How Traders Use Financial Ratios for Market Analysis

For traders, financial ratios are one of the essential tools used in market analysis. They are used to understand a company's financial situation, performance, and potential risks and guide traders for their next step.

You can evaluate the financial health of companies and also identify market trends, price movements, and potential investment opportunities by correctly analyzing financial ratios.

In our article, we will discuss how financial ratios can be used in trading.

What is Ratio Analysis?

Ratio analysis is a method used to evaluate a company's financial condition, performance, and efficiency. This analytical method is carried out through calculations and comparisons made on financial statements.

The analysis includes financial ratios categorized into main groups such as liquidity, profitability, efficiency, and leverage. These categories allow the measurement of a company's short-term debt-paying ability, profit margins, asset utilization efficiency, and financial leverage level.

Ratio analysis not only assesses the performance of a single company but also allows for comparisons with other companies in the industry. This helps investors to understand whether a company is performing above or below industry averages.

How Ratio Analysis Works?

Traders evaluate the financial status of assets traded in markets by examining past and current financial data through ratio analysis. For example, by comparing the price ratios between currency pairs, they can determine the price-to-earnings (P/E) ratio, a valuable metric for assessing the value of a specific currency pair. 

Financial ratios can be used for the following purposes:

• Evaluating the performance of an asset over time
• Predicting future performance
• Comparing the financial condition of an asset with industry averages
• Measuring how an asset stands against others within the same sector 

Ratios serve as comparison points for assets and are generally not used in isolation. Instead, they are compared either to past ratios for the same asset or to the same ratios from other assets. 

For instance, in the commodity market, the average price-to-earnings ratios of assets like gold and oil can be analyzed. If the P/E ratio of a commodity is below or above the other assets in the sector, that commodity is likely undervalued or overvalued. The former may trend upwards in the future, while the latter may trend downwards until each aligns with its intrinsic value.

Types of Financial Ratios

Financial ratios are categorized to evaluate a company's financial condition and performance. They provide comprehensive information by comparing different financial metrics.

The main types of financial ratios can be listed as follows:

Liquidity Ratios

These measure a company's ability to pay off its short-term liabilities. The most common liquidity ratios are:

• Current Ratio: The ratio of current assets to current liabilities.
• Quick Ratio (Acid-Test Ratio): Calculated by excluding inventories from current assets and measuring the ability to pay short-term liabilities more precisely.

Profitability Ratios

Used to assess a company's profitability and earning potential, profitability ratios show how efficiently a company generates profit. The most common profitability ratios are:

• Gross Profit Margin: The ratio of gross profit (sales revenue minus the cost of goods sold) to total sales.
• Net Profit Margin: The ratio of net profit to total sales.

Debt Ratios

Debt ratios show the extent to which a company's financial structure is financed by debt. These ratios are used to evaluate the company's capacity to repay its debts and its financial risks. The most common debt ratios are:

• Debt-to-Equity Ratio: The ratio of total debt to equity.
• Interest Coverage Ratio: Measures the ability to cover interest expenses with earnings before interest and taxes (EBIT).

Efficiency Ratios

Used to evaluate the efficiency of business operations and the management of resources, efficiency ratios show how efficiently a company uses its assets and resources.  The most common efficiency ratios are:

• Asset Turnover Ratio: The ratio of total sales to total assets.
• Inventory Turnover Ratio: The ratio of inventories to the cost of goods sold, indicating how quickly inventory is sold.

Market Expectation Ratios

Market expectation ratios are among the most commonly used ratios in fundamental analysis. They help understand how the market evaluates a company's future profitability expectations. These ratios include:

• Price/Earnings (P/E) Ratio: The ratio of a security's price to its earnings per share. It shows how much investors value the future profitability of the asset.
• Earnings Per Share (EPS): Calculated by dividing the net profit of a commodity or CFD by the total number of shares.

Key Financial Ratios for Trading and How to Use

Here are some key financial ratios to consider when trading and their uses:

Current Ratio: Measures the capacity to pay short-term liabilities. It is calculated as the ratio of current assets to current liabilities. A high current ratio indicates that a company has high liquidity and can easily meet its short-term obligations.

Gross Profit Margin: The ratio of gross profit to total sales. This ratio shows the company's ability to control costs and how much profit it earns from sales. A high gross profit margin indicates that the company manages its costs well and has a profitable business model.

Debt-to-Equity Ratio: The ratio of total debt to equity. This ratio shows how much of the company is financed through debt. A high debt-to-equity ratio indicates that the company has a high debt load and higher financial risks.

Net Profit Margin: The ratio of net profit to total sales. It shows how much profit a company makes after covering all expenses. A high net profit margin indicates that the company operates efficiently and has high profitability.

Asset Turnover Ratio: The ratio of sales to total assets. It measures how efficiently a company uses its assets to generate sales. A high asset turnover ratio indicates that the company manages its assets well and is effective in increasing sales.

You can see the different financial ratios and their differences more clearly in the table below:

Advantages of Financial Ratios

• Helps evaluate the financial health and performance of companies quickly and effectively,
• Enables analysis of key financial health indicators such as liquidity, profitability, efficiency, and leverage,
• Tracks company performance over time and compare it to industry averages,
• Assists in identifying the strengths and weaknesses of companies, helping investors manage risks better,
• Helps company managers in making strategic decisions.

Limitations of Financial Ratios

• Because they are calculated using historical data, financial ratios may be limited in predicting future performance,
• When comparing companies, different accounting methods and policies can affect the consistency of the ratios,
• They may be inadequate in evaluating qualitative factors of companies, such as management quality or competitive advantage,
• They can be sensitive to short-term market fluctuations, which may mislead traders,
• Financial ratios may not be suitable for direct comparison across different industries,
• Seasonal effects or one-time events can cause changes in the ratios.

FAQ on Financial Ratios

What purposes are financial ratios used for?

Financial ratios are used to assess the financial health, performance, and efficiency of companies. They are also valuable for analyzing companies' liquidity, profitability, and debt levels, predicting future performance, and comparing them with other companies in the sector.

Which financial ratios are used to measure profitability?

The financial ratios used to measure profitability include the gross profit margin, net profit margin, and return on equity (ROE).

What is the current ratio, and how is it interpreted?

The current ratio indicates a company's ability to pay its short-term liabilities. It is calculated as the ratio of current assets to short-term liabilities. A high current ratio suggests that the company has high liquidity and can easily pay its short-term debts.

From which financial statements are financial ratios obtained?

Financial ratios are obtained from financial statements such as the balance sheet, income statement, and cash flow statement. These statements provide information about a company's assets, liabilities, revenues, and expenses.

How are financial ratios compared?

Financial ratios are analyzed by comparing them with the same company's past ratios or with ratios of other companies in the same sector.

How is the market value to book value ratio interpreted?

Market value refers to the company's market capitalization, while book value refers to the company's value on its accounting records. This ratio shows how the company's shares are valued by the market and whether they are overvalued.

How is the Price/Earnings (P/E) ratio calculated and interpreted?

The Price/Earnings (P/E) ratio is calculated as the ratio of a company's stock price to its earnings per share. The P/E ratio indicates how much investors are willing to pay for the company's future earnings.