How To Understand Financial Statements – Basics

Its obvious financial statements have a lot of numbers in them, and at first glance, it can seem unwieldy to read and understand. One way to interpret a financial report is to compute ratios, dividing a particular number in the financial report by another. Financial statement ratios are also helpful because they enable the reader to compare a business’s current performance with its past performance or another business’s performance, regardless of whether sales revenue or net income was bigger or smaller for the other years or the other business. In order words, using ratios can cancel out differences in company sizes.

There aren’t many ratios in financial reports. Publicly-owned businesses must report just one ratio (earnings per share or EPS), and privately-owned businesses generally don’t report any ratios. Generally accepted accounting principles (GAAP) don’t require reporting ratios, except EPS for publicly owned companies.

Ratios don’t provide definitive answers, however. They’re valuable indicators but aren’t the only factor in gauging the profitability and effectiveness of a company.

One ratio that’s a helpful indicator of a company’s profitability is the gross margin ratio. This is the gross margin divided by the sales revenue. Businesses don’t disclose margin information in their external financial reports. This information is considered proprietary and confidential to shield it from competitors.

The profit ratio is critical in analyzing the bottom line of a company. It indicates how much net income was earned on each $100 of sales revenue. A profit ratio of 5 to 10 percent is standard in most industries. However, some highly price-competitive industries, such as retailers or grocery stores, will show only 1 to 2 percent profit ratios.