A financial ratio analysis is a way of looking at performance metrics for a company, and for example, comparing line items on financial statements to look into different measures of financial strength and operational efficiency. The typical goal for a ratio analysis is to gain insight into a company's liquidity, operational efficiency, and profitability by looking at and comparing different financial statements or measures. Here are just a few that can be used:
To determine financial strength, one ratio that is often considered is the current ratio, used to determine a company's short-term liquidity. If you go to a balance sheet, you'll find a section for current assets. Current assets are all of the company's assets that are cash or will become cash within the next 12 months. Then you'll look for the company's current liabilities, these are debts that the company has that will need to be paid within the next 12 months. To find the current ratio, you will divide the company's current assets by its current liabilities. This will tell you if the organization has enough cash to pay off its upcoming debts. If the number is lower than 1, the company may have liquidity problems.
Other ratios of operational efficiency or profitability can be found by just looking at the different margins down the P&L. One way of doing the ratio analysis is comparing those over time to see if we are strengthening margins by improving operational efficiency, and managing costs in a way that we're building margins over time.
I mentioned the current ratio, a very quick read on liquidity, investors, especially with the volatility that exists in the market nowadays and with economic circumstances want to know the company has adequate cash to meet all their short midterm needs. So, the current ratio is perfect to highlight that.
Equity ratio or debt to equity ratio is calculated by dividing a company's total liability by its shareholder equity. This is used to evaluate a company's financial leverage. People often ask us - what's an appropriate equity ratio? And like all financial questions it depends, it always depends. Kind of depends on the industry, it depends on the position of the company in its life cycle.
Ratio analysis is looking at different line items on the financial statements and comparing those, particularly over time, to give insights into different strengths and weaknesses of the company. How it's performing? Are they moving toward their goals of creating greater financial strength? Increasing operational efficiency, improving profitability. So ratio analysis can give you insights into those financial results that show as a company moving towards its goals.
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