What is Ratio Analysis?
Ratio analysis is the exercise of calculating various pieces of financial data in relation to one another.
How Does Ratio Analysis Work?
There are dozens of financial ratios out there. In fact, there are too many to list here in this definition. Some examples of ratios used in financial ratio analysis include the price-to-sales ratio:
Price-to-Sales Ratio = Market Capitalization/Annual Sales
Price-to-Sales Ratio = Share Price/Revenue per Share
One of the most famous ratios in finance is the P/E ratio, which is price per share/earnings per share.
The formula for the PEGY ratio is:
PEGY = P/E Ratio/(Earnings Growth Rate + Dividend Yield)
Why Does Ratio Analysis Matter?
Active investment strategies generally dismiss long-term trends and focus on short-term profits, whereas passive investors maintain that long-term price movements are important and often predictable. This is why active investors often use quantitative and technical analyses, including ratio analysis, stock chart analysis, and other mathematical measures to determine whether to buy or sell.
Regardless of the investment method, however, ratio analysis is crucial to understanding an investment. After all, it is through ratio analysis that we detect whether a company is encountering difficulties paying the bills, taking too long to collect money from customers, unable to pay its debts, whether its stock is overpriced, and a wide variety of other insights. The mathematics typically only involve simple division, but the insights they yield can be invaluable.