A ratio is a relationship between two numerical values representing something. In case of accounting, a ratio is a relationship between two factors of accountancy. For eg.: Current Ratio= Current Assets/Current Laibilities.
Ratio Analysis is a quantitative analysis of information cantained in the financial statements of an organisation. The analysis of ratios is basically done to to evaluate various aspects of the organisations operating and financial performances such as its liquidity, profitability, returns to investment etc. Also the trend of these ratios is analyised to determine if they are growing or falling over period. The ratios are even compared across companies in the same sector and even cross sector to compare these sectors. Hence, ratio analysis is the cornerstone to fundamental analysis.
While there are several financial ratios, most investors are familiar with the key ratios namely current ratios, debt to equity ratio, sales turnover ratio, dividend payout ratio, returns to investment ratio etc.
For a specific ratio, most companies have values that fall within a certain range. A company whose ratio falls outside the range may be regarded as grossly undervalued or overvalued, depending on the ratio.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20, with the majority of companies having a P/E between 15 and 25, a stock with a single-digit P/E would be considered undervalued, while one with a P/E of 50 would be considered overvalued. Of course, this ratio would typically only be considered as a starting point, with further analysis required to identify if these stocks are really as undervalued or overvalued as the P/E ratios suggest.
As well, ratios are usually only comparable across companies in the same sector, since an acceptable ratio in one industry may be regarded as too high in another. For example, companies in sectors such as utilities typically have a high debt-equity ratio, but a similar ratio for a technology company may be regarded as unsustainably high.
Ratio analysis can provide an early warning of a potential improvement or deterioration in a company’s financial situation or performance. Analysts engage in extensive number-crunching of the financial data in a company’s quarterly financial reports for any such hints.
Successful companies generally have solid ratios in all areas, and any hints of weakness in one area may spark a significant sell-off in the stock. Certain ratios are closely scrutinized because of their relevance to a certain sector, as for instance inventory turnover for the retail sector and days sales outstanding (DSOs) for technology companies.