How to Read and Interpret Financial Statements
KEY POINTS
Ratios provide unique and valuable insights into a company’s financial statements
There are 5 major types of ratios – we could only squeeze 26 ratios into this post
Ratios are a key tool for comparing a company against its industry peers
Do not forgot to read the Notes to the Financial Statements
What are financial statements - a recap?
In our recent post What are Financial Statements?, we provided an overview of the four main financial statements:
Balance Sheet
Statement of Retained Earnings
Income Statement
Statement of Cash Flows
We invite you to click the link above to read a more detailed description of the following summary of each financial statement.
Balance Sheet
The balance sheet reports the assets owned, liabilities owed, and the equity of the entity as at a specific date. The assets and liabilities can be split between current and long-term. Current assets can be converted into cash within one year and current liabilities are due within one year. All other assets and liabilities are classified as long-term.
Statement of Retained Earnings
The statement of retained earnings shows the entity’s cumulative and current earnings.
Income Statement
The income statement shows the entity’s financial results for a given period (e.g., monthly, quarterly, semi-annual, and annual).
Statement of Cash Flows
The statement of cash flows shows the entity’s cash flows during the period related to operating, investing, and financing activities.
Notes to the Financial Statements
We did not discuss the notes to the financial statements in our previous post. It is essential that we consider the notes in this post as they are of critical importance to the users of the financial statements when interpreting the financial data.
The notes provide users of the financial statements with an understanding of the assumptions and accounting policies relied upon when making estimates within the financial statements. They also provide a more detailed understanding of specific balances and transactions that occurred during the period.
More on notes to the financial statements later in this post.
Financial Statements
We will reference the following set of financial statements throughout the remainder of this article.
General Financial Statement Observations
A basic review of the financial statements can yield some limited results.
For example, in the balance sheet above, accounts receivable increased and such seems plausible as revenue increased. Similarly, taxes payable increased and such seems plausible as income before taxes also increased.
However, these insights provide very limited information to the users of the financial statements. Even if such provided some level of value from a company specific perspective, such provides limited meaningful data for comparison against industry peers.
This brings us to the concept of using financial statement ratios to better understand a specific company and how such company compares to its peers and competition.
Financial Statement Ratios
Financial statement ratios quantify the relationship between various parts of the financial statements. Some ratios may focus on elements of a single financial statement, while other ratios will incorporate elements from more than one financial statement.
These types of ratios allow users of the financial statements (e.g., management, board of directors, shareholders, investors, banks, regulatory bodies) to assess the financial health of the company and compare it against its competitors and other industries. Charting such ratios over multiple periods provides the opportunity to spot trends, strengths, weaknesses, and opportunities.
5 Categories of Financial Statement Ratios
There is a near endless list of ratios derived from financial statements. We have grouped the ratios into 5 distinct categories. We have focused primarily on ratios that are derived solely from the financial statements. However, we have included some that reference non-financial statement data (e.g., Dividend Yield is a function of Dividend per Share and the company’s Share Price).
The 5 ratio categories are:
Liquidity and Efficiency Ratios
The financial statements above generate current ratios equal to:
2022 5.2 = (310,000 / 60,000)
2021 3.0 = (195,000 / 65,000)
The current ratio measures a company’s ability to service short-term (i.e., less than 1 year) liabilities. The average current ratio will vary by industry. However, a ratio of less than 1 indicates a potentially higher risk of default. A ratio of 1 or slightly higher is considered ideal. A ratio substantially higher than 1 may indicate underutilized assets (e.g., higher than normal cash balances) that could be better deployed as reinvestment, research and development, dividends, or a share buyback.
The financial statements above generate quick ratios equal to:
2022 3.8 = ((310,000-80,000) / 60,000)
2021 2.7 = ((195,000-20,000) / 65,000)
The quick ratio is a modification of the current ratio. The quick ratio provides a better measurement of short-term liquidity as it focuses on a company’s most liquid assets by removing inventory from the numerator. Inventory is less liquid than many current assets such as cash, cash equivalents, marketable securities, accounts receivable, and other similar balances. You may also choose to remove prepaid expenses as such cannot be readily converted into cash, if at all, and utilized to service current liabilities.
The financial statements above generate cash ratios equal to:
2022 2.3 = (140,000 / 60,000)
2021 1.9 = (125,000 / 65,000)
The cash ratio is more conservative than the current ratio and quick ratio highlighted above as it only considers a company’s most highly liquid assets and excludes items such as accounts receivable, prepaids, inventory, equities, options, etc.
The financial statements above generate inventory turnover ratios equal to:
2022 16.6 = (830,000 / 50,000)
2021 Insufficient data
The inventory turnover ratio calculates how many times a company turns over its inventory during the period (typically calculated on an annual basis). The resulting ratio indicates how efficient the company utilizes its inventory. A higher turnover rate indicates a more efficient inventory utilization rate, whereas a low turnover rate indicates a less efficient utilization rate.
A high turnover rate may be the result of strong sales and good inventory management. A low turnover rate may be the result of weak sales, seasonality, and poor inventory management. Management must guard against excess inventory levels as such are costly to maintain and could lead to obsolete inventory.
The financial statements above generate days sales in inventory ratios equal to:
2022 22.0 = (365 / 16.6)
2021 Insufficient data
The days sales in inventory ratio is an extension of the inventory turnover ratio described above. It calculates the average number of days it takes a company to sell its inventory. A lower ratio indicates the inventory moves quickly, the inventory on-hand is less likely to be obsolete, and it is more liquid which supports improved cash flows.
The financial statements above generate asset turnover ratios equal to:
2022 1.6 = (1,380,000 / 867,500)
2021 Insufficient data
The asset turnover ratio measures how efficient a company is at utilizing its assets to generate revenue. The ratio can experience skewed year-to-year comparisons resulting from the significant purchase or sale of assets in a given year as well as changes in accounting policy.
The financial statements above generate accounts receivable turnover ratios equal to:
2022 19.7 = (1,380,000 / 70,000)
2021 Insufficient data
The accounts receivable turnover ratio measures how efficient a company collects outstanding balances from its customers and how many times the accounts receivable balance is converted into cash during the period.
The financial statements above generate receivable collection period ratios equal to:
2022 18.5 = (70,000 * 365 / 1,380,000)
2021 Insufficient data
The receivable collection period is a key liquidity and operational metric that measures how long it takes a company to collect its outstanding accounts receivable balances from its customers. A lower collection period will improve a company’s liquidity and cash flows. Management can use this metric as one input into their decision-making process related to credit terms (e.g., discounts offered for early receipt of payment from customers).
The financial statements above generate average days payable ratios equal to:
2022 13.2 = (30,000 * 365 / 830,000)
2021 Insufficient data
The average days payable is a key liquidity and operational metric that measures how long it takes a company to pay its vendors. Management needs to balance the company’s liquidity needs against maintaining strong relationships with its vendors. Vendors will often provide discounts to incentivize their customers to pay in a timely manner (e.g. 2% discount if the invoice is paid in full within 10 days).
Leverage Ratios
The financial statements above generate debt to assets ratios equal to:
2022 20% = (180,000 / 900,000)
2021 24% = (195,000 / 835,000)
The debt to assets ratio measures the percentage of assets owned by creditors. A higher ratio indicates increased leverage and usually an increased level of risk. However, increased leverage does not always translate to increased risk. The average debt to asset ratio can vary widely across industries.
For example, some industries are very capital intensive and require high debt levels; however, they may produce above average cash flows that are stable and recurring. As with all ratios, you must consider the company’s unique ratios and related trends and then compare such to its industry peers.
The financial statements above generate debt to equity ratios equal to:
2022 25% = (180,000 / 720,000)
2021 31% = (195,000 / 640,000)
The debt-to-equity ratio measures the degree a company finances it operations through third parties as opposed to its own resources (e.g., capital raise, cumulative profitability). Like the debt to asset ratio above, a higher ratio indicates increased leverage and usually an increased level of risk. A below average ratio may indicate an opportunity to increase leverage and expand operations. Interpretation of the ratio must be viewed in context against industry peers.
The financial statements above generate interest coverage ratios equal to:
2022 25.0 = ((120,000+5,000) / 5,000)
2021 17.7 = ((100,000+6,000) / 6,000)
The interest coverage ratio measures a company’s ability to service the interest on its outstanding debt. A higher ratio indicates the company can service the interest on its debt and the company may be of lower risk than the average of its peers: again, average ratios vary by industry.
However, this ratio does not address the company’s ability to service the principal payments associated with such outstanding debt. The following debt service coverage ratio incorporates the need to cover principal repayment.
The financial statements above generate interest coverage ratios equal to:
2022 25.0 = ((120,000+5,000) / 5,000)
2021 17.7 = ((100,000+6,000) / 6,000)
The debt service coverage ratio measures a company’s ability to service its principal and interest payments on its outstanding debt. A ratio below 1 indicates an inability of the company to meet its current debt servicing requirements. Such could be a leading indicator of the company’s potential insolvency and could eliminate the company’s ability to obtain future financing. A ratio of 1:1 indicates a breakeven scenario that may not be sustainable in the long-term.
Profitability Ratios
The financial statements above generate return on equity ratios equal to:
2022 11.8% = (80,000 / 680,000)
2021 11.6% = (70,000 / 605,000)
The return on equity ratio measures a company’s profitability in relation to its shareholders. This ratio is of key interest to stakeholders as the ratio can be very useful when comparing a company against its peers in the same industry. The ratio does not include the company’s creditors.
Let’s look at the return on capital ratio next as it incorporates the company’s debt.
The financial statements above generate return on capital ratios equal to:
2022 13.9% = (125,000 / 900,000)
2021 12.7% = (106,000 / 835,000)
The return on capital ratio measures a company’s ability to generate a return its total capital. This calculation includes both shareholders’ equity and debt.
The financial statements above generate gross margin ratios equal to:
2022 39.9% = (550,000 / 1,380,000)
2021 38.5% = (500,000 / 1,300,000)
The gross margin ratio measures a company’s gross profit compared to its net sales. Gross profit is calculated as Net Sales less Cost of Goods Sold. Such excludes indirect costs such as selling, marketing, general and administrative expenses, interest, and taxes. Management must remain focused on gross margin as fluctuations can be caused by multiple factors simultaneously (e.g., labor hours, labor rate, cost of materials, equipment, efficiencies, etc.).
The financial statements above generate net profit margin ratios equal to:
2022 5.8% = (80,000 / 1,380,000)
2021 5.4% = (70,000 / 1,300,000)
The net profit margin ratio measures net income as a percentage of net sales. It is critical for management to be able to produce reasonably accurate forecasts of sales and related profitability. Negative trends in the ratio may indicate poor pricing power of products and services, or excessive costs related to cost of goods sold, selling, marketing, administrative, and interest.
The financial statements above generate return on assets ratios equal to:
2022 9.2% = (80,000 / 867,500)
2021 Insufficient data
The return on assets ratio measures how profitable the company is with respect to its total assets. Asset efficiency increases as the ratio increase as the company is able to generate more income for a given asset base.
Cash Flow Ratios
The financial statements above generate operating cash flows ratios equal to:
2022 25.0% = (45,000 / 180,000)
2021 69.2% = (135,000 / 195,000)
The operating cash flows ratio measures how many times a company can pay off its debts in a period. This can be a valuable tool when assessing a company’s liquidity. A low ratio may be cause for concern from an operational perspective or it may indicate other factors are impacting the ratio: for example, recent financing to invest in capital projects would increase total liabilities and result in a lower ratio than historically experienced.
The key is to not look at one ratio in isolation, but to gain a robust insight into the company through interpretation of various related ratios.
The financial statements above generate current liability coverage ratios equal to:
2022 75.0% = (45,000 / 60,000)
2021 207.7% = (135,000 / 65,000)
The current liability coverage ratio is like the operating cash flow ratio above; however, this ratio measures the company’s ability to pay its current liabilities as opposed to total liabilities.
The financial statements above generate cash flow margin ratios equal to:
2022 3.2% = (45,000 / 1,380,000)
2021 10.4% = (135,000 / 1,300,000)
The cash flow margin ratio measures a company’s operation cash flow a percentage of sales. The ratio allows users to assess profitability and the potential for future growth.
The price to cash flow ratio is the first ratio on this list that utilizes data not contained in the financial statements (i.e., market capitalization). Shareholders prefer a lower ratio as such would indicate they are paying a lower amount for each dollar of cash flow. A ratio lower than the industry average would indicate the company is undervalued from a cash flow perspective (such is only one measurement of valuation).
This ratio can also be calculated by replacing market capitalization with the per share stock price, and by replacing the cash flow from operations with per share operating cash flow.
Market Value Ratios
The book value per share ratio focuses solely on the common shareholders. Therefore, the preferred share balance is excluded from the calculation. A negative book value would indicate insolvency and potential bankruptcy on the horizon.
Book value may be lower than the company’s liquidation value as some assets may be accounted for at their historical prices that may be lower than their market values.
It is possible for a company’s stock price to drop below its book value. Such may provide investors the opportunity to buy shares in the company at an effectively discounted price.
Company’s may elect at their discretion to pay dividends to their shareholders. The dividend yield illustrates the dividends paid as a percentage of the share price.
Shareholders expect the company to maximize the value of their shareholdings. Therefore, management seeks growth opportunities through research and development, technologies, new business lines, mergers, acquisitions, etc.
In the absence of such growth opportunities, a company may consider paying excess earnings to shareholders in the form of dividends.
Many companies will balance investing in growth opportunities with the consistent payment of annual dividends. Such dividends provide shareholders with a steady income stream which may be highly sought-after during times of market volatility.
The earnings per share ratio divides the company’s profit by its number of outstanding shares. This ratio can show a valuable trendline when tracked monthly, quarterly, annually.
The price earnings ratio divides the company’s share price by its earnings per share (see previous ratio calculation).
This price earnings ratio is quoted for all publicly listed companies. Investors can use this ratio as one measurement of a company’s stock price compared to its industry peers and the stock market at large.
Notes to the Financial Statements
Financial statement ratios are a great tool for analyzing and comparing a company’s financial statements. However, the notes to the financial statements can be critical in understanding what lies beneath the face of the balances reported.
Before we highlight some of the key disclosures that may be contained in the notes, we need to highlight that not all financial statements will contain notes. We have listed the 5 main types of financial statement reporting in descending order of disclosure,
Internal management statements
The company’s annual report will contain comprehensive notes as well as extensive management discussion and analysis. Whereas internal financial statements prepared by management will not contain notes or any other supporting commentary.
The notes will disclosure which accounting standard the financial statements have been prepared in accordance with. Such may vary by country and include, but are not limited to, International Financial Reporting Standards, Generally Accepted Accounting Principles, and Accounting Standards for Private Enterprise. Each standard has its own unique aspects that dictate how specific balances and transactions need to be recorded.
The accounting standard utilized will dictate the accounting policies adopted by management and reflected in the financial statements. Any material change in accounting policy would be disclosed and can be critical to your use of the financial statement ratios referenced above.
Management will also disclose the following, if applicable:
Material assumptions utilized when making estimates
Prior period adjustments
Stock option compensation details
Exposure to on-going or potential legal action
Subsequent events
Going concern issues, if any
You should never ignore the notes to the financial statements. They can be a powerful tool when combined with the ratio analysis described above.
Bottom Line
This post introduces the role of ratios in the interpretation of financial statements. A single ratio should never be used in isolation. As illustrated above, a single variable (e.g., total asset, net income, etc.) can be utilized in multiple ratio calculations. Ratios become a valuable source of information when they are compared against their industry peers as each industry will have its own unique profile of average ratios.
