Using ratios in financial analysis

Ratio analysis is a fundamental part of financial analysis that considers several account types from a company’s financial statements. As explained in one of my previous posts, financial statements assess whether or not the company is healthy. A combination of either of the four financial statements of a company can tell you several things about the company, such as:

1. How well the company meets its short-term obligations such as salaries and account payables
2. How liquid the company is, that is, how much cash or near cash assets the company possesses
3. How certain we are that a company meets its long-term obligation to lenders and other financial institutions.
4. How geared a company truly is. Gearing measures how much of a company’s capital is financed with debt rather than equity.
5. How easily a company sells its inventory

Trying to answer all the above questions and much more using a combination of a company’s financial statements is called financial analysis. Several analyses can be done on a company’s financial statements, including horizontal analysis, vertical analysis, trends, du point analysis, ratio analysis, etc.

This article focuses on ratio analysis, understanding the various types of ratios and their utilization. Ratio analysis uses information from its financial statement to determine how well a company is doing in its industry. However, both in the transportation sector, comparing the accounts of British Airways (BA) in the aviation industry to that of Mercedes Benz (MB) in the automotive industry will not do us much good. This is due to varying styles of operations; while MB is interested in manufacturing, BA focuses on offering transportation services.

Ratios are used to observe how two or more companies of varying sizes compare. There are six major categories of ratios:

1. Profitability ratios: this ratio conveys how well a company can generate profit from its operations.
2. Solvency ratios:  also called the financial leverage ratio. It compares the company’s debt levels to its assets, equity and earnings to evaluate how well it is doing.
3. Liquidity ratio: measures the company’s ability to pay off its short-term debts. It includes the current, quick and working capital ratios.
4. Efficiency ratios: measures how well a company uses its assets and liabilities to generate sales and maximize profits. It comprises turnover ratio, inventory turnover, and days’ sales in inventory.
5. Coverage ratios: shows the ability of a company to make interests and other payments associated with its debt. It includes times interest earned ratio and debt-service coverage ratio.
6. Market prospect ratios are primarily used in stock market evaluations and allow investors to predict earnings and the company’s future performance. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio.

It was a lot of fun learning about how statements are analyzed, and I feel more confident in trying my hands on the financial markets.

I will stop here with one of my quotes, I do not remember where I heard this one, but I think John Lasseter said it:

‘Quality is the best business plan.’

Signed: The prince of Business