Basic Financial Statement Analysis
Financial ratios are a convenient way to summarize large quantities of financial data and to compare firms' performance.
They enable investors to take a unique look at the inner workings of companies - but do not substitute for a crystal ball.
They won't tell you all of the company's innermost secrets nor will they answer all of your questions.
They will, however, give you a firm foundation to build your analysis and subsequent investment decisions.
Before getting started, it is imperative to distinguish between the three most important financial statements: *Income Statement - a financial statement that shows the revenues, expenses and net income of a firm over a period of time *Balance Sheet - a financial statement that shows the value of the firm's assets and liabilities at a particular time *Statement of Cash Flows - a financial statement that tracks cash coming into and flowing out of a firm over a period of time When it comes to various financial ratios, they can be categorized into four broad groups: *Leverage Ratios - show how heavily a firm is in debt and measures its ability to meet financial obligations *Liquidity Ratios - measure how easily a firm can convert its assets into cash *Efficiency Ratios - measure how productively the firm is using its assets *Profitability Ratios - measure a firm's return on its investments, giving an overall indication of its performance Now let's take a look at some of these ratios.
Leverage Ratios *Long-Term Debt Ratio = long-term debt / long-term debt + equity *Debt-Equity Ratio = long-term debt / equity *Total Debt Ratio = total liabilities / total assets *Times Interest Earned = EBIT / interest payments *Cash Coverage Ratio = EBIT + depreciation / interest payments *Fixed-charge Coverage Ratio = EBIT + depreciation / interest payments + (debt repayment)/(1 - tax rate) Liquidity Ratios *Net Working Capital to assets = net working capital / total assets *Current Ratio = current assets / current liabilities *Quick Ratio = cash + marketable securities + receivables / current liabilities *Interval Measure = cash + marketable securities + receivables / average daily expenditures from operations *Cash Ratio = cash + marketable securities / current liabilities Efficiency Ratios *Total Asset Turnover = sales / total assets *Average Collection Period = receivables / average daily sales *Inventory Turnover = cost of goods sold / inventory *Days' Sales in inventories = inventory / cost of goods sold/365 *Average Payment Period = payables / average daily expenses Profitability Ratios *Net Profit Margin = net income / sales *Return on Assets = net income / assets *Operating Profit Margin = net income + interest / sales *Operating Return on Assets = net income + interest / total assets *Return on Invested Capital = net income + interest / debt + preferred equity + common equity *Return on Equity = net income / equity *Payout Ratio = dividends / earnings *Plowback Ratio = 1 - payout ratio *Growth in Equity from Plowback = plowback ratio x ROE Using Financial Ratios Once you have selected and calculated important ratios, you still need some way of judging whether they are high or low.
In essence, you need a benchmark for assessing a company's financial position.
A good starting point is to compare them to the equivalent figures for the same company in earlier years.
This will show you whether the company has improved or deteriorated in certain fundamental areas.
It is also helpful to compare ratios with the ratios of competing companies in the same specific-business area as well as overall industry averages.
(On a side note, don't be alarmed if you notice certain industries having very contrasting ratios with other industries.
For example, the retail industry typically has a higher asset turnover and a lower operating profit margin than the steel industry.
This is simply due to the nature of operating a business in this industry.
) Word of Caution Financial ratios will rarely be useful if practiced mechanically.
It requires a large dose of good judgment.
Financial ratios seldom provide answers but they do help you ask the right questions.
It is important to note that accounting data does not necessarily reflect market values properly, and so must be used with caution.
In addition, accounting rules are subject to change, like everything else in life.
This means that your concrete analysis may not be a fair representation of the financial position of a company after changes have been put in place, which could prove costly if you invested.
They enable investors to take a unique look at the inner workings of companies - but do not substitute for a crystal ball.
They won't tell you all of the company's innermost secrets nor will they answer all of your questions.
They will, however, give you a firm foundation to build your analysis and subsequent investment decisions.
Before getting started, it is imperative to distinguish between the three most important financial statements: *Income Statement - a financial statement that shows the revenues, expenses and net income of a firm over a period of time *Balance Sheet - a financial statement that shows the value of the firm's assets and liabilities at a particular time *Statement of Cash Flows - a financial statement that tracks cash coming into and flowing out of a firm over a period of time When it comes to various financial ratios, they can be categorized into four broad groups: *Leverage Ratios - show how heavily a firm is in debt and measures its ability to meet financial obligations *Liquidity Ratios - measure how easily a firm can convert its assets into cash *Efficiency Ratios - measure how productively the firm is using its assets *Profitability Ratios - measure a firm's return on its investments, giving an overall indication of its performance Now let's take a look at some of these ratios.
Leverage Ratios *Long-Term Debt Ratio = long-term debt / long-term debt + equity *Debt-Equity Ratio = long-term debt / equity *Total Debt Ratio = total liabilities / total assets *Times Interest Earned = EBIT / interest payments *Cash Coverage Ratio = EBIT + depreciation / interest payments *Fixed-charge Coverage Ratio = EBIT + depreciation / interest payments + (debt repayment)/(1 - tax rate) Liquidity Ratios *Net Working Capital to assets = net working capital / total assets *Current Ratio = current assets / current liabilities *Quick Ratio = cash + marketable securities + receivables / current liabilities *Interval Measure = cash + marketable securities + receivables / average daily expenditures from operations *Cash Ratio = cash + marketable securities / current liabilities Efficiency Ratios *Total Asset Turnover = sales / total assets *Average Collection Period = receivables / average daily sales *Inventory Turnover = cost of goods sold / inventory *Days' Sales in inventories = inventory / cost of goods sold/365 *Average Payment Period = payables / average daily expenses Profitability Ratios *Net Profit Margin = net income / sales *Return on Assets = net income / assets *Operating Profit Margin = net income + interest / sales *Operating Return on Assets = net income + interest / total assets *Return on Invested Capital = net income + interest / debt + preferred equity + common equity *Return on Equity = net income / equity *Payout Ratio = dividends / earnings *Plowback Ratio = 1 - payout ratio *Growth in Equity from Plowback = plowback ratio x ROE Using Financial Ratios Once you have selected and calculated important ratios, you still need some way of judging whether they are high or low.
In essence, you need a benchmark for assessing a company's financial position.
A good starting point is to compare them to the equivalent figures for the same company in earlier years.
This will show you whether the company has improved or deteriorated in certain fundamental areas.
It is also helpful to compare ratios with the ratios of competing companies in the same specific-business area as well as overall industry averages.
(On a side note, don't be alarmed if you notice certain industries having very contrasting ratios with other industries.
For example, the retail industry typically has a higher asset turnover and a lower operating profit margin than the steel industry.
This is simply due to the nature of operating a business in this industry.
) Word of Caution Financial ratios will rarely be useful if practiced mechanically.
It requires a large dose of good judgment.
Financial ratios seldom provide answers but they do help you ask the right questions.
It is important to note that accounting data does not necessarily reflect market values properly, and so must be used with caution.
In addition, accounting rules are subject to change, like everything else in life.
This means that your concrete analysis may not be a fair representation of the financial position of a company after changes have been put in place, which could prove costly if you invested.