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Ratio analysis is an important component of financial statement analysis, but it’s often missed by average investors. Many people buy interest in companies based on a simple suggestion from their brokers or based on what their family or friends invest in. While technical analysis can be predicative of the future price, fundamental analysis can help investors spot problems in the way the company is managed and operated; review profitability history and learn how leveraged the company is.
When conducting the ratio analysis investors should start by analyzing the organization’s liquidity and debt-paying ability. The next step is to analyze profitability, financial structure and dividend history. Depending on the organization’s industry, business structure and the nature of the product, the importance of different ratios will vary.
- Liquidity analysis is important because it allows investors to see how much of its assets the company can convert to cash quickly in order to cover expenses or take advantage of opportunities. Quick ratio, inventory turnover ratio and working capital ratio are key liquidity indicators.
- To determine short-term and long-term debt paying ability, one should calculate and analyze times interest earned ratio, fixed charge coverage ratio and debt ratio. The results of this analysis will give even a novice investor a pretty clear picture of an organization’s ability to pay its obligations.
- Profitability analysis is perhaps the most important component of ratio analysis: when investors put their money on the line, they do it with returns in mind. There are many different ratios involved in profitability analysis, but investors should focus on the following key profitability indicators: net profit margin, earnings per share (EPS), return on equity (ROE), return on assets (ROA) and total asset turnover. It is important to note that net profit margin ratio will vary dramatically between industries.
Ratio analysis, whether basic or extensive, helps investors make unbiased,educated decisions.
