By themselves, financial statements tell you quite a bit: how much profit the company made, where it spent its money, how large its debts are. But how do you interpret all the numbers these statements provide? For example, is the company's profit large or small? Is the level of debt healthy or not?
Ratio analysis provides a means of digging deeper into the information contained in the three financial statements. A financial ratio is two key numbers from a company's financial statements expressed in relation to each other. The ratios that follow are relevant across a wide spectrum of industries but are most meaningful when compared against the same measures for other companies in the same industry.
These measurements evaluate a company's level of profitability by expressing sales and profits as a percentage of various other items.
- Return on assets (ROA). ROA provides a quantitative description how well a company has invested in its assets. To calculate ROA, divide net income by total assets.
- Return on equity (ROE). ROE shows the return on the portion of the company's financing that is provided by owners. To calculate ROE, divide net income by owners' equity.
- Return on sales (ROS). Also known as net profit margin, ROS is a way to measure how sales translate into bottom-line profit. For example, if a company makes a profit of $10 for every $100 in sales, the ROS is 10/100, or 10 percent. To calculate ROS divide net income by the revenue.
- Gross Profit Margin. A ratio that measures the percentage of gross profit relative to revenue, gross margin reflects the profitability of the company's products or services.
- Earnings before interest and taxes. (EBIT) margin. Many analysts use this indicator, also known as operating margin, to see how profitable a company's operating activities are. To calculate EBIT margin, divide operating profit by revenue.
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