3.2 Ratio analysis

Ratio analysis is a vital tool for assessing a company's financial health. By examining liquidity, solvency, profitability, efficiency, and market value ratios, investors and analysts can gain insights into a company's performance and make informed decisions.

Understanding financial ratios is crucial for accurate business reporting. Journalists must interpret these metrics to effectively communicate a company's financial position to their audience, providing context for corporate finance and accounting topics.

Importance of ratio analysis

• Ratio analysis is a crucial tool for evaluating the financial health and performance of a company, providing insights into its liquidity, solvency, profitability, efficiency, and market value
• Ratios allow for comparisons between companies within the same industry, as well as tracking a company's performance over time, helping investors, analysts, and managers make informed decisions
• In the context of Business and Economics Reporting, understanding and interpreting financial ratios is essential for journalists to accurately report on a company's financial position and communicate its performance to their audience

Types of financial ratios

Liquidity ratios

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• Measure a company's ability to meet its short-term obligations using its current assets
• Examples include the current ratio and quick ratio (acid-test ratio)
• Help assess whether a company has sufficient liquid assets to cover its near-term liabilities

Solvency ratios

• Evaluate a company's ability to meet its long-term financial obligations and its overall financial leverage
• Debt-to-equity ratio compares a company's total debt to its total equity, indicating the extent to which a company relies on debt financing
• Interest coverage ratio measures a company's ability to make interest payments on its outstanding debt

Profitability ratios

• Assess a company's ability to generate profits relative to its revenue, assets, or equity
• Return on assets (ROA) measures how efficiently a company uses its assets to generate profits
• Gross profit margin indicates the percentage of revenue remaining after subtracting cost of goods sold

Efficiency ratios

• Measure how effectively a company manages its assets and resources
• Inventory turnover ratio calculates how quickly a company sells and replaces its inventory
• Receivables turnover ratio measures how efficiently a company collects payments from its customers

Market value ratios

• Relate a company's stock price to its earnings, book value, or other financial metrics
• Price-to-earnings (P/E) ratio compares a company's stock price to its earnings per share (EPS)
• Price-to-book (P/B) ratio compares a company's market value to its book value

Calculating key financial ratios

Current ratio formula

• Current Ratio = Current Assets / Current Liabilities
• Measures a company's ability to pay off its short-term liabilities with its current assets
• A ratio of 1.5 or higher is generally considered healthy, although this varies by industry

Debt-to-equity ratio formula

• Debt-to-Equity Ratio = Total Liabilities / Total Shareholders' Equity
• Indicates the proportion of debt and equity a company uses to finance its assets
• A higher ratio suggests a company relies more heavily on debt financing, which may increase financial risk

Return on equity formula

• Return on Equity (ROE) = Net Income / Average Shareholders' Equity
• Measures the profitability of a company in relation to the equity invested by shareholders
• A higher ROE indicates that a company is more efficient at generating profits from its equity capital

Inventory turnover ratio formula

• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
• Measures how efficiently a company manages its inventory by calculating how many times it sells and replaces its inventory during a given period
• A higher ratio suggests that a company is effectively managing its inventory and has strong sales

Price-to-earnings ratio formula

• Price-to-Earnings (P/E) Ratio = Market Value per Share / Earnings per Share
• Compares a company's stock price to its earnings per share, indicating how much investors are willing to pay for each dollar of earnings
• A higher P/E ratio may suggest that investors expect higher growth in the future

Interpreting financial ratios

Benchmarking vs industry averages

• Comparing a company's financial ratios to industry averages helps evaluate its performance relative to its peers
• Industry-specific factors, such as market conditions and regulatory environment, should be considered when interpreting ratios

Trend analysis of ratios

• Analyzing a company's financial ratios over time helps identify trends and changes in its performance
• Positive or negative trends in key ratios can provide insights into a company's financial health and future prospects

Limitations of ratio analysis

• Financial ratios are based on historical data and may not accurately predict future performance
• Ratios can be affected by one-time events, such as asset sales or restructuring charges, which may distort the analysis
• Differences in accounting methods across companies can make comparisons challenging

Ratio analysis in financial reporting

Ratio disclosures in annual reports

• Public companies are required to disclose key financial ratios in their annual reports, such as the current ratio, debt-to-equity ratio, and return on equity
• These disclosures provide transparency and help stakeholders assess the company's financial health

Ratio analysis for investment decisions

• Investors use financial ratios to evaluate a company's performance, growth potential, and risk profile before making investment decisions
• Ratios help investors compare companies within the same industry and identify undervalued or overvalued stocks

Ratio analysis for lending decisions

• Lenders, such as banks and financial institutions, use ratio analysis to assess a company's creditworthiness and ability to repay loans
• Key ratios, such as the debt-to-equity ratio and interest coverage ratio, help lenders determine the risk associated with lending to a particular company

Advanced topics in ratio analysis

DuPont analysis

• A method that breaks down return on equity (ROE) into three components: profit margin, asset turnover, and financial leverage
• Helps identify the drivers of a company's ROE and how changes in these components impact overall profitability

Z-score for bankruptcy prediction

• The Altman Z-score is a formula that uses financial ratios to predict the likelihood of a company going bankrupt within the next two years
• The formula incorporates ratios such as working capital to total assets, retained earnings to total assets, and market value of equity to total liabilities

Ratios for non-financial metrics

• In addition to financial ratios, companies may use non-financial ratios to measure performance in areas such as customer satisfaction, employee turnover, and environmental impact
• These ratios provide a more comprehensive view of a company's overall performance and sustainability