What is a Ratio Analysis?

A ratio analysis is a form of Financial Statement analysis in which Short-term solvency ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and Market Value Ratios are analyzed to identify areas which need to be further analyzed and to provide a quick indication of a firm’s performance. This method of analysis, because it is based upon accounting information, is limited in its efficacy because of distortions that can arise when factors such as Historical Cost Analysis and inflation are considered, and as such should only be a first step toward analyzing a company’s financial health and profitability.

• Short-term Solvency Ratios

  Short-term Solvency refers to the ability of a company to meet its short-term financial obligations. There are two ratios that can be used to measure short-term solvency: the current ratio and the quick ratio. Using the current ratio, a company’s asset profile is examined to identify assets the company currently possesses that it intends to liquidate within the coming year and current obligations or debts it must settle within the coming year. Unfortunately, the current ratio is limited in that many companies have assets that cannot be liquidated quickly without substantial loss. For a more accurate snapshot of a companies ability to pay its debts in the short-term, the quick ratio examines currently liquid accounts such as Accounts Receivable and cash. The equation for the quick ratio is Current Assets – Inventories divided by current liabilities.

• Asset Management Ratios

  Asset Management Ratios essentially measure a company’s success in managing assets to generate revenue. There are four asset management ratios that need to be taken into account to provide clear insight into a company’s asset management success: Receivables turnover and Days’ receivables, which measures a company’s credit policy, inventory turnover and days’ inventory, which measures a company’s management of inventory, fixed assets turnover, which measures a company’s productivity in managing fixed assets to generate revenue, and total assets turnover, which is a measure of how productive a company is in managing all of its assets to generate revenue.

• Debt Management Ratios

  Debt Management Ratios essentially measure a company’s ability to manage its financial leverage and meet obligations in the long run. There are three key debt management ratios to consider: Debt ratio, which is a measure of total debt to total assets, debt equity, which measures total debt to total owner’s equity, and the equity multiplier, which measures total assets by total owner’s equity.

• Profitability Ratios

  One of the most tell-tale indicators of a company’s overall financial health, profitability ratios measure a company’s success in generating revenue. Profit margin is taken into consideration, which is expressed mathematically as net income by sales, as well as return on assets (ROA) and Return on Equity (ROE). The ROA measures total dollars earned on its assets, while the ROE measures total dollars earned by shareholder’s equity.

• Market Value Ratios

  Finally, the market value ratios help put a specific value on a company and establish a stock price based on the company’s financial statements. This measure takes Price Earnings ratio (P/E ratio) and Market to Book Ratio. P/E ratio is measured by dividing current share price by earnings per share. The Market to book ratio is measured by comparing market value per share by book value per share.

As a financial tool, ratio analysis offers a number of important advantages: it utilizes readily available data by analyzing information already recorded in a company’s financial statement, it can be used to analyze massive multinational corporations as effectively as it can small businesses, and it can even give a business owner or shareholders insight into how the company is performing compared to industry averages. According to the Small Business Administration on their online guide, information gleaned from a ratio analysis can even be useful when establishing a small business when calculating financial projections.

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