ratios should be calculated. You may find that different books use slightly different formulas for the computation of many ratios. Therefore, if you are comparing a ratio that you calculated with a published ratio or an industry average, make sure that you use the same formula as used in the calculation of the published ratio.
Liquidity Analysis Ratios Current Ratio Current Ratio = Quick Ratio Quick Ratio = Quick Assets ---------------------Current Liabilities Current Assets -----------------------Current Liabilities

Quick Assets = Current Assets - Inventories Net Working Capital Ratio Net Working Capital Ratio = Net Working Capital -------------------------Total Assets

Net Working Capital = Current Assets - Current Liabilities

Profitability Analysis Ratios Return on Assets (ROA) Return on Assets (ROA) = Net Income ---------------------------------Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Return on Equity (ROE) Return on Equity (ROE) = Net Income -------------------------------------------Average Stockholders' Equity

Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2 Return on Common Equity (ROCE) Return on Common Equity = Net Income -------------------------------------------Average Common Stockholders' Equity

Average Common Stockholders' Equity = (Beginning Common Stockholders' Equity + Ending Common Stockholders' Equity) / 2 Profit Margin Profit Margin = Net Income ----------------Sales

Earnings Per Share (EPS) Earnings Per Share = Net Income --------------------------------------------Number of Common Shares Outstanding

Activity Analysis Ratios Assets Turnover Ratio Assets Turnover Ratio = Sales ---------------------------Average Total Assets

Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2 Accounts Receivable Turnover Ratio Accounts Receivable Turnover Ratio = Sales ----------------------------------Average Accounts Receivable

Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2 Inventory Turnover Ratio Inventory Turnover Ratio = Cost of Goods Sold --------------------------Average Inventories

Average Inventories = (Beginning Inventories + Ending Inventories) / 2

Capital Structure Analysis Ratios

Debt to Equity Ratio Debt to Equity Ratio = Total Liabilities ---------------------------------Total Stockholders' Equity

Interest Coverage Ratio Interest Coverage Ratio = Income Before Interest and Income Tax Expenses ------------------------------------------------------Interest Expense

Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense

Capital Market Analysis Ratios Price Earnings (PE) Ratio Price Earnings Ratio = Market Price of Common Stock Per Share -----------------------------------------------------Earnings Per Share

Market to Book Ratio Market to Book Ratio = Market Price of Common Stock Per Share ------------------------------------------------------Book Value of Equity Per Common Share

Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Yield Dividend Yield = Annual Dividends Per Common Share -----------------------------------------------Market Price of Common Stock Per Share

Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares Dividend Payout Ratio Dividend Payout Ratio = Cash Dividends -------------------Net Income

ROA = Profit Margin X Assets Turnover Ratio ROA = Profit Margin X Assets Turnover Ratio Net Income ROA = ------------------------ = Net Income -------------- X Sales ------------------------

Average Total Assets Profit Margin = Net Income / Sales Assets Turnover Ratio = Sales / Averages Total Assets

Sales

Average Total Assets