A financial ratio expresses a relationship between two or more financial statement numbers. Ratios are useful when compared to historical internal data or to industry averages. These comparisons can identify strengths and weaknesses and assist management in adopting corrective measures. There are four types of financial ratios: liquidity, debt, profitability and value.
Prepare the report outline. If the audience consists mainly of internal users intimately familiar with the company’s operations, summary tables along with brief explanatory notes would normally suffice. Consider a different approach if the report is for external consumption, including shareholder communications. For example, Chevron's 2008 Annual Report (see Resources) presents three key ratios in a simple tabular format, along with a brief explanation of the changes and a graphical five-year trend for one of the ratios.
Compile the liquidity ratios, including the current ratio--current assets divided by current liabilities--and the net working capital ratio--current assets minus current liabilities, then divided by total assets. These ratios indicate a company's ability to pay its bills on time. Discuss significant changes: For example, the company may have recently paid cash--a current asset--to buy new equipment, thus reducing the current ratio.
Present the debt ratios, including the debt-to-equity ratio--total liabilities divided by total equity--and the interest coverage ratio--earnings before interest and taxes divided by interest expenses. These ratios show how well a company can manage its debt obligations. Although a high debt-to-equity ratio indicates less protection for creditors, explain why it might have increased. For example, the company may have taken advantage of a low interest rate environment to issue bonds and raise cash for future acquisitions.
Prepare the profitability ratios, including profit margin--net income divided by sales--and return on equity--net income divided by shareholders' equity. The profit margin ratio shows how much of each sales dollar flows to the bottom line. The return on equity ratio shows how efficiently management has deployed shareholder funds. Explain significant trends: For example, profit margins may have taken a hit during an economic downturn when sales can often fall faster than expenses.
Show the value ratios. The most common value ratio for public companies is the price-to-earnings ratio or the PE ratio. It equals the market price per share divided by the previous four quarters’ total earnings per share--net income minus preferred dividends, then divided by the number of shares outstanding. Compare the PE ratio to other companies in your industry and explain significant differences. For example, news of an order cancellation may have impacted your company’s market price recently, thus changing the PE ratio.