Ratio Analysis

A tool used by individuals to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. Ratio analysis is predominately used by proponents of fundamental analysis.

Investopedia Says:
There are many ratios that can be calculated from the financial statements pertaining to a company's performance, activity, financing and liquidity. Some common ratios include the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover and working capital.

Related Links:
If you don't know how to evaluate a company's present performance and its possible future performance, you need to learn how to analyze ratios. Ratio Analysis Tutorial
Learn this easy-to-understand technique of analyzing a company's financial statements and reports. Introduction To Fundamental Analysis
Learn what it means to do your homework on a company's performance and reporting practices before investing. Advanced Financial Statement Analysis

Study undertaken by financial statement preparers and users to evaluate the financial strength or weakness of a company and its operating trend. Various ratios are computed, depending upon the objective of the user analyzing the financial statements. Short-term creditors are primarily concerned with a company's ability to meet short-term debt from current assets, so they concentrate on the Liquidity Ratios emphasizing cash flow. Long-term creditors want to be paid back in the long term, so they look to solvency ratios such as total debt to total stockholders' equity. Potential investors are interested in dividends and appreciation in market price of stock, so they focus on profitability ratios (e.g., profit margin) and market measures (e.g., price-earnings ratio). Auditors zero in on the going concern of the client by determining its ability to meet debt (e.g., interest coverage ratio). Also, auditors wanting to know where to concentrate their audit attention look for illogical relationships in accounts over time such as the ratio of promotion and entertainment expense to sales. The limitations of financial ratios for analytical purposes must be considered, including: (1) a ratio is static in nature and does not reveal future flows; (2) a ratio does not reveal the amount of its components (e.g., a current ratio figure does not tell you how much is in cash or inventory); (3) a ratio does not reveal the quality of its components (e.g., a high current ratio that is made up of poor quality receivables and obsolete inventory); and (4) a ratio is based on historical cost not taking into account inflation. See also Solvent; Turnover.