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Ratio analysis is a method of analyzing data to determine the overall financial strength of a business. Financial analysts take the information off the balance sheets and income statements of a business and calculate ratios that can then be used to make assessments of the operating ability and future prospects of that business. These ratios are useful only when compared to other ratios, such as the comparable ratios of similar businesses or the historical trend of a single business over several business cycles. There are various ratios that measure a company's efficiency, short-term strength, profitability, and solvency.
The type of ratio analysis that is most effective depends upon who needs the information. Credit analysts are concerned with risk evaluation, and they therefore will concentrate of ratios that measure whether a company can pay its financial obligations and how much debt is involved in capital structure. On the opposite end of the spectrum, analysts looking at a business in terms of an investment opportunity will employ ratios that determine if a company is efficient and how great is its potential profitability.
For example, knowing that a company has a particular profit margin as determined by a corresponding ratio is meaningless by itself. Financial analysts know it's more important to determine how that ratio looks in terms of other similar companies, or even how that ratio looks compared to prior profitability levels of that same company. In addition, these ratios must be studied over a proper time period, allowing for major changes within the company to be taken into consideration.
Balance sheet ratio analysis is useful in determining the solvency of a business and the amount of reliance it has on its creditors. Specific ratios included in this group are current ratio, which measures financial strength by dividing a company's assets by its liabilities, and quick ratio, which takes the essence of the current ratio but excludes inventory. By focusing on the liquid assets of a business, a quick ratio can measure its strength even in a worst-case scenario whereby all of its funding was suddenly removed.
In contrast, income statement analysis is more concerned with the profitability of a business. Among this type of ratio analysis, gross margin ratio measures the profit from sales available to pay overhead, while net profit margin ratio is an indicator on the company's financial return on sales. Ratios known as management ratios can also be calculated from balance sheet information. These ratios measure efficiency in terms of collecting accounts receivable and managing inventory, the ability to turn assets into profit, and how much of a return the owners of the business are getting on their investment.
Of all the ratios that are analyzed, wouldn't profitability be the single most important indicator for an investor? If a business has a great efficiency ratio, exhibits short term strength and solvency but indicates a low profitability ratio, is there any way it could still be viable?