How to Read Financial Statements with Ratios
Instead of actually reading your way through the financial statements — that is, carefully digesting every line reported in all the financial statements — one approach is to compute certain ratios to extract the main messages from the financial statements.
You read financial statements by computing a relatively few ratios instead of a line-by-line probing of the financial statements. Many financial report readers go directly to ratios and don’t bother reading all the lines in the financial statements. In fact, five to ten ratios can tell you a lot about a business.
Financial statement ratios are also useful because they enable you to compare a business’s current performance with its past performance or with 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 other words, using ratios cancels out size differences.
Surprisingly, you don’t find too many ratios in financial reports. Publicly owned businesses are required to 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 demand that any ratios be reported (except EPS for publicly owned companies). However, you still see and hear about ratios all the time, especially from stockbrokers and other financial professionals, so you should know what the ratios mean, even if you never go to the trouble of computing them yourself.
Ratios do not provide final answers — they’re helpful indicators, and that’s it.
For example, if you’re in the market for a house, you may consider cost per square foot (the total cost divided by total square feet) as a way of comparing the prices of the houses you’re looking at. But you have to put that ratio in context: Maybe one neighborhood is closer to public transportation than another, and maybe one house needs more repairs than another.
In short, the ratio isn’t the only factor in your decision.