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Ratio analysis is one of the most vital cornerstones of fundamental analysis. The latter is a method, or a group of methods, which is used to arrive at an intrinsic value of a given entity.
Fundamental analysis is an indispensable aspect of modern day finance. And as one of its more important subjects, ratio analysis has developed into a science of its own and is a substantially powerful tool in making sense of financial statements.
What Is Ratio Analysis?
In layman terms, ratio analysis is a process that involves interpretation and determination of numerical relationships in a given financial statement.
The nature of ratio analysis is completely quantitative. It uses the function of ratio, i.e. a mathematical expression that relates a given number to another one. In effect, a ratio helps compare one number to another on a relative basis.
A typical financial statement includes items like balance sheet, cash flow statement and income statement among others. With ratio analysis, the ratios of these items (taken individually or combined) with each other is calculated.
Using different combinations of items for various ratios results in a set of financial and operating parameters that help gauge a business entity’s financial and operating performance. This includes aspects like liquidity, solvency, efficiency and profitability of the business.
Analysts use ratio analysis over a period of time to infer whether a particular company is on the path to increased profitability or is looking at decelerated growth in the immediate future.
Ratios analysis also help in comparing companies of different sizes within the same category thanks to the relative nature of the comparison. What this does is help in calculating the intrinsic as well as relative value of a business.
How Does Ratios Analysis Work?
As mentioned before, ratio analysis involves formulating ratios of various items in a financial statement. The number of resulting ratios is quite large and only a minority makes use of these ratios in their entirety.
However, for the average investor, there are a few important ratios that are not only easy to calculate but also offer good insights into a company’s financial health.
Examples of these ratios include return on equity (RoE), current ratio, and dividend payout ratio, debt to equity ratio and price to earnings ratio (P/E).
As with all indicators, the above ratios too have a certain range and to add to it, most companies too tend to fall within this range. This is where things get interesting as there usually are companies that fall on either side of this range.
Now depending upon the results of the ratios in question, a company can either be undervalued or overvalued.
Consider the example of the price to earnings ratio or P/E ratio. If, for a stock market index consisting of the top companies by value, the average P/E ratio is at 25 and a majority of the index’s companies have individual P/E ratios in the 20-30 range, then a company whose P/E ratio falls in the single digits can be termed as undervalued.
On the other hand, if the P/E ratio of a company in that index is over 40, it’s safe to say the company is overvalued by a long margin. That is just a starting point however as other aspects of ratio analysis are necessary in order to paint a more accurate picture, i.e. to truly ascertain if a company has the right valuations going.
Analysts make use of these ratios to lay threadbare each and every aspect of the company and its finances. This is one reason why quarterly reports of successful and large companies are highly anticipated and are subjected to aggressive number crunching almost immediately, the outcome of which has the potential to influence their stock prices and market valuations.
To add to that, a company with consistent performance and track record usually does well in most ratio analysis parameters. However, ratio analysis can offer valuable insights into whether its finances are staring at the abyss or if the sunny days are likely to continue.
Advantages Of Ratios Analysis
- Ratio analysis helps make sense of financial statements, which are full of individual categories and numbers. This helps a user understand in a concise manner how strong or weak are a given company’s fundamentals.
- It puts in numbers the relationship between the different areas and sectors of the same business, something that helps when executing important business decisions.
- It also does away with any inefficiencies and hindrances that might concern the individual/firm performance.
- Use of ratio analysis helps in setting of a benchmark to which a company’s performance is adhered to.
- It also enables quick decisions related to the business as the management is confronted with clear and indisputable information.
- It forms the basis on which a company’s management makes decisions on vital issues like controlling, organizing, forecasting and planning.
- Ratio analysis also makes for the most effective pitch by companies to investors, proprietors, creditors etc. as they paint an accurate picture of the businesses’ financial health.
- A detailed analysis helps in unearthing loss making areas of a business. This enables the management to cut down on loss making activities and divert resources toward overcoming them.
- Ratio analysis offers individual as well as enterprise investors a way to evaluate a business and make an investment decision based on the results of that evaluation.
Disadvantages Of Ratio Analysis
One of the biggest disadvantages when it comes to basing decisions solely upon ratio analysis is the prevalence of variables like environmental conditions, regulatory atmosphere, political stability, diverse market structures and overall economic policy.
These are factors that affect each industry, and thereby each company within that industry, in different ways. These variables are not only unquantifiable but also almost impossible to predict. For instance, an energy company might face an uncertain future owing to changes in environmental policy or other geo-political factors or a trading company might be affected by labor issues or a low-performing economy that curtails demand.
In light of these factors, if a company is put to the test of ratio analysis, the end result is likely to not be in sync with ground realities. Such situations also render inaccurate a comparison between two companies from different sectors as discrepancies find their way into the mix.
Another drawback is that ratio analysis only throws light on the company’s immediate past performance. An investor can at best extrapolate or bet on the company’s future performance by using ratio analysis.
Even while comparing two companies within the same sector, ratio analysis becomes difficult if the concerned companies differ massively when it comes to age, size and diversity of product portfolio.
Importantly, ratio analysis attains meaning only when its results are benchmarked against a suitable standard. As such, any conclusions obtained using ratio analysis are only as reliable as the standards to which they are compared.
For ratio analysis to give desired results, it is important that only true and verifiable facts and figures are put out in the public domain by companies. If a company management indulges in any sort of window dressing, unearthing facts becomes difficult.
Company managements that do resort to such tactics realize that most investors might only be interested in a certain set of numbers like earnings, cash flow and sales etc. This relegates other numbers to the background and the management manipulates these figures within the ambit of the law to make certain metrics appear attractive.
When analyzing two businesses vis-à-vis each other, the first step involves calculating all the relevant ratios before comparing them head to head. However, many companies within the same industry follow accounting practices that are quite different to each other’s.
In such a case, arriving at a meaningful comparison becomes close to impossible. While regulatory bodies around the world tend to guide companies toward following a uniform accounting policy, most companies continue to choose policies that make peer comparison of their financial statements highly problematic.
In the end, ratio analysis is nothing but a set of mathematical formulae. Ratio analysis is also just a tool and in a fast changing business environment, regular and adequate changes must be made to the manner in which its results are interpreted in order to gain an accurate picture of a business’ financial health and market valuation.