One of the key steps in dissecting a company’s financial statement is through financial ratio analysis. The financial ratio measures the relative magnitude of two selected numerical values from the financial statement. Generally, there are three major ratios that are widely used in the financial ratio analysis;
- Profitability ratio – measures the company’s ability to generate profits from its sales after deducting its expenses and other costs incurred during a specific period of time. Common examples of profitability ratios include;
Gross profit margin = Gross Profit / Revenue x 100%
Gross profit margin measures the company’s financial health by unveiling the sum of money left over from revenues after deducting the cost of goods sold (COGS). A high value of gross profit margin signifies an efficient operation.
Net profit margin = Net Profit / Revenue x 100%
Net profit margin measures the amount of profit that a business can extract from its total sales after deducting all its costs. Similar with gross profit margin, a high value of net profit margin signifies an efficient operation.
- Liquidity ratio – measures the company’s ability to meet short-term debt obligations. During economic downturn, a company with insufficient liquidity might be forced to liquidate its short-term assets to meet their debt obligations. Common examples of liquidity ratios include;
Current Ratio = Current Assets / Current Liabilities
Current ratio measures the company’s financial ability to repay back its liabilities (debt and accounts payable) with its assets (cash and accounts receivable. In general, a value above 1.0x indicates the company is well positioned to meet short-term obligations.
Quick Ratio = (Cash + Marketable Securities + Accounts Receivables) / Current Liabilities
Quick ratio or also known as acid-test ratio is similar with current ratio that measures the ability of the company to meet short-term financial liabilities. A common rule of thumb is that companies with a quick ratio of greater than 1.0x are sufficiently able to meet their short-term liabilities.
- Debt ratio – measures the extent of a company’s leverage of which the proportion of company’s assets are financed by debt. Common examples of debt ratios include;
Debt Ratio = Total Liabilities / Total Assets x 100%
Debt ratio measures the leverage of which the proportion of company’s assets is financed by debt. There is no general rule of thumb of how large the debt as companies across various sectors requires different scale of leverage in order to grow their operations.
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses
Interest coverage ratio measures the ability of the company to meet interest expenses from their outstanding debt. In general, a company’s interest coverage ratio that is lower than 1.5x indicates that company could struggle to meet its interest expenses payment in the future.
Although the aforementioned ratios tell us how the company is performing/operating, investors, however, should perform for comparisons (historically, between companies and between industries) in order to grasp a better understanding on the financial position of the company.
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