What is Ratio Analysis?
Similar to baseball’s use of statistics to rank players and teams, in business there are endless possible ratio combinations. Ratio Analysis uses a combination of financial or operating data from a company or industry to provide a basis of comparison. Each ratio measures a unique relationship that may impact others. Several of the most commonly used ratios are grouped into categories, including:
- Liquidity Ratios measure how easily a firm can meet its obligations.
- Profitability Ratios indicate the earnings potential of a company.
- Asset Management Ratios measure how efficiently a company uses its assets.
- Debt Management Ratios indicate financial leverage and how well a company can handle that debt.
- Dividend/Market Value Ratios measure earnings for investors.
Ratios can provide meaningful comparisons of companies in similar industries, a company to its industry, or a company to itself over time.
Limitations of Ratio Analysis
In order to be a fair point of comparison, ratios should be evaluated in relation to other companies in the same industry. For example, an asset turnover ratio of 2 times means nothing by itself, and means very different things if the industry average is 22.5 as opposed to 0.5. For businesses that have operations in more than one industry, ratio analysis is less meaningful or more challenging.
Ratio analysis does not tell the entire story. There may be good business reasons to support management’s decision to reduce or increase liquidity or fixed assets in a different manner than the rest of the industry. Having a single ratio out of line with an industry, therefore, does not necessarily mean there is a problem.