Personal Money Management 101

How to Read a Financial Statement : Accounting Ratios

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A number of key accounting ratios can be calculated from the financial statements of a business. These ratios provide an objective summary of the financial health and investment quality of a business.

Remember though that accounting methods vary from one company to another, and also that typical ratio values may vary widely from one sector to another.

These ratios are a useful addition to the investor's toolkit but should not generally be relied upon in isolation. Instead use them within the broader picture of the company's performance and pospects, and your own intangible 'gut' feelings.

The Key Ratios

Earnings per Share = Profit Before Tax / No. of shares in issue

Price-Earnings (PE) ratio = Share Price / Earnings per Share

Yield = Dividend per Share / Share Price

Compare PE ratios with similar stocks within the same market sector. A higher PE ratio indicates a stock is "highly regarded" by the market. A lower PE ratio can indicate a bargain, or a dog!

Price/Sales ratio = Share Price / Sales per Share

The Price/Sales ratio is used for non-profit-making concerns, eg Internet start-ups. The lower the figure, the better.

PEG ratio = PE ratio / Average annual growth of Earnings per Share

A PEG ratio of less than 1 may indicate good value. But avoid using this, or any other single indicator, in isolation.

Current Ratio = Current Assets / Current Liabilities

The Current Ratio indicates how well a business can pay its current debts. A Current Ratio of less than two might be cause for concern.

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Also known as the Acid Test, the Quick Ratio is an even tighter test of how well a business can pay its current debts quickly. The Quick Ratio should be at least one.

Net Asset Value per Share = Net Assets / No. shares in issue

Often Investment Trusts and Real Estate companies trade at a discount,
ie Share Price < Net Asset Value per Share.

Return on Investment = Operating Profit / Owner's equity

Return on Investment (ROI) is one of the best known financial ratios and essentially measures the performance of management. The ROI should be at least as high as other investments of comparable risk.

Inventory Turn Ratio = Turnover / Inventory

The Inventory Turn Ratio indicates how quickly goods are selling. The higher the better.

Receivables Turnover Ratio = Turnover / Debtors

The Receivables Turnover Ratio indicates how quickly the company turns sales into cash. The higher the better. Dividing 365 by the Receivables Turnover Ratio gives the average number of days to collect payment.

Debt-to-Equity Ratio = Total Liabilities / Owners' Equity

The ratio of finance coming from creditors compared to shareholders. The higher the figure, the more shareholders stand to benefit from increased profits; however this also implies increased risk. A ratio exceeding one may be cause for concern.