The most common ratios used to analyze financial statements fall into four categories: profits, liquidity, activity, and debt leverage. Managers, investors and bankers examine these ratios to identify a company's strengths and weaknesses which become the basis for strategic planning and identifying areas for improvement.
The two primary profit ratios are gross profits and net profits before taxes. Gross profit is the amount of money that a company makes from its core operations. It is defined as total sales less the combined costs of labor, materials, supplies and shipping costs, also known as cost of goods sold, but before deductions for fixed overhead and administrative costs. A useful variation of gross profits is the gross margin which is a percentage number obtained by dividing gross profits by total sales. Gross margin can be compared to other companies in the same industry to determine whether or not the business is performing above or below average.
Net profits before taxes is a company's bottom-line target. It is calculated by subtracting fixed and administrative expenses from gross profits. Most analysts initially focus on this number when evaluating a company's performance.
A business must maintain adequate liquidity to pay its debt obligations on time. Analysts use the current ratio and the quick ratio to gauge a company's liquidity.
The current ratio is calculated by dividing current assets—cash, receivables and inventory—by current liabilities—all debt obligations due within 12 months. The amounts and due dates of debts are known precisely, whereas the cash inflows from the timing of conversion of inventory to receivables to cash are not so predictable. For this reason, most businesses should maintain a current ratio of at least two to one. This means that the company should maintain $2 in current assets for each $1 in current liabilities to allow for the timing differential in cash flows.
The quick ratio is a stricter analysis of liquidity since it excludes inventory from the calculation. The quick ratio is calculated by adding cash and accounts receivable and dividing by current liabilities. Generally, the minimum acceptable quick ratio is 1.5 to 1. When a quick ratio falls below this number, a business will begin to experience difficulty paying its bills on time.
Two important activity ratios are the inventory turnover and accounts receivable turnover. The objective of any business is to purchase materials for inventory, sell the products to create receivables and convert to cash by collecting the receivables.
Inventory turnover is total cost of goods sold divided by the average inventory level. The optimum inventory turnover rate varies by industry, but every company strives to keep its investment in inventory to a minimum.
Accounts receivables turnover measures how well a business is collecting its receivables. It is calculated by dividing total annual credit sales by the average amount of receivables outstanding. If a company is selling on 30-day terms to its customers, then a turnover of 12 times per year would signify an extremely effective collection system.
Debt leverage measures how much debt a company has in relation to its shareholder equity. Companies that have high amounts of equity relative to its debt are considered financially strong. On the other hand, high amounts of debt make a business more susceptible to fluctuations in sales volume and are considered financially riskier. Bankers generally don't like to see more than $2 in debt for each $1 in equity.