Common Ratios to Evaluate Annual Financial Statements

Introduction

Ratios are the quantitative measurements that have been derived by dividing one particular financial figure by another. Ratios are used to measure the performance and financial position of a business. They provide users and investors with an insight into an organization’s trends over a period of time from the financial statements of the organization.

Evaluating financial ratios is an important part of the financial analysis process. With the help of these ratios, stakeholders can gain insight into an organization’s operations, solvency, profitability, and overall efficiency.

In this article, we will discuss the most common ratios used to evaluate annual financial statements. These ratios include operating margin, debt-to-equity ratio, return on assets, net profit margin, and liquidity ratio.

Current Ratio

The current ratio is one of the most commonly used financial ratios to evaluate an organization’s annual financial statements. This ratio measures the liquidity health of the organization and reveals its ability to pay short-term debts and liabilities.

Definition

The current ratio is a financial metric used to measure the liquidity of an organization. It is calculated by dividing the organization’s current assets by current liabilities. The higher the current ratio, the greater the organization’s ability to reach its short-term financial obligations.

Formula

The formula to calculate the current ratio is shown below:

• Current Ratio = Current Assets / Current Liabilities

Benefits

The current ratio is an important financial indicator to assess the overall financial health of the organization. It provides a measure of the organization’s liquidity and ability to pay short-term debts and obligations. It also gives lenders and potential investors an indication of the organization’s short-term financial position.

Calculation Example

Let’s assume that an organization has current assets amounting to $200,000 and current liabilities amounting to $100,000. To calculate the current ratio, we would divide the current assets ($200,000) by the current liabilities ($100,000). The result of this calculation would be 2.0, which implies that the organization has sufficient liquidity to pay its short-term debts and liabilities.

Quick Ratio

The quick ratio, also known as the acid test ratio, is a financial liquidity ratio that measures a company’s ability to meet its short-term obligations with liquid assets. Liquid assets are defined as cash and cash equivalents, marketable securities, and receivables – i.e., assets that can quickly be converted into cash. Unlike the current ratio which considers inventory, the quick ratio only considers liquid assets.

Definition

The quick ratio is a metric used to measure how well a company can pay back short-term debt by using assets that can easily be converted into cash. The quick ratio is calculated by dividing the sum of cash, cash equivalents, and marketable securities by the total current liabilities.

Formula

The formula for the quick ratio is as follows:

• Quick Ratio = (Cash + Cashequivalents + Marketable Securities) ÷ Total Current Liabilities.

Benefits

The quick ratio is a strong indicator of a company’s financial health. It shows how well a company can maintain its current financial obligations without needing to turn to inventory or long-term investments. Some of the benefits of the quick ratio include:

• It provides a more accurate measurement of a company’s financial health than the current ratio.
• It signals how well a company can pay back short-term debt.
• It can help investors and creditors determine the financial risk associated with investing in or lending to a company.

Calculation Example

Let’s assume a company has the following assets and liabilities:

• Cash: $2,000
• Cash equivalents: $4,000
• Receivables: $8,000
• Total current liabilities: $8,000

The quick ratio can be calculated as follows:

• Quick Ratio = ($2,000 + $4,000 + $8,000) ÷ $8,000 = 1.50

In this case, the quick ratio of 1.50 indicates that the company has enough liquid assets to cover its short-term liabilities 1.50 times. This is considered a healthy financial position and is desirable for companies.

Debt-to-Equity Ratio

The debt-to-equity ratio is one of the most important financial ratios used to evaluate the financial position of a company. It measures the company’s ability to pay its long-term debt obligations with the equity ownership of the company’s shareholders.

Definition

The debt-to-equity ratio is defined as the total amount of debt divided by the total amount of equity. It is used to measure the overall financial leverage of a company. If the company’s debt-to-equity ratio is high, it means that the company is highly leveraged and has a greater risk of financial distress.

Formula

The debt-to-equity ratio can be calculated by dividing the company’s total liabilities by its total shareholders’ equity. The formula for calculating the debt-to-equity ratio is:

• Debt-to-Equity Ratio = Total Liabilities/Total Shareholders’ Equity.

Benefits

The debt-to-equity ratio is a valuable tool for investors, creditors and potential investors to gauge the overall financial health of a company. A low debt-to-equity ratio typically indicates that the company has a sound financial position and is better positioned to withstand economic downturns.

Calculation example

For example, if a company has total liabilities of $4 million and total shareholders’ equity of $2 million, then the debt-to-equity ratio is:

• Debt-to-Equity Ratio = $4 million / $2 million = 2.0.

This means that the company is highly leveraged and has a significantly higher risk of financial distress.

Return on Equity Ratio

Return on equity ratio is a commonly used financial ratio used to identify the profitability of a company. It is also known as the return on net worth ratio and is used to assess the effectiveness of management in utilizing the shareholders' funds to generate profits.

Definition

Return on Equity (ROE) is a financial ratio that measures the amount of net income a company generates compared to the equity that its shareholders have invested.

Formula

Return on Equity is calculated by dividing a company's net income by its total equity:

• ROE = Net Income / Total Equity

Benefits

Return on equity ratio provides a quick evaluation of how efficiently a company is using its shareholders’ funds. A higher ROE suggests that a company has a higher level of efficiency. It also helps to identify if the company is underutilizing their resources or is over-investing in their capital structure.

Calculation Example

Let’s say a company has a reported net income of $2,500 and an equity of $10,000. So, the return on equity ratio of the company will be 2,500/10,000 or 25%. This means that the company has made 25% return on the shareholders’ funds.

Gross Profit Margin Ratio

Gross Profit Margin Ratio is a useful tool for investors and business owners to measure the profitability of their business. This ratio expresses the percentage of gross profit that a business obtains from each dollar of sale.

Definition

Gross profit margin ratio, also known as gross margin ratio, is used to measure the financial health of a company. It is the ratio of total revenue of a business, minus the cost of goods sold, divided by total revenue.

Formula

The formula is as follows:

• Gross Profit Margin Ratio = (Total Revenue - Cost of Goods Sold) / Total Revenue

Benefits

It is a good measure of a company's profitability, and can be used to compare different businesses. It is also used to evaluate the performance of a company over different periods of time.

Calculation Example

For example, if a business has total revenue of $10,000 and cost of goods sold is $8,000, then its gross profit margin ratio is (10,000 - 8,000) / 10,000, or 20%.

Conclusion

Financial reporting is a crucial process for businesses of all sizes. As such, it is essential to evaluate financial statements and ensure accurate information is being presented. To get the most out of financial statements, it is important to understand common ratios that can be used to assess the performance of a business.

Annual financial statements provide the primary source of reliable financial data. Ratios can be used to assess whether a company is performing well and to compare performance with other similar companies. Common ratios such as current ratio, quick ratio, debt-to-equity ratio, return on assets, and others provide insights into the financial health of a business.

By utilizing ratio analysis, businesses can get useful insights from annual financial statements and make informed decisions about the future of their company. Ratios are powerful tools for evaluating financial statements and making informed decisions about the direction of a business.