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Financial Ratios
by WealthEffect Staff

 
 

Profit Margins
 
  Interest Coverage  
  Operating Working Capital  
 
1.

Financial ratios help investors to better understand a company's results. By comparing certain numbers in the company reports, you can gauge the success of a business relative to its potential and to its competitors. You can also compare the ratios of a company in one industry to those in another.

Profit margins — gross margin, operating margin, pretax margin, net margin — measure how much is earned on each dollar of sales. These profitability ratios highlight the relationship of costs to sales, and are derived from the numbers in the income statement.

The gross margin is determined by dividing gross profits (revenues minus cost of goods sold) into revenues, operating margin by dividing operating profits (gross profits minus selling, general and administrative costs) into revenues, pretax margin by dividing pretax income (operating profits minus interest expense) into revenues, and net margin by dividing net income (pretax income minus taxes) into revenues.

 
 
2.

The coverage ratio, also from the income statement, provides a measure of financial risk — namely, the possibility that the company could go bankrupt by not paying the interest on its debt. The coverage ratio — operating profits divided into interest expense — measures how many dollars are available to pay each dollar of interest expense. A ratio above 3 is desirable in a stable industry (eg. food and beverages). In a volatile industry, such as semiconductors, a ratio of at least 6 is preferable.
 
 
3.

The most important statistic from the balance sheet is operating working capital, defined as current assets (net of cash and marketable securities) minus current liabilities (net of short-term debt). Contrary to textbook thinking, you want operating working capital to be as little as possible.

The reason is simple: as the company grows, the working capital to finance that growth will increase, as well — and this ties up cash. As an investor, cash is the name of the game. You put up cash to buy shares of stock. As a stockholder, you have a claim on a portion of the cash flow the company generates into the future. Anything which ties up cash, such as working capital, is bad. In the case of Coca-Cola, operating working capital is negative, which is wonderful.

Suggestion: Go to Cash Flows