How to Interpret Accounting Ratios
Tools to analyze a company's financial standing include key metrics known as financial ratios. Investors and other stakeholders analyze the balance sheet and income statement using ratios to better understand a company's financial situation. Analyzing the information contained in the balance sheet and income statement allows investors to determine various aspects of a company's finances, such as the amount of debt relative to assets and equities, a company's ability to meet its financial obligations in time, profitability and overall financial health. Financial ratios portray a company's financial condition in percentages, rather than absolute amounts, enabling a potential investor to compare companies of different sizes in different industries.
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Instructions
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Familiarize yourself with the content and organization of a balance sheet. The balance sheet is one of a company's four main financial statements. The other statements are the income statement, the statement of cash flows and the statement of retained earnings. The balance sheet provides a snapshot of a company's assets, liabilities and equity at a point in time and informs the reader of the company's worth.
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Understand the income statement. For most readers of financial statements, such as investors and creditors, the income statement, along with the balance sheet, are the two most important statements. The income statement provides information on the profitability of a company over a period of time.
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Learn to compute the current ratio. The current ratio is the most relied-upon metric to gauge a company's liquidity or solvency. The ratio helps investors measure the company's ability to pay current liabilities as they become due. Current ratio is calculated by dividing current assets by current liabilities. The "current assets" and "current liabilities" numbers are plucked from the balance sheet and fed into the formula to arrive at a ratio or percentage.
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Learn to compute the quick ratio. This is another measure of solvency and is computed by including only highly liquid current assets, such as cash and marketable securities and excluding less liquid current assets such as inventory, from the numerator. The denominator is the same as the current ratio -- current liabilities.
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Understand the significance of the current ratio or quick ratio. If a company's current ratio is 2.30, it means the company has $2.30 in current assets for every dollar of its current obligations. If the current ratio falls below 1, the company has more short-term debt than assets and will not be able to meet its obligations as they become due. The quick ratio is a more challenging test of solvency because it excludes some portions of a company's current assets. As a result, a company's quick ratio is always lower than its current ratio. The quick ratio measures the ability to pay off only immediate obligations.
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Compute and understand the significance of the leverage ratio. Also known as the debt-equity ratio, this measures the relative portions of a company's assets that are funded by lenders and owners. The leverage ratio is calculated by dividing long-term debt by stockholders' equity. If the ratio is too high compared to an industry benchmark, the company is heavily reliant on debt, which may indicate possible defaults on loans.
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Learn to compute the net profit margin to gauge a company's profitability. This is computed by dividing net profit by total revenues, which are plucked from the income statement. If a company has sales of $100 and its net profit is $15, its net profit margin will be 15 percent, meaning that for every dollar of sales, the company makes a profit of 15 cents. It also means the company incurs 85 cents in expenses for $1 of sales.
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Tips & Warnings
You may compare a company's ratios to an industry average, a competitor, or the same company's ratios for a prior period. Comparing to a different set of ratios will enable you to put the numbers into context.
References
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