Why is understanding financial statement ratios important to analyzing a business?

Financial statement ratios help you understand more quickly and objectively a company's financial health and performance. Studying the details in financial statements can be overwhelming and time consuming, but performing a ratio analysis of financial statements quickly helps you gain an overview of the financials of a business from various perspectives and purposes.

Which financial statement ratios are important to know?

Depending on the end-results you are seeking, you will need to know how to study certain financial statement ratios. For example, investors may focus on certain ratios, while business managers may have a larger set of ratios they need to monitor. Generally speaking though, you should understand how to use a common set of financial statement ratios which are important to investors, business owners and management alike. It's also important to realize that each ratio gives you a financial picture of a business from one angle - so you should aim to study a combination of financial statement ratios to gain a clearer, more accurate picture.

Ratios can be categorized into the following groups:

• Liquidity Ratios - used to test and assess a company's ability to pay off short-term debt
• Profitability Ratios - used to measure how efficiently a company generates profit
• Debt Ratios - used to check how much debt a business carries and risk its owners and shareholders face
• Operating Performance Ratios - used to determine how well a business is managed from various angles
• Cash Flow Ratios - used to check how much cash a company generates from revenue to meet its financial obligations
• Valuation Ratios - used to determine the attractiveness and value of a company from an investment perspective

Here are some of the more common of the many ratios used to analyze a company's financial statements...

Current Ratio

The current ratio is used to measure the proportion of a company's current assets to current liabilities. This popular ratio helps you see how prepared a business is to meet its short-term debt obligations. Current assets include cash, accounts receivable and inventory, among other "liquid assets". The ratio looks like this:

Current Assets / Current Liabilities = Current Ratio

And here's a very simple example:

$1000 / $500 = 2

In theory, the higher the ratio of current assets to current liabilities, the better the health of a business. But this theory, along with relying solely on the current ratio to determine a company's ability to pay short-term debt, has certain flaws. Looking at it alone doesn't tell you whether a company has enough cash balance to pay its immediate debts. The fact is, businesses pay off debts with cash - not with inventory, for instance.

A more conservative and accurate picture of a company's ability to meet its immediate debt obligations is the...

Quick Ratio (also known as Acid Test Ratio)

The Quick Ratio gives you a better idea of a company's ability to pay its short-term debts than the Current Ratio, because it includes only cash and cash equivalents, receivables and short-term investments. The Current Ratio includes non-cash current assets like inventory on the other hand.

The principle and formula behind the Quick Ratio is similar to the Current Ratio however. The higher the ratio, in theory, the better position the company is to meet its debt obligations in the short term. It looks like this:

Cash and Cash Equivalents + Accounts Receivable + Short-term Investments / Current Liabilities = Quick Ratio

And using our same simple example:

$700 / $500 = 1.4

But just like the Current Ratio, the Quick Ratio doesn't tell you how quickly a company can convert its accounts receivable into cash, nor does it tell you how frequently it has to pay its bills. So it doesn't give you a clear picture of a company's cash flow and can be misleading to rely on alone.

Profit Margin

The Profit Margin is a simple ratio which tells you the company's profit as a percentage of revenue. In one way, it shows you how efficient a company is at generating profits from its revenue, but more commonly, it is used by investors to gauge the quality of a company - based on a positive margin. These margins can be used as an index to measure consistency in a company's profits as well.

There are various derivatives of this ratio, but the most common forms are the Gross Profit Margin and Net Profit Margin ratios.

Gross Profit Margin = Gross Profit / Net Revenue

Net Profit Margin = Net Income / Net Revenue

And Simple examples:

Gross Profit Margin: $1000 / $2000 = 50%

Net Profit Margin: $700 / $2000 = 35%

Debt Ratio

The Debt Ratio helps you understand how much debt a company has in proportion to its assets. Unlike the financial statement ratios above, the lower the number, the better the company's financial health, in theory.

Let's see what the ratio looks like, and take a look at a simple example:

Debt Ratio = Total Liabilities / Total Assets

For example:

$1000 / $3000 = 33%

To put this example of Debt Ratio into words, the company's total debt represents 33% of its total assets. By lowering this figure, the company lowers its total risk.

Financial Statement Ratios are like windows looking into a business.

Of course, there are many more financial statement ratios - too many to cover here. But these more common ratios give you an idea of how ratios can help you better understand a company's financial position. They're like windows looking into a business - you can't simply look through one window as you'll get only one view. Looking through various windows gives you a better perspective of the landscape, just as studying various ratios helps you see the financial picture of a company.

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