How to Understand Key Financial Ratios

Financial Statements

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The best way to see if a company is in good shape is by looking at its ratios. A healthy company will meet a certain standard when it comes to the ratio between different financial aspects such as sales, debt, or profits.

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Instructions

Difficulty: Moderate

Step1

Look at the current ratio first. This is the amount of assets the company has measured against the amount of liability. A healthy current ration is 2 to 1, or having twice as many assets as liabilities. This is a good measure of a company's short term liquidity.

Step2

Consider the inventory ratio next. This is the cost of goods sold in a year divided by the average value of the inventory during the year. You want to see a fairly high ratio to indicate that the company has good liquidity.

Step3

Recalculate by dividing the inventory by the net working capital. This tells you what ratio of the company’s funds are tied up in inventory. It is usually preferable to run a business with as little inventory as possible without affecting possible sales.

Step4

See what the average collection period is for the company. This is how fast the customers pay their bills. If the company has a slow cash flow, this is often the reason; orders are being filled, but the invoices are not being paid promptly. Divide the net annual credit sales by 365, and divide the accounts receivable by that result.

Step5

Calculate the gross profit margin ratio by dividing the gross profit by the total sales. If this ratio is lower than industry standard, the company may be under pricing its product or failing to meet deadlines. If it is much higher than standard, then business may be weak or they are not being competitive.

Tips & Warnings

There are many financial ratios you can look at in a company. Don't focus on one ratio too much. Look at the total financial picture to get a better understanding of how healthy the company is.
Remember that the past financial statements of a company can never completely guarantee the future performance of that company. Things can always change without notice.