Chapter 1

Ratio Analysis

In This Chapter

  • Introducing examples of and caveats about ratio analysis
  • Analyzing liquidity ratios
  • Analyzing leverage ratios
  • Analyzing activity ratios
  • Analyzing profitability ratios

Numbers from your financial statements make more sense when you can compare them with other numbers and external benchmarks. In this chapter, I talk about how you can perform this sort of analysis, which is called ratio analysis. Even if you’re not a numbers person, you can use ratio analysis to your benefit. Ratio analysis is easy to apply, and it enables even the nonquantitative type of person who uses it to better understand the information in financial statements.

Let me give you a quick example of ratio analysis. One particularly useful ratio is the gross margin percentage, which is your gross margin divided by your total sales. Although this ratio may not seem useful at first blush, it can be very valuable.

For example, if you compare your gross margin percentage for this year with last year and see a decline, you know that this isn’t good. Less gross margin means less money for operating expenses, interest expenses, and profits. On the other hand, if you compare your declining gross margin percentage with a competitor’s and see that your competitor’s gross margin percentage is declining even more rapidly than yours, well, you know that’s good. This comparison shows that you may actually be in pretty good shape: At least you aren’t hurting like your competitor. ...

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