Short definition: Ratio analysis is a quantitative method used to evaluate a company’s financial performance and health by examining relationships between different financial statement items.
Explanation: It involves calculating and interpreting various financial ratios to assess a company’s profitability, liquidity, solvency, and efficiency. These ratios can be compared to industry benchmarks or historical trends to gain insights into a company’s strengths and weaknesses.
Example: Common financial ratios include:
- Profitability ratios: such as gross profit margin, operating margin, and net profit margin, measure a company’s ability to generate profits.
- Liquidity ratios: such as current ratio and quick ratio, assess a company’s ability to meet its short-term obligations.
- Solvency ratios: such as debt-to-equity ratio and interest coverage ratio, evaluate a company’s long-term financial stability and ability to meet its debt obligations.
- Efficiency ratios: such as inventory turnover ratio and days sales outstanding, measure how efficiently a company manages its assets and liabilities.
Additional information (optional): Ratio analysis is a valuable tool for investors, creditors, and analysts to understand a company’s financial performance and compare it to its peers. However, it’s important to interpret ratios in context and consider other qualitative factors, such as industry trends and management quality.