Ratio Analysis As A Tool For Determining Performance

Ratio Analysis is a tool used to determine the performance of a company.

Everybody has lists. We all have mentally created ideas of what we want in a significant other and every time we meet somebody new, we consciously or unconsciously begin to sort through the list to see if the person checks out.

In creating these lists, we have determining metrics. When measuring physical looks, we consider attributes like height, the availability of abs or packs, facial beauty, shape, and so on.

Depending on what counts as beauty for many, some would even go on to add the size of the other person’s car or bank account as part of the metrics. We’re not pointing fingers. What this does for you is that it shows you whether you have aligned goals with the other person and what you potentially stand to gain from them.

In the same vein, when carrying out in-depth analysis into the performance of a company, it is important to use financial (and non-financial) metrics to make correct decision.

What do investors look out for before deciding to invest or not? How do they determine the performance of a company and its sustainability? While there are a few other ways, one of the most convenient of them is ratio analysis.

Ratio analysis, simply put, is the quantitative analysis of information contained in a company's financial statements. It helps individuals (such as potential investors) and companies (such as investment banks and private equity firms) evaluate different areas of financial performance of the company ranging from its profitability, it’s liquidity, efficiency and so on.

There are 5 broad classifications of ratios used to determine performance. They include:

Profitability Ratios: If your primary goal from investing is to make money out of it, then profitability ratios are your best friends. What profitability ratios do is measure how a company uses its available assets and control of its expenses to generate profit.

Simply put, you use profitability ratios to determine if the company is capable of yielding good returns.

Liquidity ratios

The liquidity position of a company shows how well a company has the required funds to meet its financial obligations. Of what use is the high market value of a company if it doesn’t have access to its funds to grow the business? Liquidity ratios help you out this in perspective.

Leverage Ratios

These are used to measure a company’s level of indebtedness and its ability to repay long term debt. A company that cannot meet its debt obligations or has an unfavorable debt repayment structure would be forced to shut down in no time.

Efficiency ratios

These are also called activity ratios and they simply measure the effectiveness of how a company uses its resources, that is assets and liabilities, internally. These resources could be inventories, receivables, and so on.

Market ratios

As an investor, market ratios are your friends. These ratios measure the relationship between return and the value of an investment in company’s shares. An example of this is dividend per share and earnings per share. The Yochaa App currently displays market ratios like dividend yield as well.

In the next post, we would learn how to compute these ratios towards making well informed investment decisions.

Written by Lawretta Egba