A car has many components: the engine, filters, radiator. All these parts play an important role to allow the car to operate. Companies are the same way. They have employees, cash, ideas, and more that keep the company going.
To quantitatively evaluate how a company is performing, you can use ratio analysis. Ratio analysis provides the ability to gain insight into a company’s efficiency, profitability, and liquidity ratios. These metrics identify how well the machine is running.
Finding these ratios requires an investor to utilize a company's financial statements to calculate the desired ratios. Financial statements are required to be filed quarterly with the SEC and can be found in the EDGAR database. We will dive into the four basic financial statements in an upcoming Bite.
There are many ratios that track the financial health of a company, however, in this Bite we will be focusing on three: Efficiency, Profitability, and Liquidity.
Efficiency ratios obviously evaluate efficiency, but specifically the efficiency in how a company uses its assets and liabilities to produce revenue and profit. Efficiency ratios are similar to determining if a car is fuel efficient. Investors use ratios like inventory turnover and days’ sales in inventory to gain an understanding of a company’s fuel efficiency.
Profitability ratios display how effectively a company can generate profits. Ideally, a company will want high profitability ratios to indicate they are good at making money. Ratios like profit margin, return on equity, and return on assets, all go to show that ability.
Lastly, we have liquidity ratios. These ratios provide context to a company's ability to cover their short term debt. The higher the ratio, the easier it is for a company to pay it off. The most common ratios used by investors are the quick ratio and current ratio.
Once you have collected the data needed and ratios have been found, your ratio analysis can begin! Ratios can be used individually to determine a company’s financial strength or be compared to competitors to determine the stronger company. Either way can help lead you making a stronger investment decision, but it does not guarantee your investment will be profitable.
We used the word ratio a lot. They are important. They paint a story about a company’s performance. Now, let’s explore them a bit deeper and uncover some key stats.