Analyzing Financial Reports with Ratios
Manila reports have lots of numbers in them. (Duh!) The significance of many of these numbers is not clear unless they are compared with other numbers in the financial statements to determine the relative size of one number to another number. One very useful way of interpreting financial reports is to compute ratios – that is, to divide a particular number in the financial report by another. Financial report ratios are also useful because they enable you to compare a business’s current performance with its past performance or with another business’s performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business.
Gross margin ratio
Making bottom-line profit begins with making sales and earning enough gross margin from those sales. In other words, a business must set its sales prices high enough over product costs to yield satisfactory gross margins on its products, because the business has to worry about many more expenses of making sales and running the business, plus interest expense and income tax expense. You calculate the gross margin ratio as follows:
Gross margin ÷ sales revenue = gross margin ratio
Business is motivated by profit, so the profit ratio is very important to say the least. The profit ratio indicates how much net income was earned on each £100 of sales revenue:
Net income ÷ sales revenue = profit ratio
Net income ÷ sales revenue = profit ratio
For example, the business earned £1.9 million net income from its £52 million sales revenue, so its profit ratio is 3.65 per cent, meaning that the business earned £3.65 net income for each £100 of sales revenue.
Earnings per share, basic and diluted
Publicly owned businesses, according to generally accepted accounting principles (GAAP), must report earnings per share (EPS) below the net income line in their profit and loss accounts – giving EPS a certain distinction among the ratios. Why EPS is considered so important? Because it gives investors a means of determining the amount the business earned on their share investments: EPS tells you how much net income the business earned for each share you own. The essential equation for EPS is as follows:
Net income ÷ total number of capital stock shares = EPS
Price/earnings (P/E) ratio
The price/earnings (P/E) ratio is another ratio that’s of particular interest to investors in public businesses. The P/E ratio gives you an idea of how much you’re paying in the current price for the shares for each pound of earnings, or net income, being earned by the business. Remember that earnings prop up the market value of shares, not the book value of the shares that’s reported in the balance sheet. (Read on for the book value per share discussion.)
The dividend yield tells investors how much cash flow income they’re receiving on their investment. (The dividend is the cash flow income part of investment return; the other part is the gain or loss in the market value of the investment over the year.)
Return on equity (ROE) ratio
The return on equity (ROE) ratio tells you how much profit a business earned in comparison to the book value of shareholders’ equity. This ratio is useful for privately owned businesses, which have no way of determining the current value of owners’ equity (at least not until the business is actually sold). ROE is also calculated for public companies, but, just like book value per share, it plays a secondary role and is not the dominant factor driving market prices. (Earnings are.) Here’s how you calculate this key ratio:
Net income ÷ owners’ equity = ROE
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