Beginners' Guide to Financial Statements

Financial Statement Ratios and Calculations

You’ve probably heard people banter around phrases like “P/E ratio,” “current ratio” and “operating margin.” But what do these terms mean and why don’t they show up on financial statements? Listed below are just some of the many ratios that investors calculate from information on financial statements and then use to evaluate a company. As a general rule, desirable ratios vary by industry.

• Debt-to-equity ratio compares a company’s total debt to shareholders’ equity. Both of these numbers can be found on a company’s balance sheet. To calculate debt-to-equity ratio, you divide a company’s total liabilities by its shareholder equity, or

  Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity

  If a company has a debt-to-equity ratio of 2 to 1, it means that the company has two dollars of debt to every one dollar shareholders invest in the company. In other words, the company is taking on debt at twice the rate that its owners are investing in the company.

• Inventory turnover ratio compares a company’s cost of sales on its income statement with its average inventory balance for the period. To calculate the average inventory balance for the period, look at the inventory numbers listed on the balance sheet. Take the balance listed for the period of the report and add it to the balance listed for the previous comparable period, and then divide by two. (Remember that balance sheets are snapshots in time. So the inventory balance for the previous period is the beginning balance for the current period, and the inventory balance for the current period is the ending balance.) To calculate the inventory turnover ratio, you divide a company’s cost of sales (just below the net revenues on the income statement) by the average inventory for the period, or

  Inventory Turnover Ratio = Cost of Sales / Average Inventory for the Period

  If a company has an inventory turnover ratio of 2 to 1, it means that the company’s inventory turned over twice in the reporting period.

• Operating margin compares a company’s operating income to net revenues. Both of these numbers can be found on a company’s income statement. To calculate operating margin, you divide a company’s income from operations (before interest and income tax expenses) by its net revenues, or

  Operating Margin = Income from Operations / Net Revenues

  Operating margin is usually expressed as a percentage. It shows, for each dollar of sales, what percentage was profit.

• P/E ratio compares a company’s common stock price with its earnings per share. To calculate a company’s P/E ratio, you divide a company’s stock price by its earnings per share, or

  P/E Ratio = Price per share / Earnings per share

  If a company’s stock is selling at $20 per share and the company is earning $2 per share, then the company’s P/E Ratio is 10 to 1. The company’s stock is selling at 10 times its earnings.

   

• Working capital is the money leftover if a company paid its current liabilities (that is, its debts due within one-year of the date of the balance sheet) from its current assets.

  Working Capital = Current Assets – Current Liabilities

   

http://www.sec.gov/investor/pubs/begfinstmtguide.htm