Financial Education

Just as common size financial statements improve comparability of performance over time and across companies, ratio analysis is another important tool for investors. Although common size analysis typically focuses on a particular financial statement (income statement, balance sheet, etc.) the full array of ratios also permits the investor to evaluate factors that affect multiple statements simultaneously.

Ratios are generally grouped into the following categories:

• Activity ratios indicate how efficiently and effectively a company manages its operations and assets.
• Liquidity ratios demonstrate the firm’s ability to meet its immediate obligations.
• Solvency ratios indicate whether the firm can meet its long-term obligations.
• Profitability ratios illustrate whether the company can cover its costs and have money left over to reinvest in growth opportunities.
• Cash flow ratios can fit into any of the above categories but typically replace earnings data with cash flow data. They are useful in situations where the investor is concerned about earnings quality.
• Price multiples are a form of ratio that indicates whether the firm is currently valued relative to peers, the market and its own history.

For more information, see all articles on: Financial Statement Analysis, Fundamental Analysis, Investing in Stocks, Ratio Analysis, Security Selection

See also:

Risk Adjusted Return Measures: The Information Ratio

When Should an Asset Class Be Included in a Portfolio?

The Current Ratio

The Justified Price/Earnings Multiple

Choice of Performance Measure for Hedge Funds