While analyzing a case study and looking at the financial statements in the case, I asked myself how can I determine if this company is viable from the financial statements? Then I remembered a question in the Accounting exam during the Brush up about Current ratio. It was like a light bulb came on in my head and it made sense why we have spent quite some time learning about Income statements and Balance Sheets in the CFA course.
You can learn a lot about the overall financial health of a business, more than just profit or loss and gauge the likelihood of whether a business will continue to be viable if you know what to look out for in the financial statements. Financial ratios can help with that and I will be discussing a few here:
Net Profit Margin: measures how much net income is generated as a per cent of revenue received. As an investor, it can help you assess if a company’s management is generating enough profit from its sales and whether operational costs and overheads are being controlled effectively.
Current Ratio: is a liquidity ratio that measures a company’s ability to pay short-term obligations or those obligations that are due within one year i.e. loans. A current ratio of less than one means the company cannot meet its short-term obligations.
Debt to Equity Ratio: is a measure of debt against shareholders equity. Tells investors how much of a company’s operations are financed by shareholders rather than creditors. It’s a plus for companies because shareholders don’t charge interest on the financing they provide. A lower ratio indicates company’s operations are funded by shareholders.
Return on Equity: is a measure of the company’s financial performance. It is a measure of a company’s profitability and how efficient it is in generating profits. Varies by industry/sector.
Return on Assets: measures how much profit a company can generate from its assets. The higher the number, the more efficient the company’s management is at leveraging its assets to generate profit.
Use Financial ratios with discretion as there are norms for different industries. For example, large retail companies like Walmart, Target, TESCO etc. may appear to have a low Current Ratio but it is a norm in that sector. The reason is that their inventory cycle is short (don’t keep inventory for long periods).
Hopefully, this helps someone understand more a bit about Financial statements and the kind of information that can be garnered from them to aid decision making.