Ratio Analysis
To analyze the financial condition of a company, we rely on Financial Statements. Financial ratios, derived from Financial Statements, make this analysis possible. These ratios also come in handy when you need to compare different companies.
Let's first understand what these ratios mean. Then, we will look at the different categories they fall into and study the key ratios within each category.
What are Financial Ratios?
They are expressions that give us the relationship between different components of the Financial Statements. When used properly, they tell an important story about the underlying business. However, they must always be used in the context of other ratios and information available on a business .... not on a stand-alone basis.
Important Categories of Financial Ratios
For the investment process, we can group financial ratios into the following categories:
Liquidity — how capable is the company in meeting its short-term debt obligations?
Asset Turnover — how efficiently does the company use its assets?
Leverage — what is the company's debt load like compared to its net worth?
Operating Performance/Profitability — how well is the company utilizing its resources to make profits and create shareholder value?
Valuation — is the stock price of the company trading at an attractive price?
As we delve into the details within each category, we will refer to our fictitious Smart Widget Inc. (SWI) Balance Sheet, Income Statement,and Cash Flow Statement.
LIQUIDITY RATIOS
Liquidity ratios measure the ability of a company to meet its short-term debt obligations. Here are some of the main ratios covered under this category:
Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = 182.02 / 58.37 = 3.1
A current ratio greater than 1 is a rough indication that a companiy has sufficient resources to pay its current liability. Rough because it does not tell us how quickly the company can convert its non-cash current
Let's first understand what these ratios mean. Then, we will look at the different categories they fall into and study the key ratios within each category.
What are Financial Ratios?
They are expressions that give us the relationship between different components of the Financial Statements. When used properly, they tell an important story about the underlying business. However, they must always be used in the context of other ratios and information available on a business .... not on a stand-alone basis.
Important Categories of Financial Ratios
For the investment process, we can group financial ratios into the following categories:
Liquidity — how capable is the company in meeting its short-term debt obligations?
Asset Turnover — how efficiently does the company use its assets?
Leverage — what is the company's debt load like compared to its net worth?
Operating Performance/Profitability — how well is the company utilizing its resources to make profits and create shareholder value?
Valuation — is the stock price of the company trading at an attractive price?
As we delve into the details within each category, we will refer to our fictitious Smart Widget Inc. (SWI) Balance Sheet, Income Statement,and Cash Flow Statement.
LIQUIDITY RATIOS
Liquidity ratios measure the ability of a company to meet its short-term debt obligations. Here are some of the main ratios covered under this category:
Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = 182.02 / 58.37 = 3.1
A current ratio greater than 1 is a rough indication that a companiy has sufficient resources to pay its current liability. Rough because it does not tell us how quickly the company can convert its non-cash current