A large part of my job involves analyzing financial statements. Luckily for me this skill comes in handy when looking at a company’s financials and deciding whether to invest in them.
There are tons of different things to look at with financials so I have condensed this posting into what a potential investor would want to know. Some of the easiest ones to find I have left out, such as Earnings Per Share (EPS) and Price-to-Earnings (P/E).
Below are some important (and often overlooked) ratios an investor might want to know.
Formula: current assets/current liabilities
What it measures: short term debt paying ability
Why it’s important: it shows how easily a company would be able to pay its short term obligations (debt) if it ran into some tough economic times
Formula: cost of goods sold/average inventory
What it measures: liquidity of inventory
Why it’s important: This ratio is important for retail companies and it shows how quickly a company is going through its inventory. A slowdown in sales or products that aren’t selling would lower this ratio. Note – the easiest way to find ‘average inventory’ is to add the inventory for two of the latest reporting periods and divide the amount by two
Rate of Return on Assets
Formula: net income/average total assets
What it measures: the overall profitability of assets
Why it’s important: This ratio shows how profitable a company’s assets are in relation to net income. Did the company spend a lot on assets that aren’t being used?
Obviously the higher the amount, the more profitable the assets are.
Note – the easiest way to find ‘average assets’ is to add the total assets for two of the latest reporting periods and divide the amount by two
Profit Margin on Sales
Formula: net income/net sales (note – net sales gross sales less discounts, buybacks, etc)
What it measures: profitability of sales
Why it’s important: This ratio shows how much income was generated for each dollar of sales. A lower margin may mean sales are being generated, but costs are just as high so they aren’t translating into profits
Book Value Per Share
Formula: common shareholders’ equity/outstanding shares
What it measures: the true value of each share
Why it’s important: This ratio shows what each share would receive if the company were completely liquidated (bankrupt). If a company’s shares trade for significantly higher than their book value, they may be overpriced. On the flip side if a company’s share are trading for at/near their book value, they may be underpriced
Formula: current share price/annual sales per share (note: to find ‘annual sales per share’ simply divide net annual sales by the shares outstanding)
What it measures: share price in relation to current sales
Why it’s important: This ratio shows how much investors are willing to pay for every dollar of sales. This ratio is very industry-specific and one company should only be compared to others in the same industry. It’s valuable because net earnings can often be manipulated using accounting rules but sales figures are considered reliable
Conclusion: The list of ratios above is a starting point when looking at a company’s financials. There are lots of other ratios to use that are industry-specific. Personally, I use a few of the above as well as the dividend ratios since I focus mainly on dividend stocks.
Related: Surviving a Market Meltdown