How to analyze accounting ratios

Written by rose johnson
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How to analyze accounting ratios
The formulas for calculating accounting ratios are basic arithmetic. (Comstock/Comstock/Getty Images)

It is important for businesses to stay informed about how they're performing financially. Accounting ratios, commonly called financial ratios, are analysed by businesses to compare a company's current financial performance to historical and industry performance. The data used to calculate ratios is pulled from a company's balance sheet and income statement. Ratios are used by businesses, investment bankers, lenders and individual investors. Ratio analysis helps a firm plan and forecast for the future and helps in making financial investment decisions.

Skill level:

Things you need

  • Income statement
  • Balance sheet

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  1. 1

    Gather a company's income statement and balance sheet. Look for financial statements of public companies online. The U.S. Securities & Exchange Commission and financial websites, such as Yahoo and MSN, allow you to search for a company's financial statement by name or ticker symbol.

  2. 2

    Examine the financial statements to look for unusually large movements. Look to see if revenue increased or decreased substantially from one year to the next. Review the balance sheet to see if assets, liabilities or shareholders' equity had significant changes. If any changes are unexplained, you will need to perform further research to investigate the changes.

  3. 3

    Calculate accounting ratios. Extract the necessary data from the financial statements to compute liquidity, leverage, profitability, efficiency and activity ratios. Write down the company's ratios from past years to determine if they're increasing or decreasing over time.

  4. 4

    Analyse liquidity ratios. The liquidity ratios include the current and quick ratios. The higher current and quick ratios are, the greater ability the company has to turn its assets into cash. Companies with liquidity ratios greater than 1 do not have liquidity problems.

  5. 5

    Consider the calculated leverage ratios. View the ratios to determine if a company is able to pay back money it borrowed to finance its operations. Leverage ratios are important to investors because they show the likelihood of a company having to file bankruptcy because it's unable to pay its debt.

  6. 6

    Look at the profitability ratios. Investors use these ratios to determine if a company's profits will rise or fall in the future. Profitability ratios are used to determine a company's market size.

  7. 7

    Examine the efficiency ratios. These ratios show how fast a company is able to sell its inventory. If inventory is sitting for long periods of time, then a company's profitability is negatively affected.

  8. 8

    Review activity ratios. A company that uses its assets to generate revenue has favourable activity ratios.

  9. 9

    Compare ratios to the company's competitors and to industry standards. Determine if profitability and the ability to pay debt are comparable with competitors and the industry. Consider investing in a company that has better ratios than its competitors and the industry.

Tips and warnings

  • Some financial websites have already calculated accounting ratios for public companies.
  • Don't depend solely on accounting ratios to make financial decisions. Investors should also research other relevant information about a company.

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