Financial Ratio Analysis

The basis for fundamental analysis

At the heart of fundamental analysis are the financial ratios which allow the stock investor to evaluate a company’s financial performance based on data taken from the financial statements.

The basic financial ratios such as the earnings per share growth rate, price earnings ratio, price earnings growth rate and the dividend yield provide the beginner investor with an introduction to basic idea behind financial ratio analysis. These ratios form the basis for analyzing a company’s earnings and are based on the company’s income statement.

There are some additional ratios that deal with the company’s revenue and earnings which provide a more complete analysis of a company’s ability to generate a profit. These additional earnings ratios are broadly grouped into Revenue based ratios and Earnings based ratios.

For the stock investor to fully benefit from fundamental analysis they need to perform a more through analysis which deals with the company’s balance sheet and these ratios can be broadly group into Asset based ratios.

While analyzing the revenue and earnings of a company provides valuable information regarding its profitability, information taken from the balance sheet provides valuable information on a company’s ability to maintain its profitability.

The main purpose of using fundamental ratios is that they allow the stock investor to quickly determine the current financial status of a company. This allows the stock investor to determine whether a proposed investment is an investment in a company which is fundamentally sound or not and whether it’s a bankruptcy risk.

The analysis reports in the Analysis Techniques section gives investors practical experience using fundamental analysis on actual companies with instructional guidance.

Generally the information contained in the financial statements is readily available in a summarized form and the fundamental ratios are often already calculated. To truly benefit from the use of fundamental ratios it is beneficial to understand how these financial ratios are calculated.

The information is available in a summarized form

with the fundamental ratios already calculated

Some stock investors feel that analyzing a company’s financial position using fundamental ratios is something best left to accountants. While it is true that accountants produce the financial statements, websites such as Yahoo Finance extract the information provided in these financial statements and provide them in a summarized format along with the fundamental ratios already calculated. This summarized information is explicitly intended for stock investors so that they can make an informed investment decision regarding that company.

Accountants are only interested in producing the financial statements; they are not interested in using the information for investment decision making purposes.

The stock investor can perform a more thorough financial analysis by incorporating financial ratios from prior years. This puts the current year’s financial ratios into perspective and highlights any financial trends in the ratios which might be developing.

Stock investors like to avoid companies where the bankruptcy risk is high and the Z-score is a popular indicator based on ratios which gives the likelihood of a company going into bankruptcy with two years.

Once the stock investor has analyzed the trends in the financial ratios, the company can then be compared to its competitors within the same industry. This is achieved by conducting an industry based ratio analysis which puts the company’s financial position into perspective.