What Are The Important Financial Ratios To Look At? (Part 2)

Current Ratio

This ratio indicates whether the company possessed more current assets than its current short term liabilities. It is calculated by dividing Total Current Assets against Current Liabilities.

Any value less that 1 is a bad sign.

For example,

Company A Company B
Current Assets $2,000,000 $2,000,000
Current Liabilities $1,000,000 $3,000,000
Current Ratio 2 0.67

Imagine if you can only sell your car now for $10,000, while you owe the bank $20,000. How would you feel?

Debt to Equity Ratio

This ratio measure how much debt the company has borrowed in proportion to shareholders’ equity. It is calculated by dividing total liability against total equity (total assets – total liabilities).

Imagine if you own a house worth $300,000, have a mortgage loan of $200,000. So effectively you have $100,000 equity. But at the same time, you also took up additional personal loan of $60,000.

So your debt to equity ratio is equivalent to $60,000 / ($300,000 – $200,000) = 0.6

Value less than 1 makes you feel safer because should you go jobless, you can still sell off your house to pay off the loan. And return the remaining $40,000 to your parents if you happen to borrow it from them.

However, having higher debt to equity ratio might not be a bad thing. It really depends on the business nature. Imagine if you can borrow $60,000 from your parents for 1 per cent interest, and then lent that money to your friend for 5 per cent interest. In between, you earn 4 per cent!

In that sense, financial companies will tend to have high debt to equity ratio.

Gross Margin

Formula for Gross margin = (Revenue – Cost of Goods Sold) / Revenue x 100

For example,

Revenue $100,000
Cost of Goods Sold $60,000
Gross margin 40%

Imagine you bought 10 books for the price of $200, and then you sold all of them for $1000.

The gross profit will be $800, and the gross margin will be 80%.

It is important to look at gross margin rather than looking at gross profit itself. Because as a public company, a gross profit of $2 Million might look like a lot, but it may only reflect a 10% gross margin, if the cost of goods sold is way too high.

In the end, a 10% gross margin might put the company at a loss after deducting expenses like salary of workers and etc.


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