To research possible investments, you read financial reports, prospectuses, and all manner of number- and jargon-filled analyses. Investors use different ratios to boil that information down into usable chunks to make sound investment decisions.
Before going too far with this discussion, it's important to understand the benefits and limitations of ratios. Ratios are great tools and bring understanding to key parts of the financial statements. But realize that they are just tools, not a substitute for practical judgment. Ratios won't automate your stock-picking decisions — they are a step along the way, not an "end-all" analysis tool.
With that caution in mind, examine the types of ratios, and, in a big-picture sense, how they're used in practice. Ratios can be classified into one of four categories largely defined by what you're testing for:
Asset productivity ratios: Assets are resources used in a business to produce a profit, or return. This group of ratios describes how effectively those assets are deployed or utilized. Some analysts call these efficiency or asset management ratios. How much inventory, accounts receivable, or fixed asset investment does it take to support a given volume of business? Are these assets being managed effectively with proper controls?
Financial strength ratios: Company resources are provided either by company owners (shareholders) or by creditors (debt holders or holders of other obligations). These ratios measure to what extent company resources are provided by sources other than the owners. Sometimes called liquidity or debt management ratios, these ratios are also used to assess the company's ability to pay its creditors and how vulnerable it may be to debt problems and high interest costs. They also describe financial or capital structure — that is, how financially leveraged a company may be.
Profitability ratios: How profitable is the company? Sure, there may be a lot of business activity. But how much profit is produced? Per dollar sold? Per dollar invested? Some analysts refer to these ratios as management effectiveness ratios because they indicate management's overall success in generating returns for the enterprise.
Valuation ratios: The first three ratio families examine internal business fundamentals. With valuation, the stock price enters the picture. Valuation ratios, as the name implies, relate a company's stock price to its performance. The ubiquitous price to earnings (P/E) ratio shows up here, as do its siblings price to sales (P/S), price to book (P/B), and a few others.
Adapted From: Value Investing For Dummies, 2nd Edition
