Financial statements provide a snapshot of a corporation's financial health at a particular point in time, giving insight into its performance, operations, cash flow, and overall conditions. Shareholders need them to make informed decisions about their equity investments, especially when it comes time to vote on corporate matters.
There are a variety of tools shareholders have at their disposal to make these equity evaluations. In order to make better decisions, it is important for them to analyze their stocks using a variety of measurements, rather than just one or two. Some of the metrics available to them include profitability ratios, liquidity ratios, debt ratios, efficiency ratios, and price ratios.
Profitability ratios are a group of financial metrics that show how well a company generates earnings compared to its associated expenses. However, investors should take care not to do a general comparison. Instead, they will get a better sense of how well a company is doing by comparing ratios of a similar period. For example, comparing the fourth quarter of this year with the same quarter from last year will net a better result.
Return on equity, or ROE, is a common profitability ratio used by many investors to calculate a company's ability to generate income from shareholders' equity or investments. The higher the return, the better the company's performance.
Operating profit margin is another important metric for evaluating the efficiency of a company's financial management. Also referred to as operating income, it can measure how well the company answers to its investors and creditors. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders and taxes.
The most commonly used liquidity ratio is the current ratio, which reflects current assets divided by liabilities, giving shareholders an idea of the company's efficiency in using short-term assets to cover short-term liabilities. Higher current ratios are a good indication the company manages its short-term liabilities well.
The current ratio generally measures if a company can pay its debts within a 12-month period. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.
Debt ratios indicate a company’s debt situation. The debt-to-equity ratio measures how much financial leverage a company has — a calculation of total liabilities divided by stockholder equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt.
The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt. A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses.
Efficiency ratios show how well companies manage assets and liabilities internally. They measure the short-term performance of a company, and whether it can generate income using its assets.
The inventory or asset turnover ratio reveals the number of times a company sells and replaces its inventory in a given period. The results from this ratio should be used in comparison to industry averages. Low ratio values indicate low sales and excessive inventory, and therefore, overstocking. High ratio values commonly indicate strong sales.
Price ratios focus specifically on a company's stock price and its perceived value in the market. The price/earnings (or P/E) ratio is an evaluation metric comparing the current share price of a company’s stock with its per-share earnings. Higher P/E values indicate investors expect continued future growth in earnings. The P/E ratio is most helpful when compared to historical P/E values of the same company, those of companies in the same industry or to the market in general. The dividend yield ratio shows the amount in dividends a company pays out yearly in relation to its share price. Essentially, the dividend yield ratio is a measurement for the amount of cash flow received for each dollar invested in equity.
The Bottom Line
There is no one indicator that can adequately assess a company's financial position and potential growth. That is why financial statements are so important for shareholders and market analysts alike. These metrics (along with many others) can be calculated using the figures released by a company on its financial statements.