Financial ratio analysis

Introduction

This tutorial provides a comprehensive guide to financial ratio analysis, a crucial tool for understanding a company's financial health. By analyzing key financial ratios derived from the income statement and balance sheet, you can gain insights into profitability, liquidity, and overall performance. This analysis combines both data interpretation (the science) and contextual evaluation (the art), enabling better decision-making for investments or business strategies.

Step 1: Gather Necessary Financial Statements

To begin your financial ratio analysis, you will need two primary documents:

• Income Statement: This shows how much profit a company made during a specific period.
• Balance Sheet: This provides an overview of what a company owns (assets) and owes (liabilities) at a specific point in time.

Practical Tips

• Ensure the financial statements are up-to-date and reflect the same reporting period for accurate analysis.

Step 2: Analyze Income Statement Ratios

Focus on the following key financial ratios derived from the income statement:

1. Gross Profit Percentage

   • Formula: (Gross Profit / Revenue) * 100
   • Indicates the percentage of revenue that exceeds the cost of goods sold.

2. Operating Margin Percentage

   • Formula: (Operating Income / Revenue) * 100
   • Reflects the percentage of revenue left after covering operating expenses.

3. Return on Sales Percentage

   • Formula: (Net Income / Revenue) * 100
   • Measures how much profit a company makes for every dollar of sales.

Common Pitfalls

• Avoid comparing these ratios across companies in different industries; they may have different cost structures.

Step 3: Analyze Balance Sheet Ratios

Next, examine the following financial ratios from the balance sheet:

1. Current Ratio

   • Formula: Current Assets / Current Liabilities
   • Assesses a company's ability to pay short-term obligations.

2. Working Capital

   • Formula: Current Assets - Current Liabilities
   • Indicates the liquidity available to a business for its operational needs.

3. Debt-to-Equity Ratio

   • Formula: Total Liabilities / Total Equity
   • Evaluates a company's financial leverage and risk.

Practical Advice

• A current ratio above 1 indicates good short-term financial health, while a ratio below 1 suggests potential liquidity issues.

Step 4: Combine Income Statement and Balance Sheet Ratios

For a more comprehensive analysis, consider these ratios that link both financial statements:

1. Return on Equity (ROE)

   • Formula: Net Income / Shareholder's Equity
   • Measures the profitability relative to shareholders' equity.

2. Asset Turnover Ratio

   • Formula: Revenue / Average Total Assets
   • Indicates how efficiently a company uses its assets to generate sales.

3. Receivables Turnover Ratio

   • Formula: Net Credit Sales / Average Accounts Receivable
   • Assesses a company's effectiveness in collecting receivables.

4. Days Sales Outstanding (DSO)

   • Formula: (Accounts Receivable / Total Credit Sales) * 365
   • Indicates the average number of days it takes to collect payment after a sale.

5. Inventory Turnover Ratio

   • Formula: Cost of Goods Sold / Average Inventory
   • Reflects how often inventory is sold and replaced over a period.

Key Considerations

• Always analyze these ratios in the context of industry norms and historical performance for better insights.

Conclusion

Financial ratio analysis provides valuable insights into a company's performance and financial health. By systematically analyzing both the income statement and balance sheet, you can make informed decisions related to investing or managing a business. Start by gathering the necessary financial statements, calculate the relevant ratios, and interpret the results within the context of industry standards. For further learning, consider exploring more complex ratios and their applications in financial forecasting or strategic planning.