Definition of Financial Statement Ratios
How Financial Statement Ratios Work
Types of Financial Statement Ratios
Criticism of Financial Statement Ratios
Definition of Financial Statement Ratios
Financial statement ratios are used by both investors and analysts to gain insight into a company’s financial condition. By applying ratios to financial statements, they can calculate indicators that define many important metrics about the company’s performance and financial health, such as its liquidity, solvency, and profitability.
How Financial Statement Ratios Work
Financial statements and the income statement are used to determine many of the ratios used for analyzing financial statements. For some ratios, you can use information found in the financial statements only. For others, you need to use data from both the financial statements and the income statement.
Ratios are used to create a big picture of how the company manages its money. Profitability ratios, when used together, help determine whether the company is making a profit. There is one requirement for determining if the company is profitable: it must be compared to similar companies. They should be similar in terms of financial structure, operational structure, supply chain, and other aspects of the business.
This comparison should also be applied to liquidity and solvency ratios, especially ratios that indicate poor performance. All these ratios have a general direction indicating whether the company is performing well or not. For example, if you have $1 of debt and $3 of equity, your debt-to-equity ratio is 0.333. The general guidelines for this ratio indicate that any ratio less than one is a sign of good performance.
Types of Financial Statement Ratios
Analysts, academics, and more experienced investors have many ratios to evaluate detailed aspects of the company’s finances. For the average or new investor, there are a few ratios that form the basic foundation, which can tell you about the company’s profitability, liquidity, and solvency.
How to Calculate Profitability?
Profitability ratios show the amount of money the company makes. They also show how cash is distributed for operations and rewarding investors.
- Gross Profit
- Contribution Margin
- Net Profit
- Return on Equity
- Return on Assets
How to Calculate Liquidity?
Liquidity ratios measure how well a company can pay off its debts by converting assets to cash or using them.
- Current Ratio
- Quick Ratio
- Cash Ratio
How to Calculate Solvency?
Solvency ratios are used to understand how well a company can pay off its debts. The current and quick ratios can be used for liquidity and solvency tests.
- Debt to Equity Ratio
- Interest Coverage Ratio
- Basic Solvency Ratio
Criticism of Financial Statement Ratios
Ratios derived from financial statements provide a snapshot of the company’s financial situation, but they are limited to a specific period. The snapshot you get shows how the company performed in the past, not how it is performing currently.
Published financial statements often do not disclose much financial information that could be useful to you as an investor, such as how much is spent on specific projects. Instead, you may see an estimate for research and development costs. This can be useful, as it tells you that the company is investing in itself, but there is not much other useful information about that.
Source: https://www.thebalancemoney.com/formulas-and-calculations-for-analyzing-a-balance-sheet-357277
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