How Ratio Analysis Helps in Studying Potential Stock Movement
Ratio analysis is used by investors and analysts to understand how well a company is doing, and that which eventually affects its stock.
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While stock market trading software has made trading popular, it is important to seek the advice of analysts and investors who study various aspects of stocks and the companies they represent. One of the most important aspects of studying the potential and attractiveness of stocks is analyzing the health of a company. Fundamental analysis is essential for that. It is the process of evaluating a security for assessing its intrinsic value through the examination of its related financial and economic factors along with other quantitative and qualitative factors. One of the most important ingredients of fundamental analysis is ratio analysis. So what’s ratio analysis? Quantitative Analysis of Financial Statements Investopedia explains that ratio analysis refers to the quantitative analysis of the information that is contained in the financial statements of a company. It helps in the evaluation of the various aspects of the financial and operating performance of a company including profitability, solvency, liquidity and efficiency through present as well as past financial statements. Analysts and investors normally refer to ratio analysis when they talk of quantitative or fundamental analysis. The data acquired from these statements is used for a few comparisons:
Comparing the performance of a company over a period of time, for assessing whether it improves or worsens
Comparing the financial standing of a company with its industry average
Comparing one company to another company or companies in that sector
All these factors help analyze the health of a company, its performance and its future prospects. Contents of Ratio Analysis Investopedia explains that ratio analysis basically analyzes 6 main ratios. Let’s look at these in detail: Liquidity ratio – This measures the ability of a company to get its short-term debts paid off with their quick or current assets. Liquidity ratio contains quick ratio and current ratio as well as working capital ratio. www.tradezero.co
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Solvency ratio – This is also known as financial leverage ratio. It compares the debt levels of a company with its equity, earnings and assets for evaluating its long-term sustenance by paying off its long-term debt and the interest on that debt. Interest coverage ratio, debt-assets ratio and debt-equity ratio are some of the solvency ratios involved. Profitability ratio – This ratio reveals how a company is able to generate profits from what it does. Some of the profitability ratios are return on equity, return on assets, return on employed capital, gross margin ratio and profit margin. Efficiency ratio – As the name suggests, efficiency ratio figures how effectively the company is using its liabilities for generating sales and revenue, and maximizing profits. Inventory turnover and asset turnover are some of the major efficiency ratios. Coverage ratio – This measures the ability of a company to make interest payments and other debt-associated obligations. Debt-service coverage ratio and interest earned ratio are two kinds of coverage ratio. Market prospect ratio – This analyzes factors such as P/E ratio, dividend yield, dividend payout ratio and earnings per share. These ratios are used very commonly in fundamental analysis and help determine what investors receive in earnings from the investments they’ve made in the company. These ratios also enable investors to predict the future trend of the company’s stock. With ratio analysis, investors have an advanced picture of the potential path in which the financial performance of a company could be heading – positive or negative. When companies release their quarterly financial reports, you have analysts researching all this financial data. Companies that are running profitably normally enjoy strong ratios in all the areas we discussed above. A sell-off could be triggered by a weakness in just one ratio.
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