Ratio Analysis
Ratio Analysis is a quantitative method used to evaluate the financial performance and position of a company by comparing various financial metrics from its financial statements. This technique involves calculating ratios from the financial statements, such as the balance sheet and Income Statement, to assess profitability, Liquidity, efficiency, and solvency.
Examples of common ratios include:
- Current Ratio: Measures a company’s ability to cover its short-term liabilities with its short-term Assets. Calculated as Current Assets / Current Liabilities.
- Debt to Equity Ratio: Assesses a company’s Financial Leverage by comparing its total liabilities to its Shareholders’ Equity. Calculated as Total Liabilities / Shareholders’ Equity.
- Return on Equity (ROE): Indicates how efficiently a company is using its Equity to generate profit. Calculated as Net Income / Shareholders’ Equity.
- Gross Profit Margin: Reflects the percentage of Revenue that exceeds the Cost of Goods Sold (COGS). Calculated as (Revenue – COGS) / Revenue.
In practice, a company may find that its Current Ratio is below 1, indicating potential Liquidity issues. For instance, if a company has current Assets of $50,000 and Current Liabilities of $60,000, the Current Ratio would be 50,000 / 60,000 = 0.83. This suggests that the company may struggle to pay off its short-term obligations.
Conversely, a high debt to Equity ratio, such as 2.5, implies that a company relies heavily on debt financing, which may increase financial risk, especially in volatile market conditions. For example, a company with total liabilities of $250,000 and Shareholders’ Equity of $100,000 would have a debt to Equity ratio of 250,000 / 100,000 = 2.5.