Ratio Analysis
The systematic examination of relationships between financial data points to evaluate performance, efficiency, liquidity, and financial health for decision-making.
Ratio Analysis
The systematic examination of relationships between financial statement items to evaluate a company’s performance, efficiency, liquidity, solvency, and overall financial health.
For example, a comprehensive ratio analysis might include calculating and interpreting:
- Liquidity ratios like the current ratio (2.1) and quick ratio (1.3) to assess short-term solvency
- Profitability ratios like gross margin (42%) and return on assets (8%) to evaluate earnings efficiency
- Leverage ratios like debt-to-equity (0.8) and interest coverage (7.5) to examine financial risk
- Efficiency ratios like inventory turnover (6.2) and asset turnover (1.5) to measure operational effectiveness
- Valuation ratios like price-to-earnings (18) and price-to-book (2.4) to assess investment potential
Ratio analysis provides insights beyond what individual financial statement figures reveal by establishing meaningful relationships between numbers. Effective analysis involves comparing ratios to industry benchmarks, competitors, and the company’s historical performance to identify trends, strengths, weaknesses, and anomalies requiring investigation. While providing valuable analytical shortcuts, ratios should be interpreted considering the business context, accounting methods, and economic conditions, recognizing that they represent symptoms rather than diagnoses.