Financial Ratios

Financial Ratios

Financial Ratios

Financial Performance Indicators Analysis

This page shows how to convert the data on financial statements into information for investors, shareholders, and managers. Making regularly period-to-period and company-to-company number & ratio comparisons, gives anyone a better understanding where a business needs improvement.

Financial ratios measure a company's productivity, financial health, and future potential (trend). Financial ratio analysis offers a solution to numbers overload. A ratio is noted in several ways: two-to-one would be: 2:1, or 2-to-1, or 2/1.

Books to be used as “Benchmark” are: RMA "Annual Statement Studies" and D&B’s "Industry Norms and Key Business Ratios”, covering hundreds of industry sectors. They are available in public libraries serving business communities.

The data to calculate ratios come from both the company's Income Statement (IS) and Balance Sheet (BS). The most important types of ratios listed here are:
  • Common ratios
  • Liquidity ratios
  • Efficiency ratios
  • Solvency ratios

Common Ratios

Common size ratios are calculated from each line item as a % of its total, which is Sales and EBITDA on the income statement and Assets on the balance sheet.

Crucial is the usage of a company’s cash, and spotting trends in accounts receivables and current liabilities. Any non-planned increase, requires better collection practices, and/or limiting credit to your customers.

Return on Assets =
Net Operating Profit / Average Total Assets X 100 (as a %)

This ratio measures the relationship between the assets used to generate the net profits made. It shows how well a company is using its assets to produce income. Average Total Assets is last year's BS Assets plus this years' BS Assets, divided by 2. A low ratio compared to other companies may indicate that others operate more efficiently.

Liquidity Ratios

Liquidity ratios measure your company's ability to cover its expenses. They are based on balance sheet items.

Current Ratio =
Total Current Assets / Total Current Liabilities

It is a solvency indicator that reflects a company’s financial strength. Are there enough current assets to meet the payment schedule of the current liabilities, with a margin of safety? A safe current ratio is 2/1. A high current ratio may mean that cash is not being utilized in an optimal way.

Increasing the current assets or decreasing current liabilities will improve a low ratio, such as:

  • Paying down debt
  • Selling a fixed asset
  • Putting profits back into the business
  • Acquiring a longer than 1 year-term loan.

Quick Ratio =
(Current Assets - Inventory) / Current Liabilities

The quick (assets quickly convertible to cash) ratio tests whether a business can meet its obligations even if adverse conditions occur. Quick ratios between 0.5 and 1 are OK.

Account Payable (AP) Turnover Ratio =
Cost Of Goods Sold / Net AP

This ratio measures the number of times accounts payable "turned over" during a certain time period. Since accounts payable are a "source for cash", maximizing its use by paying suppliers as late as they allow is very beneficial from a cashflow perspective.

Days' AP Ratio =
365 / AP Turnover Ratio

This ratio is important to ensure that there is enough cash on hand to pay suppliers on time and run the business.

Operating Efficiency Ratios

Of the many types of ratios that measure the efficiency of a company's operation, the 9 ratios most widely used are:

  • Inventory Turnover Ratio
  • Inventory Days on Hand Ratio/span>
  • Sales to Receivables Ratio
  • Days' Receivables Ratio
  • Total Asset Turnover Ratio
  • Return on Assets Ratio
  • Return on Equity Ratio
  • Net Fixed Asset Ratio
  • Cash Conversion Cycle

Inventory Turnover Ratio =
Cost Of Goods Sold / Net Inventory

This ratio measures the number of times sellable inventory "turned over" or was converted into sales during a certain time period. The higher a cost of sales to inventory ratio, the better. A high ratio means that inventory is turning over quickly, and little unused inventory is being stored.

Inventory Days on Hand =
365/Inventory Turnover Ratio

This ratio shows how often Inventory turns over during a year. Important if there are many cash sales. However, it is only a one point in time measurement, and does not take into account seasonal fluctuations, but is vital for calculating the cash conversion cycle.

Sales to Accounts Receivables (AR) Ratio =
Net Sales / Net AR

This accounts-receivable-turnover ratio measures the number of times accounts receivables turned over during a certain period. The higher the number, the shorter the time between making sales and collecting cash. Net sales are sales minus returns or discounts. Net receivables are receivables minus adjustments for bad debts. This day-based ratio does not take into account seasonal fluctuations.

Days' AR Ratio =
365/Sales to AR Ratio

This accounts-receivable-days-on-hand ratio or collection period measures how many days on average the accounts receivable are outstanding. The less the better. Cash should be used to build a company, not to finance its clients. Nonpayment often increases the longer the money is outstanding. The "365" is the # days in the year.

Total Asset Turnover Ratio =
Net Sales / Average Total Assets

This ratio measures how efficiently a firm uses its assets to generate sales. A high ratio means the company is using its assets efficiently. Lower ratios indicate management and/or production problems.

Return on Assets =
Net Profit before Taxes / Average Total Assets

This ROA ratio helps both management and investors see how well the company can convert its investments in assets into net profits. It measures how profitable a company’s assets are. The costs of acquiring the assets in the ROA calculation includes the possible interest expense from loans to acquire these assets. A positive ROA ratio usually indicates an upward profit trend as well.

Return on Equity =
Net Profit before Taxes / Equity

This ROE is a profitability ratio that shows how much profit each $ of equity generates. Potential investors can then see how efficiently a company will use their money to generate net profits. ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company. Preferred dividends are obviously taken out of the net income for this calculation. Many investors like to calculate the ROE at both the beginning and the end of a period to see the change in return. This helps track a company’s progress and ability to maintain a positive earnings trend.

Net Fixed Asset Ratio =
Net Sales / (Fixed Assets - Accumulated Depreciation)

A high ratio indicates a large sales volume, using few fixed assets, or the company sold equipment and is outsourcing. A low ratio could mean no buyers for certain products, an over-estimated demand, over-investment in machinery, or manufacturing and/or distribution problems.

Cash Conversion or Trading Cycle =
Days' AR Ratio + Inventory Days on Hand - Days' AP Ratio

This measures the number of days it takes to purchase & sell inventory, and convert it into cash. Thus, an indicator of how effective this entire money-making process is managed.

Solvency Ratios

Solvency ratios measure the stability of a company and its ability to repay debt. They give a strong indication of the financial health and viability of a business, and are thus important to lending institutions. The most widely used are:

  • Debt to Equity ratio
  • Working capital
  • Net Sales to Working Capital Ratio

Debt to Equity Ratio =
Total Liabilities / Equity (Total Assets Minus Total Liabilities)

This Net Worth ratio shows how much of a business is owned and how much is owed. If greater than 1, the capital provided by lenders exceeds the capital provided by owners, which Lenders consider to be a significant risk.

Working Capital =
Total Current Assets - Total Current Liabilities

It is a measure of cash flow, and not a ratio. It should always be a positive number. It is used to evaluate a company's ability to weather hard times.

Net Sales to Working Capital Ratio =
Net Sales / Net Working Capital

This ratio is a measurement of how working capital is supporting sales. A low ratio may indicate an inefficient use of your resources, such as investing in equipment. A high ratio is dangerous, since a drop in sales, and thus in cash, could leave a company vulnerable to creditors.

P/B Ratio =
Market-price/share  /  Book-value/share

The book-value per share is: (total assets - total liabilities = net assets) / number of shares outstanding.

Market-value per share is either the share price quote in the market or, if privately held, an analysis and recommendation of a qualified firm.

The P/B ratio reflects the value that outsiders attach to a company's equity relative to the book-value of equity. A stock's market-value is a forward-looking metric that reflects a company's future cash flows. The book-value is an accounting measure based on the historic cost principle and reflects past issuances of equity, augmented by any profits or losses, and reduced by dividends and share buybacks.

Industry-sector analysis can produce a "relevant" P/B ratio, that indicates if a stock is undervalued, a good investment, or overvalued. Overvalued growth stocks frequently show a combination of low ROE and high P/B ratios.

Sources of Info on Profitability Analysis:

  • Budgeting and Finance (First Books for Business) by Peter Engel. (McGraw-Hill, 1996).
  • Fundamentals of Financial Management, 11th ed. by James C. Van Horne and John Martin Wachowicz. (Prentice Hall, 2001).
  • Handbook of Financial Analysis for Corporate Managers, Revised ed. by Vincent Muro. (AMACOM, 1998).
  • How to Read and Interpret Financial Statements. (American Management Association, 1992).

Sources of Information on Financial Ratios:

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