Implications of Financial Ratios

by Cindy Beck ; Updated July 27, 2017
Ratio analysis provides indications of liquidity and profitability.

Financial ratios provide quick clues about the health of a company. Do not look at ratios in isolation, however. Comparison of a company’s ratios over time is crucial to gauging its prospects. It is also vital to look at ratios averages for companies in similar industries. Business news media provide ratio data and industry averages. Ratio analysis is an effective tool for selecting stocks to study further. Before investing money, conduct a thorough examination of a company’s financial statements. Also, read the notes to the financial statements, which provide supplementary information needed for sound investment decisions.

Cash

Ratios that provide a picture of a company’s cash compared to its debt indicate whether the company is financially sound. The quick and current ratios are two examples. To compute the quick ratio, first add cash and cash equivalents, such as stocks or bonds. Then divide this number by current liabilities, defined as liabilities due within one year. If the result is greater than one, this ratio implies that the company has adequate cash to pay its bills. Compute the current ratio in the same way, but add inventory to the asset amount.

Debt

Investors should also examine ratios for long- term debt. Long- term liabilities extend beyond the one-year period used for current liabilities. The debt-to-assets ratio is a basic ratio that provides a snapshot of a company’s indebtedness. Calculate it by dividing total assets by total liabilities. If the result is greater than one, this ratio indicates a company has a positive net worth.

Earnings

Earnings per share, or EPS, is a well-known financial ratio. Companies typically report earnings per share quarterly and annually. To compute earnings per share, divide the earnings for the reporting period by the number of shares of stock the company has issued. A company may have several EPS ratios. If the company has issued bonds or other securities that could be converted to stock, investors should also look at fully diluted EPS. Compute fully diluted EPS using the total potential number of shares outstanding.

Profit

Profit ratios are calculated on a before- and after-tax basis. Calculate the gross profit ratio by subtracting the cost of goods sold from sales, and then dividing this number by sales. Tracking the gross profit ratio over several reporting periods can alert investors to profitability concerns. For example, lower gross profit ratios could indicate price increases for raw materials, or conversely, that sales prices are decreasing. Perform further analysis before investing to determine if profit ratios indicate problems for the company’s profitability outlook.

About the Author

Cindy Beck completed a Bachelor of Science in finance at the University of Houston. She has worked on worldwide project teams to implement new business and information-technology systems. Beck also writes press releases in her role as a public affairs officer for a nonprofit organization.

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