How to Calculate Ratios in Finance

Ratios are culled from a firm's financial statements.

Ratio analysis is among the most pervasive tools in the investor's arsenal. Bankers, accountants, executives, investors and analysts all use financial ratios to gauge the financial success of a firm and compare it its peers. Those comparisons are made easier by a host of standard formulas that are the same for each industry. While those formulas are the same, ratio analysis is more art than science. It is important to have detailed information about a firm that allows the investor to interpret the results.

Things You'll Need

• Calculator

Instructions

1. Obtain a firm's financial statements. Public companies regularly disclose details of their financial performance. For investors and non-investors alike, these reports are available through the Securities and Exchange Commission's EDGAR database at SEC.gov. Obtain 3 to 5 years of annual statements, usually known as the 10-K, for the firm you are interested in.

2. Familiarize yourself with the reports. Scan the reports for relevant sections, including the income statement, the balance sheet and the cash flow statement. Identify key items in each section, such as revenue in the income statements, assets and liabilities on the balance sheet, etc. Look for big jumps in revenue or shareholders' equity.

3. Calculate liquidity ratios. Liquidity ratios help evaluate a firm's cash position. The current ratio is current assets divided by current liabilities. The quick ratio adds cash, plus marketable securities plus net receivables and divides that total by current liabilities. A ratio of more than one indicates that a firm has cash to pay off its immediate debts.

4. Calculate the debt ratio. Debt ratios help the investor evaluate how a firm is financed and the stake that its stockholders and lenders have in the firm. The you can calculate the debt-to-asset ratio by dividing total liabilities by total assets. Debt-to-equity (long-term debt divided by shareholders' equity) is often used by analysts to determine whether a firm will be able to generate new capital for growth.

5. Calculate profitability ratios. Profitability ratios depict the amount of money a firm makes, taking into account what it spent in the period. Operating profit margin ratio (operating income divided by sales) is a measure of profit. The net profit margin (net income divided by sales) is another measure.

6. Calculate efficiency ratios. Profitability isn't the only measure of how much money a firm makes. Investing $10,000 to make $1 million is probably a good deal. Investing $1 billion to make $1 million is decidedly a worse investment. This is where efficiency ratios come in. Return on assets (net income divided by total assets) evaluates the ability of a firm to generate cash with the assets it has. Return on equity (net income divided by shareholders equity) evaluates how much money a firm generates with its owners' investment.

Tips & Warnings

• There are numerous categories of ratios. Some that aren't detailed here but which may be important include the activity ratios, which typically evaluate how much economic activity a company is engaged in. Stock market ratios, such as earnings per share, evaluate whether a firm has met analysts expectations. You should calculate the above ratios for each year of financial statements that you have obtained. It also may help to compare those results to similar companies. Evaluate firms in the same industry. Ratio standards are usually similar within industries but can diverge wildly between industries.

References

• Philadelphia University; "Steps to a Basic Company Financial Analysis;" Harvey B. Lermack; May 2003
• University of Notre Dame; "Financial Ratio Analysis"; Barry Keating