A common topic requested by our students is financial statement analysis. Financial statement analysis is not a topic that can be covered in one day! In this blog, we’ll discuss some of the very basics of financial statement analysis, starting with common financial ratios that accountants and finance professionals often look at when analyzing a company.
First, what is a financial ratio? The basic definition of a ratio is the quantitative relation between two amounts showing the number of times one value contains or is contained within the other. For example, if a professor has 50 students in a class, the professor to student ratio is 1:50, 1/50 or 0.02. In the same way, if a university has 12 professors and 1,000 students, the professor to student ratio is 12:1,000, 12/1,000 or 0.012. For every one professor, there are approximately 83 students.
For financial ratios, we do the same analysis, except we use figures from the financial statements (i.e. the statement of financial position, the statement of profit and loss, or the statement of cash flows).
Let’s look at a few of the most common ratios and how to interpret them.
The current ratio is a liquidity ratio which measures a company’s ability to pay off its short-term liabilities using its current assets. It is calculated as:
Current ratio = current assets / current liabilities
Using an example, if current assets are 150M and current liabilities are 50M, the ratio is 3 (150M / 50M) and means that with the current assets on hand, the company could pay off its current debts 3 times. This means the company should not have any issues paying off its short-term debts in the near future.
The cash ratio is also a liquidity measure which looks at a company’s ability to pay off its short-term liabilities using only cash. It is calculated as:
Cash ratio = cash and cash equivalents / current liabilities
For the same company as the example above, if cash is 25M, the ratio is 0.5 (25M / 50M). In this case, the company has enough cash to pay off half of its current liabilities. To repay the remaining balance, other current assets would need to be converted into cash. For example, a customer could make a payment against an account receivable and that cash can then be used.
Debt to equity:
The debt to equity ratio measures leverage, which is the amount of the company that is funded by debt (liabilities). It is calculated as:
Debt to equity = Total liabilities / shareholders’ equity
Again, let’s use an example. If a company has $100,000 of debt (loans from the bank) and $200,000 of shareholders’ equity (amounts contributed by the company’s owners), then the ratio is 1:2, or 0.5. This means that liabilities are 50% of the shareholders’ equity.
A key profitability measure is gross margin. It is calculated as:
Gross margin percentage = Gross profit / net sales
This measure calculates the % of gross profit that is retained from sales. Remember, gross profit is equal to sales less cost of sales. This measure shows how much profit remains after direct expenses have been incurred.
These are just a few of the most common measures an accountant or finance professional might look at but there are hundreds of different ratios that can be analyzed. What is the best way to learn more? Ask your manager or the managers in different business units of your company. Everyone is concerned with different performance indicators and it can be quite interesting to hear about the different figures different people look at on a daily basis!
Are there any other financial statement ratios you use regularly? Share them in the comments section below.