Analysing a financial statement of a company by calculating the most important financial ratios is a critical part of researching a stock as a potential investment. A thorough analysis of the financial ratios will allow you to get a good understanding of the financial situation of a company, and a comparison of it's numbers to those of peers in the same industry will give you some real insight into where the business stands.
Many different financial ratios have been developed over the years for specific accounting or research purposes, but this article will focus on the three financial ratios that are most commonly used in investment research - liquidity ratios, financial leverage ratios, and profitability ratios.
- Skill level:
- Moderately Easy
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Things you need
- Company financial statement
- Calculator (or pencil and paper)
Calculating liquidity ratios is relatively straightforward. The most commonly used liquidity ratio is the current ratio, which is ratio of current assets to current liabilities. The current ratio is also called the working capital ratio.
Current Ratio = current assets/current liabilities
Most short-term creditors would prefer a company to keep a high current ratio since that would reduce their risk. On the other hand, shareholders would prefer a lower current ratio so that more of the firm's assets are being used to grow the business. The usual values for current ratios vary by firm and industry. For example, companies in cyclical industries may seek to keep a higher current ratio in order to have plenty of operating capital during downturns.
Calculating financial leverage ratios is also a simple process, but there are two commonly used debt ratios to compute.
Debt Ratio = total debt/total assets
Debt-to-Equity Ratio = total debt/total equity
Financial leverage ratios are used to provide an understanding of the long-term solvency of the firm. Different from liquidity ratios, which are concerned with short-term assets and liabilities, financial leverage ratios illustrate how much the firm is using long-term debt.
Calculating profitability ratios is just a little more complex. The two most commonly used profitability ratios are the gross profit margin and the return on equity.
Gross profit margin is the gross profit earned on sales. The gross profit margin does take into account the company's cost of goods, but does not include other costs.
Gross Profit Margin = sales - cost of sales/sales
Return on equity is usually considered the bottom line for shareholders, measuring the profits earned for each dollar invested in the company's stock.
Return on Equity = net income/total shareholder equity
Calculating financial ratios
Tips and warnings
- All the major online brokerage companies have these basic financial ratios and many others pre-calculated for you when you are using the Research areas of their websites.
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