What is Ratio Analysis?
Financial ratios are mathematical comparisons of financial statement accounts or categories. These ratios allow investors to get a quick and standardized look at a company's financial health and performance. Ratios are most useful when compared against a company's own historical performance or against the ratios of its competitors in the same industry.
Key Categories of Financial Ratios
- Liquidity Ratios: These measure a company's ability to meet its short-term obligations. The Current Ratio (Current Assets / Current Liabilities) is a common example.
- Profitability Ratios: These measure a company's ability to generate profits from its sales or assets. The Net Profit Margin (Net Income / Revenue) is a key profitability ratio.
- Leverage Ratios: These measure the extent to which a company is using debt to finance its assets. The Debt-to-Equity Ratio (Total Debt / Shareholders' Equity) is a widely used leverage ratio.
- Valuation Ratios: These help investors assess whether a stock is overvalued or undervalued. The Price-to-Earnings (P/E) Ratio (Stock Price per Share / Earnings per Share) is the most famous valuation ratio.
Putting Ratios in Context
A single ratio in isolation provides limited information. The true power of ratio analysis comes from trend analysis (how a ratio changes over time) and industry analysis (how a company's ratios compare to industry averages). This comparative analysis helps to paint a much clearer picture of a company's strengths and weaknesses.
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