DEFINITION OF 'RATIO ANALYSIS'

Quantitative analysis of information contained in a companys financial

statements. Ratio analysis is based on line items in financial statements
like the balance sheet, income statement and cash flow statement; the
ratios of one item or a combination of items - to another item or
combination are then calculated. Ratio analysis is used to evaluate
various aspects of a companys operating and financial performance
such as its efficiency, liquidity, profitability and solvency. The trend of
these ratios over time is studied to check whether they are improving or
deteriorating. Ratios are also compared across different companies in
the same sector to see how they stack up, and to get an idea of
comparative valuations. Ratio analysis is a cornerstone of fundamental
analysis.
EXPLAINS 'RATIO ANALYSIS'
While there are numerous financial ratios, most investors are familiar
with a few key ratios, particularly the ones that are relatively easy to
calculate. Some of these ratios include the current ratio, return on equity,
the debt-equity ratio, the dividend payout ratio and the price/earnings
(P/E) ratio.
For a specific ratio, most companies have values that fall within a certain
range. A company whose ratio falls outside the range may be regarded
as grossly undervalued or overvalued, depending on the ratio.
For example, if the average P/E ratio of all companies in the S&P 500
index is 20, with the majority of companies having a P/E between 15 and
25, a stock with a single-digit P/E would be considered undervalued,
while one with a P/E of 50 would be considered overvalued. Of course,
this ratio would typically only be considered as a starting point, with
further analysis required to identify if these stocks are really as
undervalued or overvalued as the P/E ratios suggest.
As well, ratios are usually only comparable across companies in the
same sector, since an acceptable ratio in one industry may be regarded
as too high in another. For example, companies in sectors such as
utilities typically have a high debt-equity ratio, but a similar ratio for a
technology company may be regarded as unsustainably high.
Ratio analysis can provide an early warning of a potential improvement
or deterioration in a companys financial situation or performance.
Analysts engage in extensive number-crunching of the financial data in a
companys quarterly financial reports for any such hints.
Successful companies generally have solid ratios in all areas, and any
hints of weakness in one area may spark a significant sell-off in the
stock. Certain ratios are closely scrutinized because of their relevance to
a certain sector, as for instance inventory turnover for the retail sector
and days sales outstanding (DSOs) for technology companies.