How to analysis financial statements and interpret financial ratio?

When deciding where to invest your money, comparing companies can be tricky, especially if they differ in size or industry. Two powerful tools can help: common-size statements and financial ratios. These tools make it easier to understand a company’s financial health and compare it with others. In this post, I’ll break down these concepts using simple language, explain how they work.

What Are Common-Size Statements?

Common-size statements turn financial data into percentages, making it easier to compare companies of different sizes.
Why Use It? It helps you see how a company allocates its resources compared to competitors, regardless of their size.

• common size balance sheets by expressing each item as a percentage of total assets.
• common size income statements by expressing each item as a percentage of total sales.

 

Financial Ratios: Your Investment Toolkit

Financial Ratio is way for comparing and investigating the relationships between different pieces of financial information. If you are using ratios as tools for analysis, you should be careful to document how you calculate each one. If you are comparing your numbers to those of another source, be sure you know how their numbers are computed.

we must be finding answering of these questions:

• How is it computed?

• What is it intended to measure, and why might we be interested?

• What is the unit of measurement?

• What might a high or low value be telling us? How might such values be

Liquidity Ratio: the ability of the firm to pay bills in the short run. it might be is not reliable to the future.

• Current Ratio= Current Assets ÷ Current liabilities -----above 1 is a good for firms

low current ratio is not bad sign for a firm if the company have a power to borrow.

• Quick ratio= current assets - Inventory ÷ Current liabilities

because inventory is illiquid that is better to omitted it. So, focusing on more liquid assets

• Cash Ratio= Cash ÷ Current liabilities

It’s the strictest liquidity measure, useful for creditors who want to know if a company has cash on hand to pay them.

Turnover Ratio (Activity Ratio):  measures how efficiently a company uses its assets to generate sales or revenue. A higher turnover ratio typically indicates better efficiency, while a lower ratio may suggest underutilization or inefficiencies

• Inventory Turnover Ratio= Cost of Goods sold ÷ Inventory------How many times a company sells and replaces its inventory over a specific period.

 A high ratio means the company sells inventory quickly, reducing storage costs and spoilage risks. Investors like efficient operations.

• Accounts Receivable Turnover Ratio=Sales ÷ Accounts receivable ------How efficiently a company collects payments from its customers.

 Fast collection improves cash flow, which is critical for paying bills and investing.

• Accounts Payable Turnover Ratio= COGS ÷ Account Payable------ How many times a company pay to its creditors.

 Shows how a company manages its debts to suppliers. Investors want to know if a company pays too slowly (risking supplier relations) or too quickly (losing cash).

• Total Asset turnover= Sales ÷Total Assets----How effectively a company uses its assets to generate sales.

 A high ratio means the company gets more sales from its assets, indicating good management

Solvency Ratio: the Ability to meet Long Term obligations. another called: Financial Leverage or leverage Ratio)

• Total debt ratio= Total assets - Total equity ÷ Total assets

 Investors want to know how much a company relies on borrowed money, as too much debt can be risky.  High Value: High debt levels increase risk but can boost returns if used wisely. Low Value: Low debt suggests stability but might mean missed growth opportunities.

• Debt- equity ratio= Total Debt ÷ Total Equity

Shows the balance between debt and equity financing. High debt can amplify returns but also risks. High Value: Riskier, as the company relies heavily on debt. Low Value: Safer but may indicate conservative growth strategies

• Equity Multiplier=Total Assets ÷ Total Equity

A higher multiplier means more debt financing, which can increase returns but also risk.

• Interest Coverage Ratio= EBIT÷ Interest

Investors want to ensure a company can cover its interest payments. How a company has its interest obligation covered.

it does not show any available cash to pay interest because Depreciation and Amortization have been deducted of cash.

• Cash Coverage Ratio: EBITDA÷ Interest

Profitability Ratios: to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations.

• Profit margin = Net Income ÷ Sales-------for every dollar in sales, how a company makes money

• EBITDA margin = EBITDA ÷ Sales------ before-tax operating cash flow

• Return on assets (ROA) = Net income ÷Total assets--------a measure of profit per dollar of assets

If ROA exceeds borrowing rate, the firm will earn more money on its investments than it will pay out to its creditors.

• Return on equity (ROE) = Net income ÷ Total equity---- How much earn stockholders earn during the year

or

• ROE = Net income ÷ sales × sales ÷ assets × assets ÷ equity

That is so important to remember ROA, ROE are accounting rate pf return.

Market Value Ratios: calculated directly only for publicly traded companies.

• Earnings-per ratio (EPS) = Net income ÷ shares outstanding
  
• Price-earnings ratio (PE ratio) = Price per share ÷ EPS

measures how much investors are willing to pay per dollar of current earning (it shows perspective of future growth)

• Market-to-book ratio= Market value per share÷ Book value per share

A value less than 1 could mean that the firm could not be successful for creating value for its stockholders.

• Market capitalization= Price per share × Share outstanding

Helps classify companies (e.g., small-cap, large-cap) and assess their size

• Enter price Value (EV) = Market capitalization + market value of debt + Market value of Preferred stock - cash 

 Allows comparison of companies with different debt levels or cash reserves.

• EV Multiples = EV ÷ EBITDA

The goal is to estimate the value of the firm's total business. this valuation allows us to compare of one firm with another when there are differences in capital structure.

High Value: Suggests high growth expectations or overvaluation. Low Value: Could mean undervaluation or low growth prospects