Overview of Ratio Analysis

Classification

Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market.

Learning Objectives

Classify a financial ratio based on what it measures in a company

Key Takeaways

Key Points

  • Ratio analysis consists of the calculation of ratios from financial statements and is a foundation of financial analysis.
  • A financial ratio, or accounting ratio, shows the relative magnitude of selected numerical values taken from those financial statements.
  • The numbers contained in financial statements need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one method an investor can use to gain that understanding.

Key Terms

  • liquidity: Availability of cash over short term: ability to service short-term debt.
  • ratio: A number representing a comparison between two things.
  • ratio analysis: the use of quantitative techniques on values taken from an enterprise’s financial statements
  • shareholder: One who owns shares of stock.

Classification

Financial statements are generally insufficient to provide information to investors on their own; the numbers contained in those documents need to be put into context so that investors can better understand different aspects of the company’s operations. Ratio analysis is one of three methods an investor can use to gain that understanding.

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Business analysis and profitability: Financial ratio analysis allows an observer to put the data provided by a company in context. This allows the observer to gauge the strength of different aspects of the company’s operations.

Financial statement analysis is the process of understanding the risk and profitability of a firm through analysis of reported financial information. Ratio analysis is a foundation for evaluating and pricing credit risk and for doing fundamental company valuation. A financial ratio, or accounting ratio, is derived from a company’s financial statements and is a calculation showing the relative magnitude of selected numerical values taken from those financial statements.

There are various types of financial ratios, grouped by their relevance to different aspects of a company’s business as well as to their interest to different audiences. Financial ratios may be used internally by managers within a firm, by current and potential shareholders and creditors of a firm, and other audiences interested in understanding the strengths and weaknesses of a company, especially compared to the company over time or compared to other companies.

Types of Ratios

Most analysts think of financial ratios as consisting of five basic types:

  • Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.
  • Liquidity ratios measure the availability of cash to pay debt.
  • Activity ratios, also called efficiency ratios, measure the effectiveness of a firm’s use of resources, or assets.
  • Debt, or leverage, ratios measure the firm’s ability to repay long-term debt.
  • Market ratios are concerned with shareholder audiences. They measure the cost of issuing stock and the relationship between return and the value of an investment in company’s shares.