Welcome to our Financial Bites newsletter.
This month, we introduce a crucial topic in financial analysis: ratios and ratio analysis. Written and curated by our team of experts, this collection of articles helps you navigate the types of ratios and why they’re essential for anyone looking for a career in finance.
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Navigating Financial Ratios: Why They Are Important and How to Apply Them
Ratios are simple but powerful tools in the financial analyst’s toolbox. Internal and external stakeholders—such as investors, analysts, management, and creditors—use them to evaluate various aspects of a company’s financial health.
What Is Ratio Analysis?
Before introducing the ratio types, you need to know what ratio analysis is. It evaluates a company’s profitability, liquidity, solvency, and operational efficiency using information from its financial statements. Ratio analysis gives insights into a company’s financial performance over time, against an industry benchmark, or compared to another business. Find out why it’s essential in our article.
Profitability Ratios
Profitability ratios measure a company’s ability to generate profit relative to its sales, assets, and equity. Typically, a higher value indicates better financial health. But these ratios are just numbers when seen in isolation. They provide meaningful information when analyzed compared to an industry benchmark, the firm’s competitors, or its past performance. Learn how to navigate them in our article.
Activity Ratios
Activity ratios (efficiency multiples) measure how well a firm manages its resources to generate revenue. They show how effectively a company converts net assets into profits. Like other financial ratios, activity ratios provide meaningful insights compared to industry averages or the firm’s historical data. Activity ratios bring little value when examined individually but, combined, offer a comprehensive insight into operating efficiency. We explain how to calculate them in detail in our article.
Liquidity Ratios
Liquidity ratios are important indicators of a firm’s short-term financial health. They reveal its ability to convert assets into cash quickly to cover current debts without raising external capital. And although they do not provide meaningful insights about businesses’ long-term standing, they are among the first metrics you should check when making investment decisions. For more insights and formulas, read our article.
Solvency Ratios
A firm’s ability to meet its long-term financial obligations is called solvency. Analysts, investors, and prospective lenders use solvency ratios to evaluate a firm’s long-term financial health and creditworthiness. A high solvency ratio indicates a firm’s ability to stay afloat or become debt-free. At the same time, a low one signals the company will struggle to repay its long-term obligations and may go bankrupt. Learn more about these types of ratios in our article.
Valuation Ratios
Valuation ratios examine the relationship between a company’s market value and different financial metrics. Analysts compare the results to industry averages, peer companies, and historical data to obtain meaningful insights. Equity valuation is a complex process that goes beyond ratio analysis. Typically, financial analysts use a mixture of methods depending on their objectives. Explore the most popular market value ratios in our article.
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