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If one is investing or planning to start investing, they are likely to have come across the term ‘PE Ratio’, a tool frequently used by investors to evaluate stocks. However, besides the PE ratio, investors use several other tools or ratios to assess stocks. A wise, diligent investor is able to look beyond the stock price and identify great investing opportunities. To do that, they analyse the company from a fundamental perspective and evaluate its financial health. Ratio analysis is one of the techniques investors implement to help them analyse companies fundamentally. This blog post explains ratio analysis and covers different types of ratios.
Table of Contents
Introduction to Ratio Analysis
Ratio analysis can be defined as the process of analysing various business-related components in a company’s financial statements. These financial statements include the company’s earnings report and balance sheet. Regarding business-related components, ratio analysis focuses on liquidity, operational efficiency, and profitability. Both experts in the domain as well as beginners, implement ratio analysis to gauge the company’s financial health, albeit the extent to which they use it may vary.
In simple words, ratio analysis tells the current state of the company from a financial angle. It can also help investors estimate the company’s value over time.
Types of Ratio Analysis
The PE ratio may be one of the most popular financial ratios. However, one ratio alone cannot help an investor to assess multiple areas of a business. Different financial ratios are used to evaluate various areas. They can be broadly categorised into six types:
Liquidity Ratios
Liquidity ratios help measure the company’s strength in terms of its ability to pay off its short term debt. These ratios do that by taking into account the company’s current assets. The quick ratio, current ratio, and cash ratio are some of the most widely used liquidity ratios. In simple terms, these ratios help investors gauge if the company can convert all its assets into cash to successfully pay off its debts in case the company gets into a predicament.
Solvency Ratios
Like liquidity ratios, solvency ratios also measure the company’s ability to pay off its debt, but, in this case, its long term debt. So, solvency ratios take into account the company’s assets, equity, or annual earnings while evaluating its debt. Some of the most widely used solvency ratios include the debt to capital ratio, debt to equity ratio, interest coverage ratio, and equity multiplier.
Profitability Ratios
These ratios portray the company’s ability to earn profits with respect to its expenses. Ratios like the return on equity (ROE), return on assets (ROA), return on capital employed (ROCE), and profit margins. If a company’s profitability ratio improves over a period of time, it means that the company is also improving financially. Investors frequently compare a company’s profitability ratio to that of a comparable company.
Efficiency Ratios
These ratios highlight how well the company is able to manage its assets and liabilities to generate revenue and earnings. Hence, these ratios deal with inventory utilisation, turnover of liabilities, and equity usage. Popular efficiency ratios include the asset turnover ratio, inventory turnover, working capital turnover, and receivables ratio. When the efficiency ratios improve, it means the business will likely generate more revenues and profits.
Coverage Ratios
Coverage ratios gauge the company’s ability to service its debts and other obligations. Investors may use coverage ratios across a time period to estimate the company’s position in the future. Widely used coverage ratios include the debt coverage ratio, interest coverage ratio, fixed charge coverage, and EBITDA coverage. When these ratios improve, it means the company should have no trouble servicing its bets and associated obligations.
Market Prospect Ratios
The market prospect ratios include ratios like the price to earnings ratio, earnings per share (EPS), and dividend yield. They help investors predict how much they can earn from specific investments. Investors can help investors predict how much they expect to gain from their investments in the form of higher stock value or dividends.
Uses and Benefits of Ratio Analysis
Ratio analysis gives out financial ratios, and that helps present data in a format that is very easy to interpret. Thanks to that, it becomes effortless for analysts to compare the financials of the company with those of its industry peers. At the same, these ratios also let investors compare the company’s current financial health with its historic financial health.
Besides comparison, analysts also use ratio analysis to determine the phase or the trend of the company’s financial performance. One must be familiar with the concept of price trends in technical analysis. However, in this case, it is from a fundamental perspective. For example, one refers to the company’s ROE to see whether the trend of profitability is improving or worsening over time. So this helps to determine the management’s capabilities when it comes to managing the company’s assets and liabilities, expenses, and resources.
Conclusion
Investors always refer to such financial ratios to make smart investing decisions. However, it is always advisable to consider multiple ratios before making the final decision. Investors may refer to multiple ratios and create their own ratios to filter stocks. For example, an investor may filter stocks on the basis of their PE Ratio, ROE, and debt to equity ratio. Here, the investor may only consider stocks with a PE ratio under 20, an ROE of more than 15%, and a debt to equity under 1.00.