Introduction to Ratios
What is the Purpose of Ratio Analysis?
Ratio Analysis is a tool used to compare different companies across different performance areas (liquidity, profitability, efficiency, market).
They allow users to compare like to like, the same performance measures to understand which company may meet the end user's needs.
Why Should I Care About Ratios?
Ratios allow for easy comparison to understand the risk, profitability and market performance for each to determine which best meets your investor appetite. There are two simple reasons why you would compare Imagine, you are considering investing in Woolworths, which had a share price of $40 in December 2020. How would you know this is a good deal?
Comparing Against Other Companies: Ratios allows you to compare one number with another number. It's a quick and dirty comparison tool against another Company. For example, Woolworths has a current ratio of 0.62, while Coles has a current ratio of 0.67. As for liquidity, the higher the number, the better, technically Coles is less risky and more favourable.
Comparing Against the Industry and Market Average: What about how it compares to the industry and market? The market average, is the average of all companies on the ASX, while the industry average is the average of the specific group where the Company belongs. For Woolworths, the Company belongs under Food & Staples Retailing. For example, Woolworths has a current ratio of 0.62 while the industry average is 0.69. This suggests that Woolworths is slightly more risky than the average Company in the Food & Staples Retailing category.
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What are the Types of Ratios?
In this Unit we explore four different types of ratios:
Liquidity: Measure the level of risk, often through measuring the amount of short-term and overall debt in a business relative to its asset base. In other words, how likely the business will go bust!
Profitability: Measure the level of profitability or in other words, how much money the business is making.
Efficiency: Measure the effectiveness of a business to use its resources. In other words, how good is it at using its assets or capital to make money?
Market: Measures the performance of the Company in terms of return and value on the share market. The ratios we will look at are determined by the syllabus. These are the common ratios with many more ratios in the financial world under these categories.