Computing and interpreting financial ratios is the cornerstone of financial statement analysis. The main financial statements are the balance sheet, income statement and statement of cash flows. Ratios are fractions that show the relationship between the numerator and denominator. These ratios are computed as a convenient way to see how the firm is performing financially.
For the ratios to have meaning, they need to be compared to at least one of the following:
- The firm’s historical ratios
- The ratios of other firms of similar size, in the same industry
Financial ratios provide information about five areas of financial performance:
- Profitability: The company’s level of profitability (return on shareholders’ equity)
- Short-term liquidity: The company’s ability to meet short-term obligations
- Financial leverage: The extent to which the company relies on debt financing
- Activity: How effectively the company’s assets are being managed
- Value: The value of the company
We’ll take a look at some ratios in each of these categories.
The profitability of a firm is difficult to gauge. Profitability from an accounting perspective is the difference between revenues and costs. However, firms typically take on projects that sacrifice current profitability for future profitability. New projects often require considerable funds to start, and may only cover their costs years down the road. This means that current profitability may be a poor measure of true future profitability.
Common profitability ratios are net profit margin, return on assets, and return on equity.
Net Profit Margin
Profit margins are calculated by dividing profit by total operating revenue.
Net profit margin = Net income ÷Total operating revenue
Profit margin ratios are not a direct measure of profitability. This is because they aren’t based on total operating revenue. Additionally, profit margin ratios are not based on the investment made in assets. Profit margins reflect the ability of the firm to produce projects or services at a low cost, or to sell them at a high price.
Return on Assets
Return on assets (ROA) is the ratio of income to average total assets. The ratio is often calculated both after and before tax. It’s a common measure of managerial performance.
Net return on assets = Net income ÷ Average total assets
Gross return on assets = Earnings before interest and taxes ÷ Average total assets
Retrun on Equity
Return on equity (ROE) is calculated by dividing net income after interest and taxes by average common shareholders’ equity. It is the return to the company owners.
ROE = Net income ÷ Average shareholders’ equity
Short-Term Liquidity Ratios
Short-term liquidity (or solvency) ratios measure a company’s ability to pay its bills. Liquidity is often associated with net working capital (the difference between short-term assets and short-term liabilities).
The most widely used liquidity ratios are the current ratio and the quick ratio.
The current ratio is found by dividing current assets by current liabilities. These values are found on the balance sheet.
Current ratio = Total current assets ÷ Total current liabilities
A higher current ratio usually means greater liquidity. It should be compared to the ratios of firms with similar operations, as well as to calculations over previous years for historical perspective.
It’s possible for this ratio to be too high. It may indicate excessive inventory or difficulty collecting accounts receivable.
The quick ratio is calculated by subtracting inventories from current assets (called quick assets) and subtracting the difference by current liabilities.
Quick ratio = Quick assets ÷ Total current liabilities
Quick assets are assets that can by quickly converted to cash. Inventory is usually the least liquid current asset. It may be important to determine the ability of a firm to meet short-term obligations without relying on sales of inventory.
Financial leverage ratios show how dependent the firm is on debt financing as opposed to equity financing. The more debt a firm has, the harder it is to fulfill its contractual obligations. High debt ratios increase the probability of insolvency and financial distress.
Two commonly used leverage ratios are the debt ratio, and the interest coverage ratio.
The debt ratio is found by dividing total debt by total assets. It provides a measure of the ability of the firm to pay off its creditors.
Debt ratio = Total debt ÷Total assets
It’s important to note that debt ratios don’t take interest rates or risk into account. Additionally, some forms of debt such as lease obligations may not appear on the balance sheet at all.
The interest coverage ratio is calculated by dividing earnings before interest and taxes (dividend earnings) by interest. This ratio measures whether a firm is able to generate enough earnings to cover its interest expense. Paying interest is necessary for a firm to avoid default. A large debt burden becomes a problem when the firm’s cash flow isn’t enough to make the debt service payments.
Interest coverage = Earnings before interest and taxes ÷ Interest expense
Activity Ratios measure a company’s effectiveness in managing its assets. There commonly used activity ratios discussed below are total asset turnover, receivables turnover, and inventory turnover.
Total asset Turnover
Total asset turnover shows how effectively a firm is using its assets to generate revenue. It is found by dividing total operating revenue by average total assets.
Total asset turnover = Total operating revenues ÷ Average total assets
- Operating revenue is revenue generated from the operating activities of the company. It excludes interest revenue.
- Average total assets are the average of the assets at the beginning of the period, and the assets at the end of the period.
If the asset turnover ratio is high, it presumably means that the firm is using its assets efficiently to generate sales. Again, for a meaningful interpretation, the value should be compared with other firms of similar size in the same industry and/or to the company’s historical values.
The receivables turnover ratio is used to gauge how well the firm manages its accounts receivables. It can be used to determine the average time it takes to collect customer payments.
The receivables turnover ratio is calculated by dividing sales by average receivables during the period.
The average time it takes to collect payments from accounts receivables can be found by diving the number of days in the year (365) by the receivables turnover ratio.
The inventory turnover ratio is used to find out how long it takes for inventory to be produced and sold.
The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory level.
The number of days it takes to produce and sell goods (days in inventory ratio) is calculated by dividing the number of days in the year (365) by the inventory turnover ratio.
Company Value Ratios
The market value of a firm cannot be found on an accounting statement. We’ll briefly cover some common ratios used to value publicly traded companies.
The market price of a share of a firm’s common stock is the price that buyers and sellers establish when they trade. Different companies have widely different stock prices, financial analysts calculate ratios to extract ratios that are independent of a firms size. Two common value ratios are the price-earnings ratio and the dividend yield.
Price-Earnings (P/E) Ratio
The price-earnings ratio is the defined as the market price for a stock divided by its current annual earnings per share.
P/E ratio = Share price ÷ Earnings per share
The P/E ratio shows how much investors are willing to pay for $1 of earnings per share. The P/E ratio reflects investor belief in the growth potential of the firm. Investors who buy the stock of firms with high P/E ratios expect large earnings growth.
The dividend yield is computed by dividing the last dividend payment (annualized) of a firm by the current market price.
Dividend yield = Dividend per share / Market price per share.
Like P/E ratios, dividend yields are related to investor’s expectation of future growth prospects for firms. Firms with higher growth prospects usually have lower dividend yields. This is because firms typically pay out less dividends to shareholders if they can invest the cash into promising projects.
Pitfalls of Financial Ratio Analysis
Financial ratios are a powerful tool to help gauge company performance, but they shouldn’t be relied on blindly. It’s important to be aware of their limitations.
For one, there is no underlying theory with financial ratio analysis to help identify which quantities to examine, or to guide in establishing benchmarks. This is why individual experience and judgement play a big role.
Other problems are common. For example, unusual events, such as a one-time profit from a sale of a building, can affect financial performance. This can give misleading signals when comparing companies.