How to Use Ratio Analysis to Compare Companies

Ratio analysis is a highly valuable tool investors can use to compare the financial performance of companies. It can provide insight into their relative financial health and future prospects and yield data about profitability, liquidity, earnings, and extended viability. The results of such comparisons can mean more powerful decision-making when it comes to selecting companies in which to invest.

A single ratio from just one company can't give investors a reliable idea of a company's current performance or potential for future financial success. Using a variety of ratios to analyze financial information from various companies that interest you can help you make smart investment decisions.

What Is Ratio Analysis?

Ratio analysis is the analysis of financial information that's found in a company's financial statements. It can shed light on financial aspects that include risk, the reward of profitability, solvency, and how well a company operates. Investors can use ratio analysis to simplify the process of comparing the financial information of multiple companies.

There are five basic types of financial ratios:

• Profitability ratios: net profit margin and return on shareholders' equity
• Liquidity ratios: working capital
• Debt or leverage ratios: debt-to-equity and debt-to-asset ratios
• Operations ratios: inventory turnover
• Market ratios: earnings per share (EPS)

Some key ratios used by investors are the net profit margin and price-to-earnings (P/E) ratios.

Net Profit Margin

Net profit margin is often referred to as simply profit margin or the bottom line. It's a ratio that investors use to compare the profitability of companies within the same sector. Net profit margin measures the amount of net profit or gross profit earned from sales minus expenses. It's calculated by dividing a company's net income by its revenues.

An investor can use this ratio Instead of dissecting financial statements to compare how profitable companies are. Suppose Company ABC and Company DEF are in the same sector. They have 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 but DEF converted only 10%.

Price-to-Earnings Ratio (P/E)

The price-to-earnings ratio is another that investors often use. This is a valuation ratio that compares a company's current share price to its earnings per share. It measures how buyers and sellers price the stock per $1 of earnings.

The P/E ratio gives an investor an easy way to compare one company's earnings with those of other companies. Suppose ABC has a P/E ratio of 100. DEF has a P/E ratio of 10. An investor can conclude that investors are willing to pay $100 per $1 of earnings that ABC generates and only $10 per $1 of earnings that DEF generates.

Other Factors to Consider

It's important to take a variety of financial data and other factors into account when researching a possible investment.

Return on Assets Ratio

The return on assets ratio can help you determine how effectively a company is using its assets to generate profit. The higher the ratio, the more profit each dollar in assets produces. It's calculated by dividing net income by total assets.

Operating Margin Ratio

The operating margin ratio uses operating income and revenue to determine the profit a company is gaining from its operations. Along with net profit margin, this ratio can give investors a good feel for the profitability of a company as a whole. The operating margin ratio is calculated by dividing net operating income by total revenue.

Return on Equity Ratio

The return on equity ratio is another way to gauge profitability. It measures how well a company generates profit using shareholder equity or the money that's been invested in it. It's calculated by dividing net profit by total equity.

Inventory Ratios

Inventory ratios can show how well companies manage their inventories. Turnover and days of inventory on hand are often used. Bear in mind that the inventory method that a company employs can affect the financial data that underlie ratios. Be sure that they use comparable methods when you're comparing companies.

The Bottom Line

Take note of ratio analysis results over time to spot trends in company performance and to predict potential future financial health. Compare companies that aren't just in the same industry but have similar product types, years in operation, and locations as well. These factors can all affect financial results.

Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.