Question

Ratio analysis is a common analytical tool. What are some of the strengths of ratio analysis, and what are some of its weaknesses? How would you incorporate ratio analysis into a broader analytical process when analyzing a company?

Answer 1

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.

Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company's financial standing with industry averages while measuring how a company stacks up against others within the same sector.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.

Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make its stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.

Examples of Ratio Analysis Categories

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios.

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

5. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio.

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

The limitations of ratio analysis

Ratio analysis involves comparing information taken from the financial statements to gain a general understanding of the results, financial position, and cash flows of a business. This analysis is a useful tool, especially for an outsider such as a credit analyst, lender, or stock analyst. These people need to create a picture of the financial results and position of a business just from its financial statements. However, there are a number of limitations of ratio analysis to be aware of. They are:

• Historical. All of the information used in ratio analysis is derived from actual historical results. This does not mean that the same results will carry forward into the future. However, you can use ratio analysis on pro forma information and compare it to historical results for consistency.

• Historical versus current cost. The information on the income statement is stated in current costs (or close to it), whereas some elements of the balance sheet may be stated at historical cost (which could vary substantially from current costs). This disparity can result in unusual ratio results.

• Inflation. If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not comparable across periods. For example, if the inflation rate was 100% in one year, sales would appear to have doubled over the preceding year, when in fact sales did not change at all.

• Aggregation. The information in a financial statement line item that you are using for a ratio analysis may have been aggregated differently in the past, so that running the ratio analysis on a trend line does not compare the same information through the entire trend period.

• Operational changes. A company may change its underlying operational structure to such an extent that a ratio calculated several years ago and compared to the same ratio today would yield a misleading conclusion. For example, if you implemented a constraint analysis system, this might lead to a reduced investment in fixed assets, whereas a ratio analysis might conclude that the company is letting its fixed asset base become too old.

• Accounting policies. Different companies may have different policies for recording the same accounting transaction. This means that comparing the ratio results of different companies may be like comparing apples and oranges. For example, one company might use accelerated depreciation while another company uses straight-line depreciation, or one company records a sale at gross while the other company does so at net.

• Business conditions. You need to place ratio analysis in the context of the general business environment. For example, 60 days of sales outstanding for receivables might be considered poor in a period of rapidly growing sales, but might be excellent during an economic contraction when customers are in severe financial condition and unable to pay their bills.

• Interpretation. It can be quite difficult to ascertain the reason for the results of a ratio. For example, a current ratio of 2:1 might appear to be excellent, until you realize that the company just sold a large amount of its stock to bolster its cash position. A more detailed analysis might reveal that the current ratio will only temporarily be at that level, and will probably decline in the near future.

• Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms that are pursuing different strategies. For example, one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market share. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and gross margins are higher, but it will never attain the revenue levels of the first company.

• Point in time. Some ratios extract information from the balance sheet. Be aware that the information on the balance sheet is only as of the last day of the reporting period. If there was an unusual spike or decline in the account balance on the last day of the reporting period, this can impact the outcome of the ratio analysis.

In short, ratio analysis has a variety of limitations that can restrict its usefulness. However, as long as you are aware of these problems and use alternative and supplemental methods to collect and interpret information, ratio analysis is still useful.