Whether you're a financial professional or an investor, analyzing financial statement information is crucial. But there are so many different numbers that it can seem cumbersome and very intimidating to wade through it all. But if you know what some of the more important figures on these statements are—like financial ratios—you'll probably be on the right track.
The following financial ratios are derived from common income statements and used to compare different companies within the same industry. There are other ratios that are gleaned from an income statement, though the ones below represent some of the most common.
Key Takeaways
- Financial ratios are used to compare companies within the same industry.
- These ratios are derived from income statements.
- Some of the most common ratios include gross margin, profit margin, operating margin, and earnings per share.
- The price per earnings ratio can help investors determine how much they need to invest in order to get one dollar of that company's earnings.
Gross Margin
Gross margin represents how much of a company's sales revenue it keeps after incurring anydirect costsassociated with producing its goods and services. This ratio is, therefore, the percentage of sales revenue available for profit or reinvestment after the cost of goods sold (COGS) is deducted. So if a company has a gross margin of 40%, that means it keeps 40 cents for every dollar it makes. It uses the remainder on operating expenses.
Gross margin can be calculated in two ways—by dividing gross profit by net sales or by subtracting the COGS from the company's net sales.
Financial ratios are used to analyze different categories including company debt, liquidity, and profitability.
Profit Margin
A profit margin ratio is one of the most common ratios used to determine the profitability of a business activity. It shows the profit per sale after all other expenses are deducted. Furthermore, it indicates how many cents a company generates in profit for each dollar of sale. So if Company X reports a 35% profit margin, that means its net income was 35 cents for every dollar generated.
In order to figure out the profit margin, you need to divide net income after tax by net sales.
Operating Margin
A company's operating margin equals operating income divided by net sales. This is used to show how much revenue is left over after paying variable costs such as wages and raw materials. It is the same as the company's return on sales, and indicates how well that return is being managed.
Earnings Per Share
This is one of the most widely cited ratios in the financial world. The result of net income less dividends on preferred stock—which is then divided by average outstanding shares—earnings per share is a crucial determinant of the price of a company's shares because of its use in calculating price-to-earnings.
A higher EPS means more value, as investors are more likely to pay for a company that has higher profits.
Many investors look at earnings per share as a way to determine which stocks they favor by comparing the ratio with the share price. This helps them find out the value of earnings, giving them an idea of a company's future growth.
Price-Earnings Ratio
The price-earnings, or P/E ratio, is calculated by taking market value per share divided by earnings per share. This is one of the most widely used stock valuations and generally shows how much investors pay per dollar of earnings. Simply put, this ratio tells an investor how much he needs to invest in a company in order to receive one dollar of that company's earnings. For this reason, it's often called the price multiple.
If a company has a high P/E ratio, that may mean its share price is high relative to earnings, potentially making it overvalued. A low P/E, on the other hand, may indicate its stock price is low relative to its earnings.
Times Interest Earned
Times interest earned (TIE) is an indication of a company's ability to meet debt payments. Divide earnings before interest and taxes, or EBIT, by total annual interest expenses and get the times interest earned ratio.
Return on Stockholders' Equity
Return on equity is another critical valuation for shareholders and potential investors and can be calculated by dividing net income after taxes by weighted average equity, though there are several other variations. This indicates the percentage of profit after taxes that the corporation earned.
