Financial Document Ratios: A Guide
If you are a new investor, or if you’ve only started navigating financial documents, it may be an overwhelming experience. Balance sheets and income statements are admittedly unpleasant to navigate, and not knowing what to look for makes them nearly nonsensical! I remember looking at a balance sheet for the first time and being overwhelmed with all the information. Rest assured that — no matter how daunting it may be — you are stronger than those numbers!
Income Statement Ratios
The income statement reports the revenue, expenses, and ultimately, profit or loss of a company. A lot can be interpreted from the income statement other than just the net profit, these information allow insight into company health and the yield produced from buying a stock. Got a company to try? Let’s see how they do!
Earnings per Share (EPS)
A relatively easy formula to run. It’s an estimation of how much profit you are reaping by owning a share. Sometimes companies have a lot of profit but also have a diluted pool of stocks, making you earn less by owning a share!
The first step is locating the numbers you need: net income and number of shares issued. You will want to divide net income by the later. Simple right? The awesome news is you can use is number in another — arguably more helpful — formula.
The price-earnings ratio helps value a company to determine if market price is over or undervalued. Take your trading price and divide this by your EPS. Ideal price-earnings ratio vary from industry to industry, so make sure to compare the company you’re interested in to other industry competitors!
Net Profit Margin
You’ve probably heard this word floating around, and that’s because it’s a very useful number to know! Net profit margin tells you how much money the company keeps at the end of the day out of how much it makes. It again depends on industry standard to evaluate what is considered a good margin. Inventory costing, price at which goods or service sells, and expenses associated are all factors in determining what an industry standard margin would be.
The net profit margin is calculated by dividing the net profit by the revenue. You want to multiply this by 100, as the margin is usually expressed as ratios. Comparing the company’s margin to the industry standard will generally give you excellent insight into company operations and if they’re a good investment.
Return on Equity (ROE)
The ROE of a company is often used by investors to asses the effectivity of business operations. Higher ROE percentage indicates the company is better at generating profit from the money it generates through issuing stocks. A good ROE would depend on the industry under which the company operates, but the rule of thumb is the higher ROE, the better. To calculate ROE, simply divide net income by total shareholders equity. This metric is also expressed as a percentage.
Balance Sheet Ratios
The big picture of a company’s assets, liabilities, and equity lay on this one statement. Let’s take our time exploring what to extract, after all, this long document is extremely important! Think of it as a simplified summary of the company’s financial health. Most of the time, balance sheets will show the current fiscal year and a few prior years. This is for comparative purposes to show the company’s trajectory. Balance sheets read from left to right with the current year on the left most column.
Current Ratio
As an investor, you will want to know if a company is able to pay it’s debt — especially if it’s due soon! The current ratio is often used to determine if a company has enough assets on hand to pay it’s liabilities. If it doesn’t the company is in big trouble.
Unlike previously discussed ratios and percentages, there is a universal ideal ratio. Most companies will want a current ratio (assets:liabilities) of 2:1. Anything lower may indicate the company won’t meet its debt, anything higher suggest the company isn’t using its capital effectively to make profit. A fluctuation of a couple of decimal points is forgivable.
Current ratio will use 2 numbers on the balance sheet: current assets and current liabilities. Make sure to use the current number, not the total. Divide the current assets by the current liabilities. Like all other things in investing, having a good current ratio doesn’t always guarantee successful operations, it’s just an indicator. You will want to use this ratio along with other ones in this article.
Acid Test
An acid test, formally know as the quick ratio, is also an indicator used to decipher a company’s ability to meet liabilities. Think of it as the current ratio on steroids. The acid test only uses cash, accounts receivable, and current investments instead of all current assets. Do the same division over current assets.
We only use a select few assets because we need to remember that inventory and other forms of assets aren’t always liquid. This means it won’t necessarily be converted to cash in time to pay debtors. The ideal ratio is 1:1 universally.
Time to Calculate!
Now that you know a few basic ratios, pull up a balance sheet and start calculating! It may take a couple of tries to properly understand the outcomes, but that’s completely normal. There are so many ratios out there and I encourage you to try them once you have the ones in this article down. Remember that the more you analyze, the more informed your decision is, so go wild!
