When financial analysts seek insight into annual reports, they employ ratio analysis as a primary tool. In fact, ratio analysis is the dominant analytical technique used in the analysis of financial statements. Although it is an important tool, it isn’t a magic formula.
Ratio analysis isn’t often easy to understand. Having this valuable tool is crucial but it requires hard work and diligence to make it work in one’s favor.
A ratio is a measure of relative size that is calculated by dividing one number into another. A ratio describes the relative size of the two numbers or quantities but it doesn’t explain the absolute size. Ratios can be especially useful if a standard of reference for a company in that particular industry is used in comparison.
A ratio for a company can be compared to…
- The company industry average or standard
- Another company in the same industry
- The same ratio for the company in prior years
A financial analyst uses the comparison of ratios within a company differently than a comparison with the industry average or a similar company. Comparing ratios from previous years may reveal a pattern, for better or for worse.
In ratio analysis, it is important to use a variety of ratios to make an accurate determination. There are ratios to help analyze profitability, solvency, liquidity and activity. One area may reveal a strong ratio. Yet, when other ratios are used as well, weakness in the company can be unveiled. A financial analyst needs the whole picture.