Ratio analysis is an important tool for financial analysts, accountants and investors. Ratios provide a means to analyze data consistently across companies and industries. They also provide insight into a company's operational efficiency and resource management from many different angles. Ratios work best when used as a group, to illustrate the overall picture of a company and its performance.
1. Choose the ratio to use. Analysts commonly use certain financial ratios to assess performance, such as the current ratio. The current ratio -- current assets divided by current liabilities -- tells analysts how well a company can cover its current debts with current, or easily liquidated, assets.
2. Locate the financial data to use in the ratio calculation. Choose a period such as year-end or month-end for the data. In your choice, consider that certain firms experience seasonal fluctuations in their business, such as companies that make most of their money selling products during the holidays.
3. Plug the appropriate financial data into the ratio formula and solve. Use a spreadsheet program for ease of calculation. When calculating ratios for more than one time period, verify that the data was formulated consistently in each period and that nothing unusual took place that should be factored into your analysis. For example, a company might experience one-time expenses from closing an under-performing business division, or accounting regulations might have changed the required accounting method for certain items such as stock options in future periods. These changes might make ratios from different time periods incomparable without further adjustments.
4. Interpret the results of your ratio calculations. Use benchmarks to compare changes in ratios over time. One ratio does not tell much -- it is the ratio's comparison to prior periods, the same ratios from peer companies or competitors that makes the ratio informative. The ratio may also provide a basis or test for budget or forecast financial data. RMA Associates, a publication found in public libraries, provides several ratios for companies grouped by Standard Industrial Classification, or SIC, codes as a means for comparison against individual firms.
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