Financial ratio analysis is the process of calculating financial ratios based on financial statements to gain meaningful information about a company. They are used to assess a company’s liquidity, growth, margins, profitability, rates of return, valuation, and more. Balance Sheet, Income statement, and cash flow statement are commonly used financial statements to evaluate financial ratio.
It really tough to go through information in financial statements, various available financial ratios can make the life of a stock investor easy. Using these ratios they can choose right companies to invest in or to compare the financials of two companies to find out which one is better.
The typical tools used in financial statement analysis are
- Comparative analysis : It is the evaluation of consecutive financial statements of a company, to identify the direction, speed, and magnitude of any trends in financial performance.
- Common size analysis : It is the evaluation of the internal make-up of financial statements, and/or financial statements items across companies.
- Ratio analysis : It evaluates the relationship between two or more economically important items.
Types of Financial Ratio
Financial Ratios largely fall into below categories
- Profitability Ratios : It measure company’s ability to generate income relative to its revenue, operating costs and other cost associated with the generation of income during a particular period.
- Activity Ratios : Activity ratios measure a company’s ability to convert assets and liabilities into cash or sales. The faster it is able to do this, the more efficiently it is operating.
- Solvency Ratios : It measure a company’s ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Better solvency ratios indicate a more creditworthy and financially sound company in the long-term. Shareholder’s Funds (Owner’s Equity) portion out of the total liabilities determines the Solvency of a company.
- Liquidity Ratios : It measure a company’s, i.e. its ability to convert its assets to cash and pay off its obligations. Obligations can beoh short term and long term.
- Market Value Ratios : They are the financial metrics which are used to evaluate the stocks of publicly traded companies. These ratios are used to check whether the share’s prices are valued correctly in the market. If a share is overpriced, the price might fall in the future.