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.
Very Important: However, it is important to realize this fact: the ratios have no financial theory behind them. Theory tells us what SHOULD BE the case (or value). With financial ratios, 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.
When using ratios, think of yourself as a detective who is looking for clues (like the little guy at the top of the page). 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.
Financial ratios are generally grouped together by their purpose. Although there are many of these classifications, the most commonly used groups are:
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 ship 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:
Liquidity - short-term creditors
Debt - existing lenders or potential lenders
Activity - top management of the company
Additional details on these classifications may be found on the "Commonly Used Ratios" handout shown below.
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.
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.
After going to the company's homepage (see the link below), point to the "News and Markets" heading at the top of the screen. A sub-menu will pop up; under the "Markets" heading, click on "Stocks." On the next page's Search box, type in the ticker symbol for the company that you want to look up. (If you don't know the ticker symbol, type in the company name and press Search. The next page will allow you to type in the full company name.) When the company's screen appears, click on the box for "Financials." You will then 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.
There are two primary ways to use financial ratios:
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.
Click on the link to see a sample financial statement analysis for the restaurant industry.
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 ROE into the sources 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)?
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:
Breakdown of ROE Using the DuPont Method
A Sample Ratio Comparison