When investors wish to compare the financial performance of different companies, a highly valuable tool at their disposal is ratio analysis. Ratio analysis can provide insight into companies' relative financial health and future prospects. It can yield data about profitability, liquidity, earnings, extended viability, and more. The results of such comparisons can mean more powerful decision-making when it comes to selecting companies in which to invest. Show
It's important that investors understand that a single ratio from just one company can't give them a reliable idea of a company's current performance or potential for future financial success. Use a variety of ratios to analyze financial information from various companies that interest you in order to make investment decisions. Key Takeaways
What Is Ratio Analysis?Ratio analysis is the analysis of financial information found in a company's financial statements. Such analysis can shed light on financial aspects that include risk, reward (profitability), solvency, and how well a company operates. As a tool for investors, ratio analysis can simplify the process of comparing the financial information of multiple companies. There are five basic types of financial ratios:
Some key ratios that investors use are the net profit margin and price-to-earnings (P/E) ratios. Net Profit MarginNet profit margin, often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It measures the amount of net profit (gross profit minus expenses) earned from sales. It's calculated by dividing a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector. They have profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%. One metric alone will not give a complete and accurate picture of how well a company operates. For example, some analysts believe that the cash flow of a company is more important than the net profit margin ratio. Price-to-Earnings Ratio (P/E)Another ratio investors often use is the price-to-earnings ratio. This is a valuation ratio that compares a company's current share price to its earnings per share. It measures how buyers and sellers price the stock per $1 of earnings. The P/E ratio gives an investor an easy way to compare one company's earnings with those of other companies. Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An investor can conclude that investors are willing to pay $100 per $1 of earnings that ABC generates and only $10 per $1 of earnings that DEF generates. A high P/E ratio can indicate that a company's stock is overvalued or that investors may be expecting high future earnings growth. A low P/E ratio can indicate that a stock is undervalued or that future earnings are in doubt. Other Factors to ConsiderAs mentioned, it's important to take into account a variety of financial data and other factors when doing research on a possible investment.
What Are the 5 Categories of Ratio Analysis?Ratio analysis includes these five types of financial ratios: profitability ratios, liquidity ratios, debt or leverage ratios, operations ratios, and market ratios. How Do You Compare the Ratios of 2 Companies?Start by choosing companies in the same industry. Narrow this down to companies with similar products, inventory methods, business longevity, and location. Then, compare the same financial ratios for both. Consider looking at a big picture of results over time rather than just one year-end snapshot. Where Can You Find a Company's Financial Information?Company information is available in many places, including news and financial publications and websites. However, to be sure of its credibility, look for financial information in audited company annual reports. In addition, the Securities and Exchange Commission (SEC) maintains financial and business information about publicly held companies in the online database called EDGAR. Access is free of charge. Why is it difficult to compare financial ratios between businesses in the same industry?Lack of Comparability Between Companies
Using ratios to compare two firms in the same industry may be difficult if, for example, a company uses a last-in-first-out valuation, its ratios that include inventory will be significantly different than a company that uses first-in-first-out.
Why is it complicated to compare a given ratio of two companies operating in different sectors industries?Different Divisions May Need Comparison to Different Industry Averages. Very large companies may be composed of different divisions manufacturing different products or offering different services. different industry averages need to be used for each different division to make ratio analysis mean something.
Why is it important to compare a company financial ratios with the industry average ratios?Financial ratios and industry averages are useful for comparing a company with its industry for benchmarking purposes. Some of the most common are: Current ratio – current assets divided by current liabilities. It indicates how well a company is able to pay its current bills.
Why do financial ratios differ from industry to industry?D/E ratios vary across industries because some industries are more capital intensive than others. The financial sector has one of the highest D/E ratios but this is not indicative of high risk, just the nature of the business.
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Why is it misleading to compare a companys financial ratios with those of other firms that operate within the same industry?
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