Making Sense of Financial Statement Ratios

Many basic features of a business' business can be gleaned from their set of financial statements. However, the more intricate details can be found through ratio analysis.

The financial statement's figures are measured in currency units, which have little value in themselves because they do not consider the scale of business operations. By comparing relative sizes of these figures, this problem with units of measurement are eliminated by removing the units entirely. The resulting ratios are scale-free and can be used in comparing:

• Two businesses of different sizes
• The same business as it grows (or collapses) over time.

Analysts have devised myriad ratios to use in this type of analysis. What do they mean in real-world terms?

Profitability ratios
These ratios consider how well the business is achieving its basic purpose of generating profit:

• Return on equity: The amount of profit that one currency unit of shareholder investment generated.
• Return on assets: The amount of profit that one currency unit of asset value generated.
• Profit margin: The proportion of revenue generated that ended up as net profit (where all expenses are deducted).
• Gross margin: The proportion of revenue generated that ended up as gross profit (where only cost of the goods sold is deducted).
• Cash flow to total assets ratio: The number of times above its value the business' assets generated cash inflows from its ordinary business operations.
• Earnings per share: A single ordinary share's share of net profit once preference share dividends have been ignored.
• Price-to-earnings ratio: The number of times the total market value of the business' shares exceeded its net profit.
• Dividend payout ratio: The proportion of net profit paid out as dividends.

Financial structure ratios
These ratios consider the relationships between a business' assets, liabilities and equity:

• Debt-to-equity ratio: The number of times that total liabilities exceeds total shareholders' equity.
• Debt-to-assets ratio: The proportion of assets funded by liabilities.
• Leverage ratio: The proportion of assets funded by owners' equity.

Activity ratios
These ratios consider how intensively the business is using its resources:

• Total asset turnover: The number of times above total asset value the business used those assets to generate revenue.
• Inventory turnover: The number of inventories the business sold during the year.
• Debtors turnover: The number of accounts receivable the business collected during the year.

Liquidity ratios
These ratios consider how safe the business is playing it with its current assets (which include cash):

• Current ratio: The number of times the business can pay its current liabilities using its current assets.
• Quick ratio (acid test): An extreme form of the current ratio that assumes the business cannot sell its inventory (a current asset) in time to help pay off current liabilites.
• Interest coverage ratio: The number of times the business can pay its net interest expenses using its pre-interest profit.

EDIT 18Dec09: Amended interpretation of inventory and debtors turnovers.