Definition: Ratio analysis is the process of examining and comparing financial information by calculating meaningful financial statement figure percentages instead of comparing line items from each financial statement.
Managers and investors use a number of different tools and comparisons to tell whether a company is doing well and whether it is worth investing in. The most common ways people analysis a company’s performance are horizontal analysis, vertical analysis, and ratio analysis. Horizontal and vertical analyzes compare a company’s performance over time and to a base or set of standard performance numbers.
What Does Ratio Analysis Mean?
Ratio analysis is much different. Ratio analysis compares relationships between financial statement accounts. This means that one income statement or balance sheet account is being compared to another. These relationships between financial statement accounts will not only give a manager or investor an idea of the how healthy the business is on a whole, it will also give them keen insights into business operations.
Take inventory turns for example. Inventory turnover is the ratio between cost of goods sold and average inventory. Inventory turnover tells managers and investors not only how much inventory the company maintained, it also tells them how efficient the company was with its inventory. A high inventory turnover ratio means that the company is lean and is able to move its inventory quickly. This could indicate proper management and thoughtful inventory purchasing.
The opposite is true about a low inventory turnover. A low inventory turnover usually means either that companies buy too much inventory or they have problems selling it. Neither of these facts indicate a healthy business.
Managers and investors use a ton of different ratios in this analysis. Here are a few:
- Current Ratio
- Acid Test Ratio
- Accounts receivable turnover
- Inventory turnover
- Total asset turnover
- Debt-to-equity ratio