Here are twelve important accounting formulas investors need to know. If investors know these ratios, they can review a company's financial statements quickly and thoroughly.

Profitability Ratios

Gross profit margin = Gross profit/Sales

Gross profit is calculated by subtracting the cost of goods sold (COGS) from revenue. The result is the amount of revenue remaining after all costs to produce the product or service have been backed out.

After gross profit is found, gross margin can be calculated. This result gives us the percentage of each dollar of sales that becomes gross profit.

When gross margin declines, it means a business is keeping less of its sales either because production costs have increased or it is charging less to its customers. Small changes in gross margin can quickly add up to big changes in earnings, so watch this number carefully!

Operating margin = Operating profit/sales

Operating margin, or operating profit margin, measures the percentage of operating income (profit after operating expenses) relative to total revenue.

This ratio provides insights into a company's operational efficiency and ability to manage operating expenses.

EBITDA Margin = EBITDA/Sales

EBITDA is an acronym for earnings before interest, taxes, depreciation, and amortization. EBITDA margin measures the percentage of EBITDA relative to total revenue.

The cable industry pioneer John Malone developed the metric in the 1970s to sell investors on his company’s true profitability, which he believed was not accomplished by GAAP figures such as net income.

Charlie Munger, Warren Buffett’s famed business partner, called EBITDA "bulls**t earnings" because it did not always accurately reflect a company’s earnings. For instance, because EBITDA does not consider all business activities, it might overstate cash flow.

Net profit margin = Net income/sales

Net margin, or profit margin, represents the percentage of net income (profit after all expenses, including interest and taxes) relative to total revenue. It provides a comprehensive view of a company's overall profitability.

This ratio indicates the portion of each sales dollar that results in net profit.

Return On Capital Ratios

Return on Equity (ROE) = Net income/Total equity

This formula tells us how efficiently a company generates profits.

ROE is calculated by dividing net income by shareholder equity (the average amount of equity investors have put into a company over a set period).

The higher the ROE, the better the business converts equity into profits.

It should also be noted that if a company buys back a lot of shares, its ROE will appear unusually high. That’s because the repurchasing activity lowers the equity. Of course, buying back stock can be a great way to reward shareholders, but it can warp the ROE calculation.

Return on Assets (ROA) = Net income/Total assets

This formula tells investors whether a company efficiently uses its assets to generate profits. It also factors a company’s debt, which ROE fails to do.

ROA is calculated by dividing a company’s net income by total assets on the balance sheet.

Assets are any item of property owned by the company that has value. They are found on the balance sheet.

Return on Capital Employed (ROCE) = EBIT/(Total assets - Current liabilities)

This ratio measures how efficiently a company uses its available capital (both equity and debt) to generate profits.

Current liabilities are bills due within the following year. This could include wages owed to workers, money owed to suppliers, and taxes owed to the government. They are found on the balance sheet.

Return on Invested Capital (ROIC) = NOPAT/Invested capital

NOPAT is a company’s income after taking out debt expenses (e.g., paying interest) and interest income. This gives investors a clearer picture of the underlying earnings power of the business.

Invested capital is the total debt and issued equity of a company.

This ratio measures how effectively a company deploys capital in profitable ways. In other words, it tells us how well the company uses its capital to generate profits and create shareholder value.

Liquidity Ratios

Current Ratio = Current assets/Current liabilities

Current assets are expected to be sold, used, or exhausted through standard business operations within one year. This includes assets like cash, accounts receivable, and inventory.

Current liabilities are bills due within the following year. This could include wages owed to workers, money owed to suppliers, and taxes owed to the government.

The current ratio measures a company's ability to pay its upcoming bills using its assets.

Cash ratio = Cash + Cash equivalents/Current liabilities

Cash and cash equivalents refer to cash in a checking account but also include other short-term assets, such as Treasury Bonds or CDs, within a few months of maturity. For the equivalent in your personal life, this is the money in your checking account.

The current ratio measures a company's ability to pay its upcoming bills using its cash on hand.

Financial Leverage Ratios

Debt Ratio = Total debt/ Total assets

This ratio measures the extent of a company's leverage. It shows the proportion of company assets financed by debt.

Debt-To-Equity Ratio = Total liabilities/Total equity

This calculation answers the question of how much leverage the company is using.

Dividend Ratios

Payout Ratio = Dividends per share/earnings per share

This formula shows how much a company pays out in dividends per share as a proportion of total earnings per share.

Dividend Yield = Dividends per share/Share price

Expressed as a percentage, this ratio shows how much return investors are getting paid in dividends on their investment.

Key Takeaway

Understanding these essential accounting formulas equips investors with the tools to analyze a company's financial health and operational efficiency effectively. These ratios provide valuable insights into profitability, liquidity, leverage, and returns, enabling investors to make informed decisions.

By mastering these metrics, investors can quickly identify strengths and weaknesses in a company’s financial performance and assess its potential for long-term value creation. Armed with this knowledge, investors are better prepared to navigate the complexities of financial statements and identify promising opportunities.