Ratio Analysis and Equity Valuation: From Research to Practice

  • Published: March 2001
  • Volume 6 , pages 109–154, ( 2001 )

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  • Doron Nissim 1 &
  • Stephen H. Penman 2  

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Financial statement analysis has traditionally been seen as part of thefundamental analysis required for equity valuation. But the analysis has typicallybeen ad hoc. Drawing on recent research on accounting-based valuation, this paperoutlines a financial statement analysis for use in equity valuation. Standardprofitability analysis is incorporated, and extended, and is complemented with ananalysis of growth. An analysis of operating activities is distinguished from theanalysis of financing activities. The perspective is one of forecasting payoffs to equities. So financial statement analysis is presented as a matter of pro formaanalysis of the future, with forecasted ratios viewed as building blocks offorecasts of payoffs. The analysis of current financial statements is then seen asa matter of identifying current ratios as predictors of the future ratios thatdetermine equity payoffs. The financial statement analysis is hierarchical, withratios lower in the ordering identified as finer information about those higher up.To provide historical benchmarks for forecasting, typical values for ratios aredocumented for the period 1963–1999, along with their cross-sectionalvariation and correlation. And, again with a view to forecasting, the time seriesbehavior of many of the ratios is also described and their typical “long-run,steady-state” levels are documented.

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Nissim, D., Penman, S.H. Ratio Analysis and Equity Valuation: From Research to Practice. Review of Accounting Studies 6 , 109–154 (2001). https://doi.org/10.1023/A:1011338221623

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The Analysis and Use of Financial Ratios: A Review Article

Profile image of Paul Barnes

1987, Journal of Business Finance & Accounting

Financial ratios are used for all kinds of purposes. These include the assessment of the ability of a firm to pay its debts, the evaluation of business and managerial success and even the statutory regulation of a firm's performance. Not surprisingly they become norms and actually affect performance.' The traditional textbooks of financial analysis also emphasise the need for a firm to use industry-wide averages as targets , and there is evidence that firms do adjust their financial ratios to such targets.* Whittington (1980) identified two principal uses of financial ratios. The traditional, normative use of the measurement of a firm's ratio compared with a standard, and the positive use in estimating empirical relationships, usually for predictive purposes. The former dates back to the late nineteenth century and the increase in US bank credit given as a result of the Civil War when current and non-current items were segregated and the ratio of current assets to current...

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The certainty of the reliance on the use of financial ratio analysis in making investment decisions by potential investors still remained a mystery. This has to do with the choice of ratios to select when making investment decisions. Many shareholders in Nigeria are uneducated or illiterate, and due to their ignorance, they cannot use ratio analysis in evaluating firms for investment decisions. Thus, this paper explores the concept of financial ratio analysis in terms of the decision usefulness of financial ratios. The paper suggests that the relevant financial information needed for the purposes of making investment decision can be sourced through the use of financial ratio analysis. Therefore, management must ensure that disclosure of comprehensive financial ratios form part of financial statement prepared for the overall appraisal of firms.

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Financial ratios are assumed to be very useful predictors of business performance, growth and financial status. This study evaluates the collinearity and correlation of financial ratios to establish a pattern of relationship that could serve s n empirically supported guide for financial ratios reliance in business evaluation decisions. The research data were gathered from the annual account report of vita foam Plc and analyzed using collinearity and correlation to test the research propositions. The paper found the existence of correlation and collinearity in the financial ratios, and concludes that financial ratios are reliable business status indicators. We therefore recommend the application of financial ratios in the evaluation of business performance, growth and financial strength.

navneet joshi

The current business environment has forced business units to devise innovative means and mechanisms so as to stay competitive in the market. This necessitates the need for constantly evaluating their performance measures. Business units have identified several measures which depict the performance yet ambiguities remain with respect to what is appropriate measure for performance measurement. Ratio analysis is one such measure which business units have been using for sufficient period of time. Yet there exists certain points of consideration which form the basis for this paper and their convergence into research question namely (a) What constitutes ratio analysis and (b) Which of the component of ratio analysis, has the greatest contribution? While addressing these questions, HUDCO’s secondary data is used as a base. Ratio analysis is used to depict the measure of performance while descriptive statistics is used for data interpretation. Findings indicate that there is no single comp...

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Ratios are routinely used for extracting information from accounting reports. However, ratios present only part of the information available and can be easily complemented provided that information-technology facilities are accessible. This study infers the functional form of the information discarded by ratios. Then it develops extensions of ratios incorporating the discarded information, showing examples of their use and discussing the benefits obtained. Extensions of ratios seem promising as a facility attached to computerized databases of accounting reports. The concepts developed here are a step toward a more technology-supported analysis of financial statements.

Paul Barnes

Empirical studies have shown distributions of financial ratios are skewed. An explanation for this is given and it is argued that in such circumstances comparison of a fmancial ratio with some norm (e.g. industry average) is likely to misinform. It is also shown that where financial ratios are used as inputs to statistical models normality is irrelevant but a method of transformation into a normal distribution is provided whereby original interrelationships are preserved. Finally, because of the inadequacies of financial ratios, it is shown how regression analysis may be used in financial statement analysis.

MRS. OKWO IFEOMA MARY

The British Accounting Review

This study identifies general postulates underlying the validity of the financial ratio measurement. Then, new relationships are suggested obeying the same postulates, which may replace the ratio form in the case of non-proportionality. Where proportionality holds, these relationships revert to the traditional ratio. The paper also reviews the reasons for expecting non-proportional components in ratios and presents application examples of the new relationships.

Vichy Pattiasina , Victor Pattiasina

A Company will be interested in investors if its financial report is relevant and reliable. The relevance and reliable financial report can be reflected in the Asset Number and Liability Report on a Financial Position Statement (Balance Sheet). The success of a company can be measured by company ability, which is reflected in management performance. A company's performance parameter that commonly used is profit change. Profit itself is important to the company since this will be decision basis for investors to invest in the company. Profit Change reflected in financial statements using fair value will bring benefits to market participants, as the financial statements itself reflects the real market value. This research aims to examine the influence of Current Ratio, Total Asset Turnover, Price Earnings Ratio, and Return on Asset, towards profit changes that based on fair value. Research problem discussed in this study was how CR, TATO, PER, and ROA influence profit changes of a property company, real estate, and building construction, in period 2013-2016. The study was based on fair value. The population was company property, real estate, and building construction, that have been listed in Indonesia Stock Exchange (ISE). It consisted of 63 companies. Through Purposive Sampling technique, 12 companies were selected to be examined. Data analysis was conducted through a multiple linear regression analysis. Results of multiple linear regression analysis showed that the CR, TATO, and PER had an influence towards Profit Changes, while ROA had no influence toward it.

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What Is Ratio Analysis?

  • What Does It Tell You?
  • Application

The Bottom Line

  • Corporate Finance
  • Financial Ratios

Financial Ratio Analysis: Definition, Types, Examples, and How to Use

research papers on financial ratio analysis

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis .

Key Takeaways

  • Ratio analysis compares line-item data from a company's financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
  • Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
  • Ratio analysis may also be required by external parties that set benchmarks often tied to risk.
  • While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company's financial health.
  • Examples of ratio analysis include current ratio, gross profit margin ratio, inventory turnover ratio.

Investopedia / Theresa Chiechi

What Does Ratio Analysis Tell You?

Investors and analysts employ ratio analysis to evaluate the financial health of companies by scrutinizing past and current financial statements. Comparative data can demonstrate how a company is performing over time and can be used to estimate likely future performance. This data can also compare a company's financial standing with industry averages while measuring how a company stacks up against others within the same sector.

Investors can use ratio analysis easily, and every figure needed to calculate the ratios is found on a company's financial statements.

Ratios are comparison points for companies. They evaluate stocks within an industry. Likewise, they measure a company today against its historical numbers. In most cases, it is also important to understand the variables driving ratios as management has the flexibility to, at times, alter its strategy to make it's stock and company ratios more attractive. Generally, ratios are typically not used in isolation but rather in combination with other ratios. Having a good idea of the ratios in each of the four previously mentioned categories will give you a comprehensive view of the company from different angles and help you spot potential red flags.

A ratio is the relation between two amounts showing the number of times one value contains or is contained within the other.

Types of Ratio Analysis

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

1. Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term debts as they become due, using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company's debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios .

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days' sales in inventory.

5. Coverage Ratios

Coverage ratios measure a company's ability to make the interest payments and other obligations associated with its debts. Examples include the times interest earned ratio and the debt-service coverage ratio .

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield , P/E ratio , earnings per share (EPS), and dividend payout ratio . Investors use these metrics to predict earnings and future performance.

For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es between 15 and 25, a stock with a P/E ratio of seven would be considered undervalued. In contrast, one with a P/E ratio of 50 would be considered overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

Most ratio analysis is only used for internal decision making. Though some benchmarks are set externally (discussed below), ratio analysis is often not a required aspect of budgeting or planning.

Application of Ratio Analysis

The fundamental basis of ratio analysis is to compare multiple figures and derive a calculated value. By itself, that value may hold little to no value. Instead, ratio analysis must often be applied to a comparable to determine whether or a company's financial health is strong, weak, improving, or deteriorating.

Ratio Analysis Over Time

A company can perform ratio analysis over time to get a better understanding of the trajectory of its company. Instead of being focused on where it is today, the company is more interested n how the company has performed over time, what changes have worked, and what risks still exist looking to the future. Performing ratio analysis is a central part in forming long-term decisions and strategic planning .

To perform ratio analysis over time, a company selects a single financial ratio, then calculates that ratio on a fixed cadence (i.e. calculating its quick ratio every month). Be mindful of seasonality and how temporarily fluctuations in account balances may impact month-over-month ratio calculations. Then, a company analyzes how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).

Ratio Analysis Across Companies

Imagine a company with a 10% gross profit margin. A company may be thrilled with this financial ratio until it learns that every competitor is achieving a gross profit margin of 25%. Ratio analysis is incredibly useful for a company to better stand how its performance compares to similar companies.

To correctly implement ratio analysis to compare different companies, consider only analyzing similar companies within the same industry . In addition, be mindful how different capital structures and company sizes may impact a company's ability to be efficient. In addition, consider how companies with varying product lines (i.e. some technology companies may offer products as well as services, two different product lines with varying impacts to ratio analysis).

Different industries simply have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies more heavily on private investor funding.

Ratio Analysis Against Benchmarks

Companies may set internal targets for their financial ratios. These calculations may hold current levels steady or strive for operational growth. For example, a company's existing current ratio may be 1.1; if the company wants to become more liquid, it may set the internal target of having a current ratio of 1.2 by the end of the fiscal year.

Benchmarks are also frequently implemented by external parties such lenders. Lending institutions often set requirements for financial health as part of covenants in loan documents. Covenants form part of the loan's terms and conditions and companies must maintain certain metrics or the loan may be recalled.

If these benchmarks are not met, an entire loan may be callable or a company may be faced with an adjusted higher rate of interest to compensation for this risk. An example of a benchmark set by a lender is often the debt service coverage ratio which measures a company's cash flow against it's debt balances.

Examples of Ratio Analysis in Use

Ratio analysis can predict a company's future performance — for better or worse. Successful companies generally boast solid ratios in all areas, where any sudden hint of weakness in one area may spark a significant stock sell-off. Let's look at a few simple examples

Net profit margin , often referred to simply as profit margin or the bottom line, is a ratio that investors use to compare the profitability of companies within the same sector. It's calculated by dividing a company's net income by its revenues. Instead of dissecting financial statements to compare how profitable companies are, an investor can use this ratio instead. For example, suppose company ABC and company DEF are in the same sector with profit margins of 50% and 10%, respectively. An investor can easily compare the two companies and conclude that ABC converted 50% of its revenues into profits, while DEF only converted 10%.

Using the companies from the above example, suppose ABC has a P/E ratio of 100, while DEF has a P/E ratio of 10. An average investor concludes that investors are willing to pay $100 per $1 of earnings ABC generates and only $10 per $1 of earnings DEF generates.

What Are the Types of Ratio Analysis?

Financial ratio analysis is often broken into six different types: profitability, solvency, liquidity, turnover, coverage, and market prospects ratios. Other non-financial metrics may be scattered across various departments and industries. For example, a marketing department may use a conversion click ratio to analyze customer capture.

What Are the Uses of Ratio Analysis?

Ratio analysis serves three main uses. First, ratio analysis can be performed to track changes to a company over time to better understand the trajectory of operations. Second, ratio analysis can be performed to compare results with other similar companies to see how the company is doing compared to competitors. Third, ratio analysis can be performed to strive for specific internally-set or externally-set benchmarks.

Why Is Ratio Analysis Important?

Ratio analysis is important because it may portray a more accurate representation of the state of operations for a company. Consider a company that made $1 billion of revenue last quarter. Though this seems ideal, the company might have had a negative gross profit margin, a decrease in liquidity ratio metrics, and lower earnings compared to equity than in prior periods. Static numbers on their own may not fully explain how a company is performing.

What Is an Example of Ratio Analysis?

Consider the inventory turnover ratio that measures how quickly a company converts inventory to a sale. A company can track its inventory turnover over a full calendar year to see how quickly it converted goods to cash each month. Then, a company can explore the reasons certain months lagged or why certain months exceeded expectations.

There is often an overwhelming amount of data and information useful for a company to make decisions. To make better use of their information, a company may compare several numbers together. This process called ratio analysis allows a company to gain better insights to how it is performing over time, against competition, and against internal goals. Ratio analysis is usually rooted heavily with financial metrics, though ratio analysis can be performed with non-financial data.

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  • What Is Valuation? 2 of 37
  • Valuation Analysis: Meaning, Examples and Use Cases 3 of 37
  • Financial Statements: List of Types and How to Read Them 4 of 37
  • Balance Sheet: Explanation, Components, and Examples 5 of 37
  • Cash Flow Statement: How to Read and Understand It 6 of 37
  • 6 Basic Financial Ratios and What They Reveal 7 of 37
  • 5 Must-Have Metrics for Value Investors 8 of 37
  • Earnings Per Share (EPS): What It Means and How to Calculate It 9 of 37
  • P/E Ratio Definition: Price-to-Earnings Ratio Formula and Examples 10 of 37
  • Price-to-Book (PB) Ratio: Meaning, Formula, and Example 11 of 37
  • Price/Earnings-to-Growth (PEG) Ratio: What It Is and the Formula 12 of 37
  • Fundamental Analysis: Principles, Types, and How to Use It 13 of 37
  • Absolute Value: Definition, Calculation Methods, Example 14 of 37
  • Relative Valuation Model: Definition, Steps, and Types of Models 15 of 37
  • Intrinsic Value of a Stock: What It Is and Formulas to Calculate It 16 of 37
  • Intrinsic Value vs. Current Market Value: What's the Difference? 17 of 37
  • The Comparables Approach to Equity Valuation 18 of 37
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  • How to Become Your Own Stock Analyst 20 of 37
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  • Determining the Value of a Preferred Stock 22 of 37
  • Qualitative Analysis 23 of 37
  • How to Choose the Best Stock Valuation Method 24 of 37
  • Bottom-Up Investing: Definition, Example, Vs. Top-Down 25 of 37
  • Financial Ratio Analysis: Definition, Types, Examples, and How to Use 26 of 37
  • What Book Value Means to Investors 27 of 37
  • Liquidation Value: Definition, What's Excluded, and Example 28 of 37
  • Market Capitalization: How Is It Calculated and What Does It Tell Investors? 29 of 37
  • Discounted Cash Flow (DCF) Explained With Formula and Examples 30 of 37
  • Enterprise Value (EV) Formula and What It Means 31 of 37
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    Purpose - Financial ratios are an instrumental tool in the world of finance and hence comprehensive knowledge of its various aspects is mandated for its user. This study aims at providing the aforesaid comprehensive knowledge by highlighting the areas in which ratios can be used, limitation of ratios and methods to deal with the limitation.

  10. PDF Ratio Analysis: A Study on Financial Performance of Tata Motors

    Abstract: Financial ratio analysis is the process of reviewing the financial position of the company. Ratio analysis is extensively used by firms as a technique to forecast the financial soundness of the company to build future growth.

  11. The Analysis and Use of Financial Ratios: A Review Article

    FINANCIAL RATIOS?AN EMPIRICAL STUDY 1977 • Ronald Bird Download Free PDF View PDF Financial ratio analysis: decision usefulness for potential shareholders' benefit 2017 • Usman kabir The certainty of the reliance on the use of financial ratio analysis in making investment decisions by potential investors still remained a mystery.

  12. PDF A Comparative Analysis of the Financial Ratios of Selected Banks ...

    This research is to analyze the financial statements of these banks using liquidity ratios, activity ratios, leverage ratios, profitability ratios, and market value ratios. For liquidity, the following ratios were used: current ratio, quick or acid-test ratio.

  13. Financial Statement Analysis: A Review and Current Issues

    Andrew B. Jackson UNSW Australia Business School, School of Accounting Date Written: October 28, 2021 Abstract The literature on financial statement analysis attempts to improve fundamental analysis and to identify market inefficiencies with respect to financial statement information.

  14. Financial Ratio Analysis: Definition, Types, Examples, and How to Use

    Ratio Analysis: A ratio analysis is a quantitative analysis of information contained in a company's financial statements. Ratio analysis is used to evaluate various aspects of a company's ...

  15. PDF Performance Evaluation through Ratio Analysis

    Financial ratios analysis is use to evaluate the performance of an organization: it aims at determine the strong and weak points and it offers solutions by providing appropriate plans based on the specific interest of the evaluator. Firstly, the claims of bondholders are long term.

  16. PDF A Study on Financial Performance Using Ratio Analysis of Bhel, Trichy

    Ratio analysis is one of the techniques of financial analysis where it is used as a yardstick for evaluating the financial conditions and performance of a firm. Ratio analysis is a powerful tool of financial analysis. It is used as a device to analyze and interpret the financial health of a firm.

  17. PDF Financial Analysis A Study

    5. Financial analysis helps the managers in taking certain decisions for improving the profitability or reducing the losses of the firm. 6. Helps in judging the solvency i.e. the capacity of the business to repay their loans. 7. Financial statement analysis is a significance tool in predicting the bankruptcy and failure of the

  18. Financial Ratio: Detailed Analysis For Hup Seng Industries

    By paying early, interest for late payment charged is avoided by Hup Seng. Beyond the financial analysis, maintaining overall debt position helped Hup Seng maintains its reputation with suppliers. Long Term Solvency and Stability Gearing Ratio Gearing ratio for Hup Seng in both years 2017 and 2018 are same at 49%.