In the preceding three lessons, we discussed each of the three main financial statements. You learned about the different components of the income statement and how to determine if a company is profitable. We talked about the distinction between assets, liabilities, and shareholders' equity and where to find them on the balance sheet. Finally, we went over the statement of cash flows to figure how much cash a company uses or makes from its operating, investing, and financing activities.

But now that you have this knowledge about each of the financial statements, how do you, as an investor, use it?

In this lesson we'll apply what you've learned so far in a process called financial statement analysis. Financial statement analysis looks to explain, often through financial ratios, the important relationships among the different numbers included in the financial statements. The ultimate goal of financial statement and ratio analysis is to help you interpret the numbers and come up with a clear picture of a company's financial performance and condition.

Before we jump in, we should inform you that the following ratios are for non-financial companies only. Financial companies, such as banks or insurance companies, have unique characteristics. As a result, their financial statements look much different than those of most other companies.

How to Use Financial Ratios

We've touched on some of the ratios mentioned here in earlier lessons, but this lesson will give you a comprehensive look at the most important numbers to key in on. Some ratios can be useful by themselves. Others are completely useless when considered without context. Typically, financial ratios provide the most benefit when they are compared with other identical ratios.

A company's ratios are used comparatively in two main fashions: over time and against other companies. Comparing the same ratios for a firm over time is a great way to identify a company's trends. If certain ratios are steadily improving, it may suggest an improvement in a company's operations or financial situation; conversely, if certain ratios seem to be getting worse, it may highlight some troubling prospects about the firm.

It's also important to compare a company's ratios against those of others in the industry. A company's ratios may be improving over time, but how do they stack up against their peers' ratios? If they aren't as rosy as those of competitors, this may indicate that the company isn't as well positioned or managed as well as other industry players.

At Morningstar, we evaluate many ratios as we perform our analyses. Four of the major types we consider are efficiency, liquidity, leverage, and profitability ratios. As we describe some of the main ratios within each category, we'll discuss what each one attempts to measure and what changes in them may indicate.

Efficiency Ratios

No matter what kind of business a company is in, it must invest in assets to perform its operations. Efficiency ratios measure how effectively the company utilizes these assets, as well as how well it manages its liabilities.

Inventory Turnover. Inventory turnover illustrates how well a company manages its inventory levels. If inventory turnover is too low, it suggests that a company may be overstocking or overbuilding its inventory or that it may be having issues selling products to customers. All else equal, higher inventory turnover is better.

Inventory Turnover = (Cost of Sales) / (Average Inventory)

Accounts Receivable Turnover. The accounts receivable turnover ratio measures how effective the company's credit policies are. If accounts receivable turnover is too low, it may indicate the company is being too generous granting credit or is having difficulty collecting from its customers. All else equal, higher receivable turnover is better.

Accounts Receivable Turnover = Revenue / (Average Accounts Receivable)

Accounts Payable Turnover. You'll notice that the accounts payable turnover ratio uses a liability in the equation rather than an asset, as well as an expense rather than revenue. Accounts payable turnover is important because it measures how a company manages paying its own bills. High accounts payable turnover may be a signal that a firm isn't receiving very favorable payment terms from its own suppliers. All else equal, lower payable turnover is better.

Accounts Payable Turnover = (Cost of Sales) / (Average Accounts Payable)

Total Asset Turnover. Total asset turnover is a catch-all efficiency ratio that highlights how effective management is at using both short-term and long-term assets. All else equal, the higher the total asset turnover, the better.

Total Asset Turnover = (Revenue) / (Average Total Assets)

Liquidity Ratios

In a nutshell, a company's liquidity is its ability to meet its near-term obligations, and it is a major measure of financial health. Liquidity can be measured through several ratios.

Current ratio. The current ratio is the most basic liquidity test. It signifies a company's ability to meet its short-term liabilities with its short-term assets. A current ratio greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues.

Current Ratio = (Current Assets) / Current Liabilities

Quick Ratio. The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and prepaid expenses that may be more difficult to convert to cash. Like the current ratio, having a quick ratio above one means a company should have little problem with liquidity. The higher the ratio, the more liquid it is, and the better able the company will be to ride out any downturn in its business.

Quick Ratio = (Cash + Accounts Receivable + Short-Term or Marketable Securities) / (Current Liabilities)

Cash Ratio. The cash ratio is the most conservative liquidity ratio of all. It only measures the ability of a firm's cash, along with investments that are easily converted into cash, to pay its short-term obligations. Along with the quick ratio, a higher cash ratio generally means the company is in better financial shape.

Cash Ratio = (Cash + Short-Term or Marketable Securities) / (Current Liabilities)

Leverage Ratios

A company's leverage relates to how much debt it has on its balance sheet, and it is another measure of financial health. Generally, the more debt a company has, the riskier its stock is, since debtholders have first claim to a company's assets. This is important because, in extreme cases, if a company becomes bankrupt, there may be nothing left over for its stockholders after the company has satisfied its debtholders.

Debt/Equity. The debt/equity ratio measures how much of the company is financed by its debtholders compared with its owners. A company with a ton of debt will have a very high debt/equity ratio, while one with little debt will have a low debt/equity ratio. Assuming everything else is identical, companies with lower debt/equity ratios are less risky than those with higher such ratios.

Debt/Equity = (Short-Term Debt + Long-Term Debt) / Total Equity

Interest Coverage. If a company borrows money in the form of debt, it most likely incurs interest charges on it. (Money isn't free, after all!) The interest coverage ratio measures a company's ability to meet its interest obligations with income earned from the firm's primary source of business. Again, higher interest coverage ratios are typically better, and interest coverage close to or less than one means the company has some serious difficulty paying its interest.

Interest Coverage = (Operating Income) / (Interest Expense)

Profitability Ratios

How good is a company at running its business? Does its performance seem to be getting better or worse? Is it making any money? How profitable is it compared with its competitors? All of these very important questions can be answered by analyzing profitability ratios.

Gross Margin. You'll recall from our earlier discussion of the income statement that gross profit is simply the difference between a company's sales of goods or services and how much it must pay to provide those goods or services. Gross margin is simply the amount of each dollar of sales that a company keeps in the form of gross profit, and it is usually stated in percentage terms. The higher the gross margin, the more of a premium a company charges for its goods or services. Keep in mind that companies in different industries may have vastly different gross margins.

Gross Margin = (Gross Profit) / (Sales)

Operating Margin. Operating margin captures how much a company makes or loses from its primary business per dollar of sales. It is a much more complete and accurate indicator of a company's performance than gross margin, since it accounts for not only the cost of sales but also the other important components of operating income we discussed in Lesson 301, such as marketing and other overhead expenses.

Operating Margin = (Operating Income or Loss) / Sales

Net Margin. Net margin considers how much of the company's revenue it keeps when all expenses or other forms of income have been considered, regardless of their nature. While net margin is important to take note of, net income often contains quite a bit of "noise," both good and bad, which does not really have much to do with a company's core business.

Net Margin = (Net Income or Loss) / Sales

Free Cash Flow Margin. In Lesson 303, we discussed the concept and importance of free cash flow. The free cash flow margin simply measures how much per dollar of revenue management is able to convert into free cash flow.

Free Cash Flow Margin = (Free Cash Flow) / Sales

Return on Assets (ROA). Return on assets measures a company's ability to turn assets into profit. (This may sound similar to the total assets turnover ratio discussed earlier, but total assets turnover measures how effectively a company's assets generate revenue.)

Return on Assets = (Net Income + Aftertax Interest Expense) / (Average Total Assets)

You'll notice that we are adding back the company's aftertax interest expense to net income in the calculation. Why is that? Return on assets measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.

Why are we adding interest back in on an "aftertax" basis? Interest expense is one of the many line items that are either added to or subtracted from revenue to calculate the pretax income amount. This pretax income amount is then taxed to come up with net income. Thus, when the income-reducing effect of interest expense is ultimately filtered down to net income, it is on an aftertax basis.

A company's aftertax interest expense is easy to determine. First, determine its tax rate by dividing its income tax expense by its pretax income. Then plug that figure into the following formula:

Aftertax Interest Expense = (1 - Tax Rate) x (Interest Expense) 

Return on assets is generally stated in percentage terms, and higher is better, all else equal.

Return on Equity (ROE). Return on equity is a straightforward ratio that measures a company's return on its investment by shareholders. Like all of the profitability ratios we've discussed, it is usually stated in percentage terms, and higher is better.

Return on Equity = (Net Income) / (Average Shareholders' Equity)

The Bottom Line

In this lesson, we began to apply what we had learned about the financial statements in the previous three lessons. We talked about the use of financial ratios and the importance of considering them in a comparative context. We covered several types of ratios, including efficiency, liquidity, leverage, and profitability ratios. By studying the concepts outlined above and completing the exercises that follow, you'll be well on your way toward understanding how to interpret a company's financial statements and analyzing a company for investment purposes.