Financial Ratio Analysis is a form of Financial Statement Analysis that we use to obtain a quick view of the financial performance of a company in critical areas. Ratios can be used to compare one company against another or one period against another. To compare different companies, we use Common Size Statements, where we express each line item as a percentage from another baseline, and therefore, we can use them for an accurate comparison against different sized companies. The trend analysis of ratios is also helpful to understand the change in a company’s financial statements over more than one period.
Today we will look at the most commonly used financial ratios, separated in the following categories:
- Liquidity Ratios
- Profitability Ratios
- Activity Ratios
- Capital Structure Ratios
- Market Ratios
- Efficiency Ratios
We use liquidity ratios to gauge a company’s ability to cover its short term debts as they arise using the company’s current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.
We use the Current Ratio to evaluate the company’s ability to pay short term obligations as they arise. If the Current Ratio gets below 1, this means the company does not have sufficient incoming cash flow to meet its short-term obligations. Usually, we consider a value above 1.2 to be enough.
The Quick Ratio is an indicator of the short-term liquidity of a company. We use the Quick Ratio to measure a company’s ability to meet short-term liabilities with its most liquid assets. A higher quick ratio usually means a better position for the company.
We commonly assess the financial performance of a company with the Working Capital Ratio. Working Capital values near zero or below can indicate severe economic problems with a company. In such a situation, a company is likely to have difficulty paying back its creditors. Looking at the working capital ratio shows us if the company has enough short-term assets to pay off its short-term debt.
We use Profitability Ratios to assess a company’s ability to generate earnings based on its revenue, operating costs, assets, and share capital over time.
Return on Assets (ROA) is a measure that indicates how profitable a company is based on its total assets. ROA shows us how efficient the management is in using company assets to generate earnings.
Return on Equity (ROE) shows us how much profit a company generates with the money invested by its shareholders. Return on Equity evaluates the profitability of a business. ROE quantifies how much profit a company makes for each euro shareholders have invested.
The Return on Invested Capital (ROIC) measure shows us how the company is generating returns using its money. It is a good idea to compare the company’s ROIC with its cost of capital WACC, to reveal how productively management is using invested capital.
Gross Profit Margin, or simply Gross Margin, is used to assess the financial health of the company by revealing the proportion of money left over from revenues after accounting for the cost of goods sold.
Profit Margin, or also Net Margin, is used to determine the profitability of sales made by the company.
The Operating Margin ratio shows us the profitability of the ongoing operations of the company before financing costs and taxes.
The Earnings Per Share ratio puts the company’s profitability in perspective by showing us how much profit is allocated to each share of a company’s capital.
Activity ratios are financial analysis ratios we use to measure a company’s ability to convert different accounts from its balance sheet into sales and cash. Activity ratios help us by showing the relative efficiency of the company based on its use of assets or other balance sheet items. Activity Analysis is essential to determine if the management is employing the company resources well enough.
The Asset Turnover ratio measures a company’s efficiency at using its assets to generate sales. The higher the Asset Turnover is, the better the company is at using its assets to generate revenue.
Next, we have the Accounts Receivable Turnover ratio, which helps us to quantify how active the company is in debt collection. This ratio shows us how active the company is at managing its assets.
We use the Inventory Turnover ratio to measure how many times a company’s inventory will be sold and replaced in a year.
The Fixed Asset Turnover ratio measures the efficiency of fixed assets to generate profit. The higher the rate, the more efficient management’s employment of fixed assets.
The last Activity Analysis ratio we will look at is the Working Capital Turnover, which helps us evaluate the generation of sales from the employment of working capital over a given period. This measure provides some useful information as to how effectively a company is using its working capital to generate revenue.
We use the Capital Structure Ratios, also referred to as Financial Leverage Ratios, to evaluate components of equity and debt. We perform capital structure analysis to measure the combination of debt and equity the company should have to operate optimally. We expect the mix of debt – equity to change over time, based on the cost of debt and investment as well as risk factors influencing the company and its environment.
The most common ratio in Capital Structure Analysis is the Debt Ratio, which indicates what proportion of debt a company has as compared to its assets. By looking at this ratio, we get an idea as to the risk the company faces concerning its debt load.
Next is the Debt to Equity Ratio. This ratio measures the proportions of debt and equity the company uses to finance its assets.
We use Times Interest Earned to evaluate the company’s ability to meet its debt obligations. Not being able to satisfy financial debt obligations could mean bankruptcy.
Another standard ratio is the Debt Servicing Ratio, which is used to evaluate the company’s ability to cover its debt repayments, including principal and interest.
Market value ratios are mostly used by current and potential investors to determine whether a company’s shares are under- or over-priced. Management usually doesn’t pay much attention to those ratios, as they are more interested in the operational performance of the company.
The Price to Earnings Ratio tells us how long it will take for earnings to repay the current market share price. This ratio gives us an excellent benchmarking measure to compare companies in the same industry.
Earnings Per Share (or EPS) is the portion of a company’s profit allocated to each outstanding share of ordinary share capital.
We use the Dividend Yield to evaluate how much a company pays out in dividends each year relative to its share price.
The Dividend Payout Ratio measures the portion of earnings that are paid out to shareholders.
We often categorize the following efficiency ratios within other types of ratios. However, we feel these can be understood easier if they get their category.
We start with the Gross Efficiency of Assets, which tells us how much income each dollar of assets generates before paying out taxes and interest. This ratio tells us how efficiently management uses its assets.
We can dive deeper by looking at Pretax Income. It is made up of two sources, income from assets funded by shareholders equity, and assets funded by borrowed debt.
Income from Unleveraged Assets is the income generated by the assets funded by shareholders equity and company operations.
On the other hand, Income from Leveraged Assets is the income generated by assets funded by borrowed debt.
The percentage of the pretax income that is the result of the company’s use of debt to fund assets helps us evaluate the contribution leveraged assets have to the performance of the business. Higher numbers show the proper use of debt. Figures below zero show that assets financed by debt generate losses.
Last, but not least, let us look at the Sustainable Growth Rate ratio. We put it in this category, as SGR is an excellent measure of how efficiently the company is and can run. We use the Sustainable Growth Rate to calculate the maximum growth rate a company can sustain organically, without financing its activities with additional debt. If the company wants to operate above the SGR, it has to maximize sales and focus on high-margin products, as well as take into consideration the inventory turnovers that would be required to operate above the Sustainable Growth Rate.
To sum it all up, Ratio Analysis is a form of financial statement analysis. What we always need to remember is that Ratio Analysis is based on Accounting information. Therefore its effectiveness is limited by the potential distortions within financial statements due to things like inflation, historical cost accounting, etc. Ratio Analysis is a great tool to analyze a company’s performance, either by comparing it to other companies within the industry or by looking at trendlines to evaluate the company’s performance over more than one period.
In future articles, we will look at applying some of the above-discussed ratios to actual data and what conclusions we can draw from that.
Thank you for reading! These were the most common Financial Ratios.
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