Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. Ratio analysis helps creditors solve these issues. Here is how:
What are Financial Ratios ?
- Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios helps investors shortlist companies that meet their criteria.
- Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
- Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the forefront the inter-relationship between ratios and how they help a company become more profitable.
Sources of Data
Here is where the investors get the data they require for ratio analysis:
- Financial Statements: The financial data published by the company and its competitors is the prime source of information for ratio analysis.
- Best Practices Reports: There are a wide range of consulting firms that collate and publish data about various companies. This data is used for operational benchmarking and can also be used for financial data analysis.
- Market: The data generated by all the activity on the stock exchange is also important from ratio analysis point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow and such other metrics to check if it is fairly priced.
