Pros and Cons of Assessing Investments using Ratio Analysis

Whether evaluating future investment possibilities or reviewing existing investments one tool that is often used is ratio analysis. The question is: how efficient is ratio analysis, otherwise known as trend analysis, when it comes to assessing investments.

Some of the ratios used are: leverage ratios, liquidity ratios, profitability ratios and efficiency, market value, asset turnover, and dividend ratios. The companies themselves provide the bulk of the information required to calculate the ratios used for the analysis in their annual reports.

There are many parts to an annual report; it is part sales brochure to attract investors and part report card. The financial statements from the report are where the information needed for ratio analysis can be found.  Data from the balance sheet can be used for ratios showing liquidity/ solvency and leverage while the income statement will provide the information to formulate profitability ratios. 

The insight into a company’s financial health that these ratios provide can be extremely helpful but one must be cautious to look at the full picture. It is vital to remember that ratio analysis is meant to be used to compare a company’s financial situation over time. It is just as important to know how a company came to be in their present financial situation as it is to know the currently situation.

If, for instance, a company is highly leveraged to the point of making it seem a risky venture the wise investor used information from previous years to determine if this an ongoing situation for the company. If the debt is new why was it taken on? Is it the result of past poor business decisions or of a new potentially profitable endeavor?

A minimum of four years worth of ratios need to be analyzed to receive a clear picture of a company’s financial trend. Even when the good and bad aspects of how a company has preformed over time have been uncovered the investor’s job isn’t finished.  This information needs to be viewed in light of the economy in general and other companies of similar size and type or in other words the competition.

It is romantic to think of investing as an easy effortless way of making money; however, there is much work involved if it is to be done correctly. It is important to remember that when you invest you are gambling and if you take half measures and only use current information and don’t look for trends you are giving the “house” the better odds.