How to Judge Financial Strength From Financial Statements

Before you become an investor in a company, you have to evaluate the financial strength of that company. Investors often turn to the information in financial statements to determine the financial strength of companies. When looking at the financial statements of companies, using financial ratios can be an effective way to evaluate the information they present. When you need to gauge the strength of a company, some commonly used financial ratios can give you the help you need to make a decision.

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Instructions

- 1
  
  Look at the earnings per share of the company. To calculate the earnings per share, you simply take the total amount of earnings on the income statement and divide that number by the outstanding shares in the market place. Most income statements also have this calculation already done for you. By looking at the earnings per share, you see how much money is being generated by the company for each share that is bought.
- 2
  
  Use the current ratio to determine the ability of the company to meet short-term obligations. The current ratio is calculated by looking on the balance sheet and dividing the current assets by the current liabilities. This tells you whether the company has enough liquid assets on hand to handle its short-term debt.
- 3
  
  Calculate the inventory turnover ratio to determine how quickly the company cycles through available inventory. To calculate this ratio, take the cost of goods sold and divide it by the average inventory. Once you calculate this, it tells you how quickly the company moves its inventory. If inventory sits around in the warehouse for an extended period of time, this does not reflect positively on the company.
- 4
  
  Evaluate how profitable the company is with the gross profit margin. To calculate the gross profit margin, you take the sales and subtract the cost of goods sold. Then take that number and divide it by the sales. This tells you how much profit margin is being generated on the average sale.

Tips & Warnings

Use the most up-to-date financial statements for the company that you are evaluating. This is typically available on the company website.
Do not put too much weight into financial ratios. You also have to look at factors that are not on the balance sheet, such as what the company is working toward.