What is proportion analysis?
Proportion analysis, known as ratio analysis, consists of a quantitative approach that allows you to evaluate aspects such as liquidity, operational efficiency and profitability of a company through the study of its financial statements, including the balance sheet and the income statement. This method forms the basis of fundamental asset analysis.
What does ratio analysis reveal?
By employing ratio analysis, investors and analysts gain a clear perspective on the financial health of an organization through detailed analysis of its historical and current financial statements. Comparing this data over time allows you to predict future performance and position the company in relation to sector averages, as well as its competitors. Indexes facilitate comparisons between companies, evaluating current performance in relation to historical data. It is essential to understand the variables that influence these indices, as management decisions can change strategies to make the indices more attractive. Ratios are not usually analyzed in isolation, but rather in conjunction with others, which provides a broad view of the company from different perspectives and helps identify potential warning signs.
Types of Ratio Analysis
Financial ratios fall into six main categories based on the information they provide:
Liquidity Indices
These indices assess the company's ability to pay its short-term obligations when due, using current or immediate assets. Examples include the current ratio, the dry ratio, and the working capital ratio.
Solvency Ratios
Also known as financial leverage ratios, these measure the level of debt in relation to the company's assets, equity and profits, helping to assess its ability to cover long-term debts and the respective interest. They include ratios such as debt-equity, debt-assets and interest coverage.
Profitability Indices
They indicate a company's ability to generate profits from its operations. They include profit margin, return on assets, return on equity and return on capital employed.
Efficiency Ratios
These ratios analyze how the company uses its assets and liabilities to generate sales and maximize profits, including turnover rates, inventory turnover and days sales in inventory.
Coverage Indices
They measure the company's ability to satisfy financial obligations such as interest payments and other debts. Examples are the interest coverage ratio and the debt service ratio.
Market Outlook Indices
Commonly used in fundamental analysis, these ratios predict future earnings and performance, including dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. A P/E ratio significantly below or above the industry average may indicate undervaluation or overvaluation, respectively.
Application of Proportion Analysis
The essence of ratio analysis lies in comparing several numbers to obtain a specific calculated value. In isolation, this value may seem insignificant. However, for effective evaluation, ratio analysis generally requires a comparative parameter to determine the strength or weakness of a company's financial condition, as well as trends of improvement or deterioration.
Proportion Analysis Over Time
Companies use index analysis over time to understand the evolution of their operations. More than focusing on the current state, the interest is focused on past performance, the changes that had an effect and future challenges. This analysis is crucial for making long-term strategic decisions. A common practice is to select a specific financial ratio and calculate that ratio periodically (e.g., monthly). It is important to take into account seasonality and how temporary variations in account balances can influence the results of calculations. Subsequent analysis focuses on how this index changes over time, the rate of change, and whether the desired change is being achieved.
Business Ratio Analysis
Consider a company with a gross profit margin of 10%. Initially, this may seem positive, until a comparison reveals that competitors have margins of 25%. Ratio analysis is essential for evaluating how a company's performance compares to that of others in the same sector. For proper comparative analysis, it is essential to only consider similar companies in the same industry and understand how different capital structures and company sizes can affect efficiency. Additionally, it is necessary to consider the impact of different product lines on the results of the indices.
Proportion Analysis in Relation to Benchmarks
Companies often establish internal goals for their financial ratios, which may be to maintain stability or aim for operational growth. For example, if a company's current ratio is 1,1 and the goal is to increase liquidity, it could set a goal of reaching 1,2 by the end of the fiscal year.
Benchmarks are also used by external entities, such as lenders, who can establish standards of financial health under the terms of loan agreements. These agreements are an integral part of the loan conditions, and companies need to maintain certain rates to avoid canceling the financing. Failure to meet these benchmarks may result in the loan becoming payable or the interest rate adjusting to reflect the increased risk. A typical example of a benchmark imposed by creditors is the debt service coverage ratio, which evaluates the company's cash flow in relation to its debt commitments.
Proportion Analysis Example
Ratio analysis serves as a potential indicator of a company's future performance, whether positive or negative. Companies that consistently demonstrate robust ratios tend to be successful, while sudden weakness in any ratio can precipitate a sharp share sell-off.
Net profit margin, often simplified as profit margin or net income, is an index used by investors to evaluate the profitability of companies within the same industry. It is calculated by dividing the net profit of a company's revenues. This ratio allows investors to compare profitability without the need for detailed analysis of financial statements. For example, if company ABC and company DEF, both in the same industry, have profit margins of 50% and 10%, respectively, an investor can quickly conclude that ABC converts 50% of its revenues into profit, while DEF just 10%.
Considering the previous example, if company ABC has a price/earnings ratio (P/E) of 100, and a DEF of 10, this suggests that investors are willing to pay 100 reais for each dollar of profit generated by ABC, and just 10 reais for every real of DEF profit.
Conclusion
Ratio analysis is an essential tool in financial management and assessing a company's economic health. It not only highlights operational efficiency and profitability, but also provides comparative insights that are crucial for strategic decision making. By comparing financial ratios over time, with other companies and against established benchmarks, managers and investors can gain a detailed understanding of market trends, competitive positioning and value creation capabilities.
The applicability of ratio analysis goes beyond mere numerical comparison, directly influencing business strategies and corporate operations. By monitoring and interpreting these indices, companies not only respond better to market dynamics, but also anticipate changes and position themselves to take advantage of growth opportunities and mitigate potential risks.
FAQ
What are the types of ratio analysis?
Financial ratios are generally categorized into six types: profitability, solvency, liquidity, turnover, coverage and market outlook. Non-financial metrics can be used across industries and departments, such as a click conversion rate in the marketing department to analyze effectiveness in attracting customers.
What are the uses of ratio analysis?
There are three main applications for ratio analysis. Firstly, you can monitor a company's changes over time to better understand its operational evolution. Secondly, it is useful for comparing performance with similar companies, evaluating how the company is positioned against its competitors. Finally, it serves to verify compliance with benchmarks defined internally or externally.
Why is ratio analysis important?
Ratio analysis is crucial because it offers a more accurate view of a company's operations. Considering a company with revenue of 1 billion dollars in the last quarter, this may seem promising, but the operational reality may be less optimistic if the company presents a negative gross profit margin, a worsening in liquidity ratios and lower profits in relation to the equity than in previous periods. Therefore, isolated numbers alone may not provide a complete assessment of performance.
What is an example of ratio analysis?
An example is the inventory turnover ratio, which indicates the speed with which a company transforms its inventory into sales. A company can monitor this ratio over the course of a year to observe how efficiently it turns inventory into revenue each month, investigating reasons for variations in performance in certain months.
