What is Financial Ratio Analysis?

A Powerful Financial Analysis Tool for Your Business

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Financial ratios are useful tools that help companies and investors analyze and compare relationships between different pieces of financial information across an individual company's history, an industry or an entire business sector. Numbers taken from a company's income statement, balance sheet and cash flow statement allow analysts to calculate several types of financial ratios for different kinds of business intelligence and information.

A Business Insight Tool

Financial ratio analysis can provide meaningful information on company performance to both a firm's  management and outside investors. Calculating the ratios is relatively easy; understanding and interpreting what they say about a company's financial state takes a bit more work. Ratios serve as a comparative tool of analysis for liquidity, profitability, debt, and asset management, among other categories -- all useful areas of financial statement analysis.

Companies typically start with industry ratios and data from their own historical financials to establish a basis for ratio comparison. Analysts compare the ratios for a given firm to the ratios of other firms in the same industry and against previous quarters or years of historical data for the firm itself.

Performing an accurate financial ratio analysis and comparison helps companies gain insight into their financial position so they can make necessary financial adjustments to enhance their financial performance.

Which Ratios are Most Commonly Used?

When choosing which ratios to work with, there are several standard ones that most companies look at often. These include the working capital ratio (current assets / current liabilities), the quick ratio or acid test (current assets-inventory / liabilities), inventory turnover (cost of goods / average inventory) and for public companies, the price to earnings ratio (stock price / earnings per share) among others.

Ratio calculations don't offer much information, however, unless analysts compare them to other ratios. For example, if a firm's debt to asset ratio for one time period (let's say a year) is 50 percent, that doesn't mean much unless management compares it to previous periods, especially if the debt to asset ratio was only 25 percent historically. The one-time calculation of the debt to asset ratio shows total liabilities / total assets, and that 50 percent of the firm's assets are financed by debt. An analyst wouldn't know if that is good or bad unless he compares to the same ratio from previous company history or for competing, similar companies, for example.

Internal Company Trend Analysis

Established companies typically have several years' worth of balance sheet and income statement data to work with for ratio analysis. Calculating the financial ratios for several periods, whether quarterly or yearly, helps track useful trends in the company's operational performance.

External Industry Analysis

Just as important as internal trend analysis is industry analysis. It's very useful to understand what a company's overall industry is doing over a span of time as compared to the individual company.

For example, if an industry's ratios are much different than a firm's results, especially if they're better, company management would benefit from examining why and perhaps taking action to improve financial results.

Companies should also compare their firm's ratios to industry and competitor data. After gathering ratio data from similar firms in the same industry, and average ratios for the industry or sector overall, analyzing how a firm is doing at one point in time in comparison to the industry at large can shed light on any strengths or weaknesses the company may have.