Ratio Analysis
Candlefocus EditorRatio analysis allows stakeholders to understand the interrelations between different line-item numbers in a company's financial statements. This information can help them make certain decisions such as whether to invest in the company or not, whether to issue new shares or bonds, or whether the company should merge or enter a joint venture. Ratios may also be used to compare a company to its peers or competitors.
Essentially, there are three key categories of ratios which are; profitability, liquidity, and solvency. Profitability ratio analysis measures a company's ability to generate income. This includes metrics such as gross profit margin, operating profit margin, return on assets and return on equity. Liquidity ratio analysis measures a company’s ability to meet its short-term debt obligations, such as current ratio and quick ratio analysis. And solvency ratio analysis measures a company's ability to meet its long-term debt obligations, such as debt-to-equity and interest coverage.
The ratios used in ratio analysis depend on the investor’s and analyst’s purpose. Some of the most commonly used ratios are the current ratio, debt-to-equity, days receivable outstanding and earnings per share. These ratios can provide insight into a company's financial position, and help investors understand the overall performance of a company.
It is important to note that while ratio analysis may provide insight into a company's financial position, it should not be used as a stand-alone tool. Ratio analysis should be used in combination with other financial metrics to get a comprehensive view of a company's performance. Moreover, when comparing companies to peers and competitors, it is important to consider other factors such as economic conditions, business models and objectives.