FINANCIAL RATIOS: How to Analyze Financial Statements

Introduction

In this tutorial, you'll learn how to analyze financial statements using financial ratios. Understanding these ratios can help you assess a company's performance, financial health, and operational efficiency. This guide will break down the five main groups of financial ratios and provide detailed calculations for 25 popular ratios.

Step 1: Understand Financial Statements

• Familiarize yourself with the two primary financial statements:
  • Income Statement: Shows a company's revenues and expenses over a specific period, leading to net income.
  • Balance Sheet: Provides a snapshot of a company's assets, liabilities, and equity at a specific point in time.

Step 2: Learn About Financial Ratio Analysis

• Financial ratio analysis is a method used to evaluate the performance and financial health of a business by comparing various financial metrics.
• Ratios can help in:
  • Identifying trends over time
  • Comparing with industry benchmarks
  • Making informed investment decisions

Step 3: Explore Types of Financial Ratios

Financial ratios can be categorized into five main groups:

1. Profitability Ratios
2. Liquidity Ratios
3. Efficiency Ratios
4. Leverage Ratios
5. Price Ratios

Step 4: Calculate Profitability Ratios

Profitability ratios measure a company's ability to generate profit relative to its sales, assets, or equity. Here are key profitability ratios to calculate:

• Gross Profit Margin (GPM)

  • Formula: ( \text{GPM} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 )

• Operating Profit Margin (OPM)

  • Formula: ( \text{OPM} = \frac{\text{Operating Income}}{\text{Revenue}} \times 100 )

• Net Profit Margin (NPM)

  • Formula: ( \text{NPM} = \frac{\text{Net Income}}{\text{Revenue}} \times 100 )

• Return on Assets (ROA)

  • Formula: ( \text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} \times 100 )

• Return on Equity (ROE)

  • Formula: ( \text{ROE} = \frac{\text{Net Income}}{\text{Shareholder's Equity}} \times 100 )

• Return on Capital Employed (ROCE)

  • Formula: ( \text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 )

Step 5: Calculate Liquidity Ratios

Liquidity ratios assess a company's ability to meet its short-term obligations. Key liquidity ratios include:

• Cash Ratio

  • Formula: ( \text{Cash Ratio} = \frac{\text{Cash and Cash Equivalents}}{\text{Current Liabilities}} )

• Quick Ratio

  • Formula: ( \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} )

• Current Ratio

  • Formula: ( \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} )

Step 6: Calculate Efficiency Ratios

Efficiency ratios evaluate how effectively a company uses its assets and liabilities. Important efficiency ratios include:

• Inventory Turnover Ratio

  • Formula: ( \text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} )

• Receivables Turnover Ratio

  • Formula: ( \text{Receivables Turnover} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}} )

• Asset Turnover Ratio

  • Formula: ( \text{Asset Turnover} = \frac{\text{Revenue}}{\text{Total Assets}} )

• Payables Turnover Ratio

  • Formula: ( \text{Payables Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Accounts Payable}} )

• Cash Conversion Cycle

  • Formula: ( \text{Cash Conversion Cycle} = \text{Days Sales of Inventory} + \text{Days Sales Outstanding} - \text{Days Payable Outstanding} )

• Days Sales of Inventory

  • Formula: ( \text{Days Sales of Inventory} = \frac{365}{\text{Inventory Turnover}} )

• Days Sales Outstanding

  • Formula: ( \text{Days Sales Outstanding} = \frac{365}{\text{Receivables Turnover}} )

• Days Payable Outstanding

  • Formula: ( \text{Days Payable Outstanding} = \frac{365}{\text{Payables Turnover}} )

Step 7: Calculate Leverage Ratios

Leverage ratios measure the degree to which a company uses borrowed funds. Key leverage ratios include:

• Debt to Assets Ratio (DTA)

  • Formula: ( \text{DTA} = \frac{\text{Total Liabilities}}{\text{Total Assets}} )

• Debt to Equity Ratio (DTE)

  • Formula: ( \text{DTE} = \frac{\text{Total Liabilities}}{\text{Shareholder's Equity}} )

• Interest Coverage Ratio

  • Formula: ( \text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}} )

• Debt Service Coverage Ratio (DSCR)

  • Formula: ( \text{DSCR} = \frac{\text{Net Operating Income}}{\text{Total Debt Service}} )

Step 8: Calculate Price Ratios

Price ratios help evaluate a company’s stock price relative to its earnings or dividends. Important price ratios include:

• Earnings Per Share (EPS)

  • Formula: ( \text{EPS} = \frac{\text{Net Income} - \text{Dividends on Preferred Stock}}{\text{Average Outstanding Shares}} )

• Price-To-Earnings Ratio (P/E Ratio)

  • Formula: ( \text{P/E Ratio} = \frac{\text{Market Value per Share}}{\text{EPS}} )

• Price/Earnings-To-Growth Ratio (PEG Ratio)

  • Formula: ( \text{PEG Ratio} = \frac{\text{P/E Ratio}}{\text{Annual EPS Growth Rate}} )

• Dividends Per Share (DPS)

  • Formula: ( \text{DPS} = \frac{\text{Total Dividends}}{\text{Number of Outstanding Shares}} )

• Dividend Yield Ratio

  • Formula: ( \text{Dividend Yield} = \frac{\text{DPS}}{\text{Market Price per Share}} )

• Dividend Payout Ratio

  • Formula: ( \text{Dividend Payout} = \frac{\text{DPS}}{\text{EPS}} )

Conclusion

Understanding and calculating financial ratios is essential for analyzing a company's performance and making informed financial decisions. Start by familiarizing yourself with financial statements, then practice calculating the ratios in each category. For further exploration, consider diving deeper into each ratio through additional resources or tutorials.