Knowing a company’s financial condition is essential before you invest in it. Whether you are a trader, an investor, or even just a financial analyst, ratio analysis is one of the most effective means to assist you in your financial endeavors. At Moneyplantfx, we help you understand financial statements using a variety of financial ratios to give you a better understanding of a company’s operations, risk, and profitability.
In this detailed guide, we will take you through the different types of ratio analysis, their purposes and limitations to help you formulate better strategies around your investment offerings.
To understand a company’s financial condition properly, you need to assess it from various perspectives. No ratio will give you a complete representation of the company. A composite of the five types of ratio analysis described below will explain the entire picture.
1. Leverage Ratios (Solvency Ratios)
Leverage ratios show how much a company depends on borrowed capital, and if it can pay long-term obligations. These ratios allow investors to assess financial risk levels, and how well a company can even service debt.
Common Leverage Ratios:
Purpose: To understand how well a company manages debt or financial obligations.
Ideal for: Large-cap companies, and capital-intensive sectors like infrastructure or real estate.
2. Performance Ratios (Profitability Ratios)
These ratios assess how well a company is able to generate profit from their business. Performance ratios provide a direct indication of how well a business is converting revenue into profit.
Common Performance Ratios:
Purpose: To assess the financial health of the company’s core operations.
Best For: Comparing profitability among peers and identifying opportunities for the best returns.
3. Liquidity Ratios
Liquidity ratios assess a company’s capacity to pay-off short-term obligations with the most liquid assets. Liquidity issues are especially common for small-cap or penny stock companies.
Common Liquidity Ratios:
Use: To assess a company’s liquidity and ensure they have adequate cash flow/liquid assets to pay off short-term liabilities.
Best Used For: Risk management and evaluation of company cash management for potential red flags.
4. Valuation Ratios (Market Ratios)
Valuation ratios assist investors in deciding whether a company’s stock share is overvalued, undervalued, or properly priced. These ratios are used by traders and portfolio managers every day to decide whether to buy/sell.
Common Valuation Ratios:
Purpose: To evaluate the company’s market value against its earnings, assets, or revenue.
Best suited for: Stock screening, equities, or long-term investing.
5. Activity Ratios (Efficiency Ratios)
Activity ratios indicate a company’s ability to generate revenue using its resources. Activity ratios are especially useful when analyzing operational efficiency, and turnover of inventory and assets.
Common Activity Ratios:
Purpose: Measures how well a company utilizes its assets and working capital.
Ideal Use: Operational analysis and performance comparison to industry peers.
We at Moneyplantfx and your portfolio company asked you to be smart with your investment approach which is easy to do when you have clarity. Ratio analysis gives clarity to an investor by providing an overall picture of how the company works and indicators of strength and weaknesses. In a fast-growing and diverse economy like India, ratio analysis is useful to maintain a balanced approach to investing across different sectors.
For investors, it does not matter if you are investing in blue-chip companies, growth stocks, or engaging in due diligence on a start-up, ratio analysis will give you an advantage by helping you understand financial ratios.
All of the different types of ratio analysis are important because they can assist stakeholders ranging from investors to company management, in understanding the true financial position of a company. No one ratio can tell you everything, but when used collectively, they can help make better investment decisions and manage some investment risk.
At Moneyplantfx, we are offering not just insights but financial education so that you can build wealth safely.