Ratios display a company's state of health. Problems with financial stability, often hidden after a brief glance at financial statements, can be uncovered by calculating applicable ratios. Conversely, an initially unimpressive company may be a solid investment after analyzing appropriate ratios. This ratio primer will help newer observers understand how to use some ratios.
Become familiar with the Current Ratio. The simplest and often most important short-term health indicator, the Current Ratio indicates a company's ability to stay solvent and in business for the next year. To find the Current Ratio, simply divide current assets by current liabilities. Current assets include cash and other assets that can be converted to cash within one year. Current liabilities are those monies owed and debts that should be paid off within one year. The company, hopefully, has a result over 1.00. This indicates they have more than $1.00 in current assets for every $1.00 in current liabilities.
Get comfortable with the basic calculations used with each ratio, particularly for the most popular varieties. Fortunately, most financial ratios are simple mathematical functions (addition, subtraction, multiplication, and division). Except for some complicated ratios, even basic algebra is not normally necessary for most calculations.
Analyze the Total Debt Ratio to learn about a company's debt and freedom to use cash flow for operating expenses and profit. Divide the total debt by total assets. If the result equals more than 1.00, the company has more debt dollars than asset dollars. This is an indication of more than $1.00 of debt for every $1.00 of assets. This is not a healthy position for a business.
Learn about the most popular business ratios and how to read them. Ratios display the health condition of companies, pointing out strengths and weaknesses. There are many Web sites targeted to investors and newbies that explain the many ratios currently in use.
Learn to read balance sheets and income statements. The information needed to calculate most ratios is found in one or both of these primary financial statements. There are many other financial ratios that support, contradict, or further display the short- and long-term health indicators for companies. The three primary financial ratios discussed above are typically used by all investors, analysts, and observers to make initial judgments on the health of a company.
Calculating the Profit Margin displays the financial health of company operations by dividing net income by total sales. Unlike the prior two ratios, the Profit Margin has no simple right or wrong result. Obviously, every business wants to have the highest Profit Margin possible. However, the benchmark profit margins of different industries can vary widely. For example, a super market with a 1% to 3% Profit Margin is considered healthy if they consistently achieve this level. Conversely, a successful service business typically seeks Profit Margins in the 22% to 25% range. Learn about some industry norms before making a stability decision about a company's profit margin.
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