None of the four types of financial statements can be used on its own to arrive at a sound investment decision, but the four together serve to provide an array of information for lenders, investors or potential investors. The bottom line figure of the income statement, net income, becomes a prominent entry on the statement of retained earnings, which in turn becomes an entry on the organization’s balance sheet. Similarly, the bottom line on the statement of cash flows – cash at the end of the period – becomes the leading entry on the balance sheet. Most of these four basic financial statements are necessary to derive various financial ratios, each of which can supply specific information.
There are many standard financial ratios, each of which has its own usefulness. Some of are greater interest to management, some are favored by investors. Some speak to profitability, while others are more useful in assessing management’s effectiveness.
Some of the most common financial ratios and their derivation are:
- Earnings per share – EPS: 12 months earnings divided by number of shares
- Price/Earnings – P/E: Share price divided by earnings per share
- Price-Earnings-Growth – PEG: Price/earnings ratio divided by earnings growth rate
- Price/Sales: Market capitalization divided by total revenue
- Total Debt/Equity: Liabilities divided by total value of stock
- Current Ratio: Current assets divided by current liabilities
- Quick Ratio: (cash plus receivables) divided by current liabilities
- Current Inventory Turnover: Cost of Goods Sold divided by average inventory
- Return on Assets (ROA): Earnings before income taxes (EBIT) divided by average total assets
- Return on Equity (ROE): net income divided by stockholders’ equity
- Operating Profit Margin: EBIT divided by sales
- Net Profit Margin: Earnings after taxes divided by sales
Two Ratio Classes
There are four profitability ratios, each of which provides specific information for the investor and for the company’s management. The profitability ratios are operating profit margin, net profit margin, return on assets and return on equity. Operating and net profit margins provide management with measures of how well the company is doing what it intends to do. Investors may be interested in these ratios, but they likely have greater interest in ROE, which provides an indication of how much the company is generating in earnings per invested dollar. This is of direct interest to shareholders, while ROA is of greater use to the company’s senior management.
Another four ratios are designed to indicate the organization’s ability to meet its short-term obligations such as interest payments and other short term debts, which typically are paid for with current assets. These ratios are the current ratio, quick ratio, working capital and leverage. The current ratio results from dividing current assets by current liabilities. In most industries, a current ratio approaching one is most desirable. A lower value can indicate that a company may be having difficulties meeting its short-term obligations, while a current ratio value higher than one can be indicative of poor or inefficient use of funds. Optimal current ratio values vary among industries, however.
Also known as the acid test, the quick ratio is similar to the current ratio. The difference between the two is that the quick ratio excludes inventory, making it a more conservative test than the current ratio. The quick ratio is a better measure in industries where inventory cannot be quickly converted to cash.
Working capital is not a ratio at all, but rather is an equation of current assets minus current liabilities. The measure of working capital provides some measure of security for the investor, in that the investor can see that if the figure is positive, then the company has an effective “security blanket” it can use to meet its obligations.
When a company has insufficient liquidity, it may be over leveraged. Leverage is the ratio that measures the organization’s capital structure, and is derived by dividing long term debt by total equity. This is of direct interest to investors because it can reveal how the organization finances its assets. Whether the organization uses all equity or a combination of debt and equity is of direct importance to the investor. The organization with a lower debt load faces less risk in times of downturn.