Ratio analysis is a useful way of gaining a "snapshot" picture of a company.  These ratios can be analyzed to identify the company's strengths and weaknesses and useful insights can be gained through the process.

However, it is just as important to realize this fact:  the ratios have no financial theory behind them.  In other words, we have no way to identify a "theoretically best" value for any of the ratios.  In fact, financial ratios are nothing more than common sense measures that have been developed and evolved over time.  As such, they are imperfect measures and should be treated as such.

Use of the Ratios

When using ratios, think of yourself as a detective who is looking for clues.  Typically, ratios are excellent devices for uncovering clues about a company's financial condition - but remember that clues simply raise more questions, not give definite answers.  Ratios tell us where to focus our attention and to ask relevant questions.  We never want to depend of just one ratio to draw a conclusion, the ratios are complementary and one ratio can be used to confirm a suspicion raised by another ratio's value.  It is only after looking at a variety of different ratios that a picture of the company's financial condition begins to form.

Types of Ratios and People Who Use Them

Financial ratios are generally grouped together by their purpose. Although there are many of these classifications, the most commonly used groups are:

1. Liquidity
2. Debt (or Leverage)
3. Activity (or Turnover)
4. Profitability

Typically, you would not calculate the ratios in all of these categories for a single company.  Usually, you would approach the ratio analysis from the perspective of an individual interested in one particular area. For example, assume that you show up for work one day and see a letter on your desk. In the letter, a company named Dragon Celebrations, Inc., orders $30,000 of merchandise from you on standard credit terms (which gives them up to 30 days to pay for the order). Accompanying the letter is a set of audited financial statements for the company. You're not familiar with Dragon Celebrations and don't have a previous business relationship with it. Should you should the merchandise to them?

Before doing so, you would like to determine the probability that they will pay you. You can purchase the credit rating for the company from a credit bureau or standard credit reporting agency. However, if you decide to do the analysis yourself, you can calculate the liquidity ratios using the company's balance sheet information. These ratios will evaluate the liquidity of the business and should offer valuable information as to the likelihood that Dragon will pay you within the 30 day period.

Although generalizations are difficult here, here are some of the key users for the different types of ratios:

1. Liquidity - short-term creditors

2. Debt - potential lenders or bondholders

3. Activity - top management of the company

4. Profitability - both existing and potential investors in the company's common stock

Additional details on these classifications may be found on the "Commonly Used Ratios" handout shown below.

Major Ratios

Here is a handout that shows eleven basic, commonly used ratios and their construction.  The second part of the handout describes nine more ratios that you may encounter, although they are not as common as the previous group.

    Commonly Used Ratios

Although there are approximately 50 ratios that are used in practice, the ratios found on this handout are used across a wide variety of industries and are a part of virtually any thorough financial analysis of a company.

Ratio Analysis on the Web

Here is my favorite web site for looking up the value of companies' financial ratios and the industry average for each ratio.  It's a great site for financial analysis of companies.

On the menu on the left side of the screen, click on Stocks.  Then enter a company's ticker symbol in one of the search boxes (there is a "ticker lookup" link if you don't know the ticker symbol) and click the Ratios button below the ticker search box.  Press the GO key.  You will see a side-by-side comparison (for the company, industry, sector, and S&P 500) of all the major ratios.  It makes an analysis easy and convenient.

    Reuters Investor

How Should We Use the Ratios?

There are two primary ways to use financial ratios:

1. Compare a ratio's value over several periods of time (trend analysis or time-series analysis).  If we see a deteriorating trend in any ratio's values over several quarters or years, we can investigate to find the cause.

2. Compare the company's ratios to the industry average (cross-sectional analysis).  A single ratio value by itself usually means nothing - we need a standard, or benchmark, to compare it to.  This benchmark is usually the industry average (i.e., the ratio's average value for all firms in the industry).

There are some people who believe that the industry average should not be used - that this means that we are trying to be average (mediocre).  They advocate that we should compare our ratios to those of the leading firm in the industry and try to match the ratios of that company.  Although this argument has a certain plausibility, it ignores the fact that the leading firm often has strengths that others in the industry will have trouble meeting (outstanding marketing, superior management training programs, etc.).  The industry average is probably a more useful standard.  After all, we aren't trying to match these ratios; we are trying to exceed the average company's performance.

A Particularly Useful Technique

A company's Return On Equity (ROE) ratio is one of the most commonly used ratios since it measures exactly what investors want to know:  how much the company is earning on every dollar that investors put into the company.  A particularly useful technique is to conduct a DuPont analysis on the company, i.e., break down the company's profits into the source of those profits.  Do the profits come from effective marketing techniques, strong control of costs, and effective pricing (all highly desirable) or do they come from the company's high use of debt (a less desirable and riskier way of increasing profits)?  Details on this technique may be found here:  Breaking down ROE into the sources of profits.

Cautions About Using Ratios

When using ratios as a form of analysis, be very careful that you don't put more trust in them than they deserve.  After all, they are simply common sense measures with no financial theory underlying them.  In fact, ratios have significant problems associated with them that should cause us to use them with caution:

1. Ratios don't prove that a problem exists or provide definite answers to any of our questions.  However they are very good at providing us with some guidance on the future steps that our investigation should take.  In other words, a ratio analysis indicates symptoms of a problem and focuses our attention on potential problems that deserve our attention.  But they rarely provide us with firm answers; usually, the best that they do is tell us what key questions we need to ask.

2. Realize that there may be significant differences between the characteristics of the company and the "average" firm in the industry.  For example, you may be analyzing the financial statements of a steel manufacturer and want to compare the firm's ratios to the the industry average.  However, while primarily steel manufacturers, some of the other firms in the industry may own their own captive finance companies, own railroad lines for transportation of the finished steel, and own an insurance company for diversification purposes.  It is often very difficult to honestly say that we are comparing apples with apples when the companies in the industry have substantially different structures and characteristics.

3. Always make sure that you are calculating a ratio exactly as the industry average ratio is calculated.  There are many variations on how to calculate the various ratios.  For example, if you look in several finance textbooks, you can easily find differences in suggested ways to calculate Return on Investment, Inventory Turnover, and the Quick (or Acid Test) Ratio.  Since we typically depend on an outside firm (e.g., Reuters, Dun & Bradstreet, etc.) to provide us with the values of the industry average for each ratio, we need to ensure that the formula that we are using for a ratio is the same formula that the industry average source is using.  For example, we may calculate the Inventory Turnover ratio as (Cost of Goods Sold)/(Average Monthly Inventory) while the outside source calculates it as (Annual Sales)/(Year Ending Inventory).  Both versions are commonly used.

4. Companies frequently don't have the same fiscal year.  Some companies' fiscal year ends on December 31st, others' end on September 30th, others' end on June 30th, etc..  If you are depending on the year-ending (end of the fiscal year) balance sheet's data, this date may vary widely among firms in the same industry.  This is especially true of companies whose sales are highly seasonal.  For example, two companies who manufacture snowmobiles may have almost identical performance numbers for the year.  However, they will have vastly different inventory and accounts receivable levels if one's year ends in June and the other's ends in December, resulting in considerable differences in the values of a ratio analysis.

5. Companies' accounting practices may differ considerably.  Companies have a great deal of discretion in their accounting procedures, particularly with regard to depreciation (straight line, double declining balance, etc.) and inventory (LIFO, FIFO, etc.).  This makes comparisons more difficult.

6. Be careful about depending too much on any one ratio.  A ratio analysis is most valuable when we evaluate a number of ratios of a certain type (liquidity, profitability, etc.) and look for a pattern in the results.

7. Audited financial statements should be used whenever possible.  Small businesses' financial statements are often unaudited and may not be accurate.

Related Topics

Breakdown of ROE Using the DuPont Method