Financial Statement Ratios

Let’s take a look at some of the common ratios that are used to analyze financial statements. When comparing profitability, liquidity or solvency from one period to another, it is important to take a look at the following:

Gross Profit Margin (Profitability)

This is a good place to start when analyzing your company’s financial health. Gross profit margin measures the percentage of revenue that is left after subtracting the cost of goods sold. This can be a good indicator of how well your business is selling its products or services. 

• A high gross profit margin indicates that a company is able to generate a lot of profit from its sales.
• A low gross profit margin indicates that a company is struggling to generate profit from its sales.

In other words, the higher the gross margin, the better. When comparing your profitability to another period, remember that the following circumstances will affect your gross profit margin:

• Your business is experiencing different levels of efficiency which can increase or decrease your gross profit margin depending on if you have become more efficient or less efficient.
• You start selling more high-margin products or services which will increase your gross profit margin.
• The cost of your raw materials have increased which will decrease your gross profit margin unless you also increase your cost.

Current Ratio (Liquidity)

Current ratio measures how well your business can pay its short-term obligations. A higher ratio means that your business is in better financial health. To calculate your current ratio, divide your current assets by your current liabilities.

For example, let’s say your business has $10,000 in cash and $5,000 in short-term debt. Your current ratio would be 2 ($10,000/$5,000). Ideally, you want your current ratio to be above 1. This means that you have more assets than liabilities and are in a good position to pay off your debts. A current ratio below 1 means that you have more liabilities than assets and may have trouble paying off your debts.

It is important to compare apples to apples when looking at different periods. This ensures that either increasing your current assets or decreasing your current liabilities is feasible for both periods you are comparing; otherwise, your analysis will look skewed. 

Debt-to-Equity (Solvency)

Debt-to-equity measures the amount of debt that your business has compared to its equity. This ratio is important because it shows how much debt your business has compared to its assets. A higher ratio indicates that your business is more leveraged and may be at greater risk of financial difficulties. (Creditors or investors typically prefer businesses with lower debt-to-equity ratios because they are seen as being less risky.)

When comparing your debt-to-equity to another period, keep in mind that it can be affected by changes in accounting standards. For example, if your company adopts a new accounting standard that requires it to recognize more debt on its balance sheet, the debt-to-equity ratio will increase.

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At the office of Wayne W. Stanforth, CPA, we offer a wide range of tax and accounting services including GAAP-compliant financial statement preparation, attestation, and personalized financial analyses. Contact us for a free one-hour initial consultation to learn more about getting the most out of your finances.