financial ratios
TRANSCRIPT
Financial Ratios
Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy.
Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:
Liquidity ratios Asset turnover ratios Financial leverage ratios Profitability ratios Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (orworking capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
Current Ratio = Current Assets
Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:
Quick Ratio = Current Assets - Inventory
Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.
Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:
Cash Ratio = Cash + Marketable Securities
Current Liabilities
The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded.
Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:
Receivables Turnover = Annual Credit Sales
Accounts Receivable
The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:
Average Collection Period = Accounts Receivable
Annual Credit Sales / 365
The collection period also can be written as:
Average Collection Period = 365
Receivables Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:
Inventory Turnover = Cost of Goods Sold
Average Inventory
The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:
Inventory Period = Average Inventory
Annual Cost of Goods Sold / 365
The inventory period also can be written as:
Inventory Period = 365
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.
The debt ratio is defined as total debt divided by total assets:
Debt Ratio = Total Debt
Total Assets
The debt-to-equity ratio is total debt divided by total equity:
Debt-to-Equity Ratio = Total Debt
Total Equity
Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity.
The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:
Interest Coverage = EBIT
Interest Charges
where EBIT = Earnings Before Interest and Taxes
Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at generating profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:
Gross Profit Margin = Sales - Cost of Goods Sold
Sales
Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as:
Return on Assets = Net Income
Total Assets
Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows:
Return on Equity = Net Income
Shareholder Equity
Dividend Policy Ratios
Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.
The dividend yield is defined as follows:
Dividend Yield = Dividends Per Share
Share Price
A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard, and is defined as follows:
Payout Ratio = Dividends Per Share
Earnings Per Share
Use and Limitations of Financial Ratios
Attention should be given to the following issues when using financial ratios:
A reference point is needed. To to be meaningful, most ratios must be compared to historical values of the same firm, the firm's forecasts, or ratios of similar firms.
Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm's situation.
Year-end values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available.
Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.
Profitability ratios Profitability ratios measure the company's use of its assets and control of its expenses to
generate an acceptable rate of return
Gross margin, Gross profit margin or Gross Profit Rate[7][8]
OR
Operating margin, Operating Income Margin, Operating profit margin or Return on
sales (ROS)[8][9]
Note: Operating income is the difference between operating revenues and operating expenses,
but it is also sometimes used as a synonym for EBIT and operating profit.[10] This is true if the firm
has no non-operating income. (Earnings before interest and taxes / Sales[11][12])
Profit margin, net margin or net profit margin[13]
Return on equity (ROE)[13]
Return on investment (ROI ratio or Du Pont Ratio)[6]
Return on assets (ROA)[14]
Return on assets Du Pont (ROA Du Pont)[15]
Return on Equity Du Pont (ROE Du Pont)
Return on net assets (RONA)
Return on capital (ROC)
Risk adjusted return on capital (RAROC)
OR
Return on capital employed (ROCE)
Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity
Cash flow return on investment (CFROI)
Efficiency ratio
Net gearing
Basic Earnings Power Ratio[16]
[edit]Liquidity ratios Liquidity ratios measure the availability of cash to pay debt.
Current ratio (Working Capital Ratio)[17]
Acid-test ratio (Quick ratio)[17]
Cash ratio[17]
Operation cash flow ratio
[edit]Activity ratios (Efficiency Ratios) Activity ratios measure the effectiveness of the firms use of resources.
Average collection period[3]
Degree of Operating Leverage (DOL)
DSO Ratio.[18]
Average payment period[3]
Asset turnover[19]
Stock turnover ratio[20][21]
Receivables Turnover Ratio[22]
Inventory conversion ratio[4]
Inventory conversion period (essentially same thing as above)
Receivables conversion period
Payables conversion period
Cash Conversion Cycle
[edit]Debt ratios (leveraging ratios) Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial
leverage.
Debt ratio[23]
Debt to equity ratio[24]
Long-term Debt to equity (LT Debt to Equity)[24]
Times interest-earned ratio / Interest Coverage Ratio[24]
OR
Debt service coverage ratio
[edit]Market ratios
Market ratios measure investor response to owning a company's stock and also the cost of
issuing stock. These are concerned with the return on investment for shareholders, and with the
relationship between return and the value of an investment in company’s shares.
Earnings per share (EPS)[25]
Payout ratio[25][26]
OR
Dividend cover (the inverse of Payout Ratio)
P/E ratio
Dividend yield
Cash flow ratio or Price/cash flow ratio[27]
Price to book value ratio (P/B or PBV)[27]
Price/sales ratio
PEG ratio
Other Market Ratios
EV/EBITDA
EV/Sales
Liquidity Analysis Ratios
Current Ratio Current Assets Current Ratio = ------------------------ Current Liabilities
Quick Ratio Quick Assets Quick Ratio = ---------------------- Current Liabilities Quick Assets = Current Assets - Inventories
Net Working Capital Ratio Net Working Capital Net Working Capital Ratio = -------------------------- Total Assets Net Working Capital = Current Assets - Current Liabilities
Profitability Analysis Ratios
Return on Assets (ROA) Net Income Return on Assets (ROA) = ---------------------------------- Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
Return on Equity (ROE) Net Income Return on Equity (ROE) = -------------------------------------------- Average Stockholders' Equity Average Stockholders' Equity = (Beginning Stockholders' Equity + Ending Stockholders' Equity) / 2
Return on Common Equity (ROCE) Net Income Return on Common Equity = -------------------------------------------- Average Common Stockholders' Equity Average Common Stockholders' Equity = (Beginning Common Stockholders' Equity + Ending Common Stockholders' Equity) / 2
Profit Margin Net Income Profit Margin = ----------------- Sales
Earnings Per Share (EPS) Net Income Earnings Per Share = --------------------------------------------- Number of Common Shares Outstanding
Activity Analysis Ratios
Assets Turnover Ratio Sales Assets Turnover Ratio = ---------------------------- Average Total Assets Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
Accounts Receivable Turnover Ratio Sales Accounts Receivable Turnover Ratio = ----------------------------------- Average Accounts Receivable Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2
Inventory Turnover Ratio Cost of Goods Sold Inventory Turnover Ratio = --------------------------- Average Inventories Average Inventories = (Beginning Inventories + Ending Inventories) / 2
Capital Structure Analysis Ratios
Debt to Equity Ratio Total Liabilities Debt to Equity Ratio = ---------------------------------- Total Stockholders' Equity
Interest Coverage Ratio Income Before Interest and Income Tax Expenses Interest Coverage Ratio = ------------------------------------------------------- Interest Expense Income Before Interest and Income Tax Expenses = Income Before Income Taxes + Interest Expense
Capital Market Analysis Ratios
Price Earnings (PE) Ratio Market Price of Common Stock Per Share Price Earnings Ratio = ------------------------------------------------------ Earnings Per Share
Market to Book Ratio Market Price of Common Stock Per Share Market to Book Ratio = ------------------------------------------------------- Book Value of Equity Per Common Share Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares
Dividend Yield Annual Dividends Per Common Share Dividend Yield = ------------------------------------------------ Market Price of Common Stock Per Share Book Value of Equity Per Common Share = Book Value of Equity for Common Stock / Number of Common Shares
Dividend Payout Ratio Cash Dividends Dividend Payout Ratio = -------------------- Net Income
ROA = Profit Margin X Assets Turnover Ratio
ROA = Profit Margin X Assets Turnover Ratio
Net Income Net Income Sales ROA = ------------------------ = -------------- X ------------------------ Average Total Assets Sales Average Total Assets Profit Margin = Net Income / Sales Assets Turnover Ratio = Sales / Averages Total Assets
Current Ratio
Current AssetsCurrent Liabilities
One of the most universally known ratios, which reflect the Working Capital situation, indicates the ability of a company to pay its short-term creditors from the realisation of its current assets and without having to resort to selling its fixed assets to do so.
Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets available to pay liabilities, should the need arise. The higher the figure the better.
For those industries such as transport where the majority of assets are tangible fixed assets, then a figure of 0.6 would be acceptable. In retail and manufacturing we would expect figures between 1.1 to 1.6; in wholesale and construction 1.1 to 1.5 and motor vehicles 1.2 to 1.6. Generally where credit terms and large stocks are normal to the business, the current ratio will be higher than, for example, a retail business where cash sales are the norm.
Liquidity Ratio
Current Assets - StockCurrent Liabilities
This ratio indicates the ability of a company to pay its debts as they fall due. It is generally considered to be a more accurate assessment of a company's financial health than the current ratio as it excludes stock, thus reducing the risk of relying on a ratio that may include slow moving or redundant stock.
Figures of this ratio are lower than the current ratio. Supermarkets can, for example, easily survive on ratios as low as 0.4 with cash being received for goods sold, before the goods are actually paid for. Plant hire contractors would also expect ratios as low as 0.6 to 0.8. Clothing retailers also operate at very low levels, with average figures being between 0.2 and 0.6 and retail as a whole between 0.3 and 0.7. In manufacturing figures between 0.7 and 1.1 are seen as acceptable and for wholesalers 0.7 to 1.0. Construction should operate at between 0.6 and 1.0.
Stock Financing Ratio
Stock + Work in ProgressCurrent Assets - Current Liabilities
Compares stock and work in progress to working capital and therefore shows how sensitive working capital is to a fall in stock value.
Solvency Ratio
Shareholders Funds x 100Total Assets
This ratio measures if the total liabilities of a business (both secured and unsecured) are too high, indicating a possible over dependency on outside sources for long-term financial support. By comparing shareholders funds to total assets we can produce a confidence factor for unsecured creditors to the business. As a general rule, the higher the result the better, although results for new companies are distorted as the business would not have had the trading history to develop high levels of net worth. An average score would be between 30% and 50% whilst poor performers can generate scores of below 10% or even have a negative score. Exceptionally performing businesses could reach a value in excess of 65%.
Insolvency Ratio
Shareholders FundsLoss
Compares a company's losses to its shareholders funds, indicating (in years) the time it will take for the company to become insolvent due to lack of profit, rather than due to cash flow liability. It assumes that the company will continue to make the same losses.
Collection Period
Debtors x365 (days)Turnover
Measures the length of time a company takes to collect its debts and is measured in days. In general terms the figure indicates the effectiveness of the company's credit control department in collecting monies outstanding.
Apart from strictly cash businesses like supermarkets with virtually zero debtors, normal payment terms are at the end of the month following delivery, giving an average credit of between 6 and seven weeks. Clothing retailers show some of the lowest figures with averages of around 7 days. In manufacturing average figures are around 63 days, with 42 being experienced at the top end and 84 days at the lower end. Average for wholesalers is around 56 days, whilst in construction the figures are lower, at around 45 days.
Creditor Days
Creditors x 365 (days)Turnover
This ratio measures the length of time it takes a company to pay its creditors.
Generally the average figure is around 30 days. In the construction industry the average is around 31 days, rising to 54 days at the bottom end and down to 17 days at the top. For wholesalers the average rises to 37 days, with top and bottom figures being 18 and 61 days respectively. For retail the average figure drops to 23 days with 40 days being in
the bottom sector. For food retailers as low as 8 - 12 days is the norm. In manufacturing averages tend to be around 37 days, with the worst performers rising to 55 days and the best showing creditor days of around 22 days.
Stock/Turnover
TurnoverStock
Measures the number of times a company converts its stock into sales during the year. When examining this ratio it should be borne in mind that different companies will have varying levels of stock turnover depending on what they produce and the industry they operate in.
Low figures are generally poor as they indicate excessively high or low moving stocks. At one end of the scale, and apart from advertising agencies and other service industries, ready mixed concrete companies probably have one of the better stock/turnover figures.
At the other end companies that maintain depots of finished goods and replacement parts will have much poorer figures. For example, a manufacturing company with stock/turnover ratio of around 25 - 30 would be reasonable, decreasing with the larger and more complex the goods being made. For retail and wholesale, average figures would be lower at around 9 - 10. For construction, average stock/turnover figures would be around 16 and for industries such as transport, where overall stock figures are low, it would produce results of around 80 - 90.
Asset Turnover
TurnoverNet Assets
The asset turnover indicates how effectively a company utilises its investment in assets. It is a measure of how efficient the company has been in generating sales from the assets at its disposal. A low figure would suggest either poor trading performance (which can be evaluated by the profit margin, sales per employee figures) or an over investment in costly fixed assets. The construction industry shows a mean asset turnover ratio of 1.6, with the poorer performers averaging 0.6 and the better companies showing an average of 2.6. The retail sector has an average asset turnover of 1.9, with poorer performers in the sector averaging 0.8 and the better ones showing an average of 3.2.
Sales/Fixed Assets
Turnover x 100Tangible fixed assets
A measure of how effectively Fixed Assets (e.g. Property, plant, equipment) are being used to generate sales.
Sales/Total Assets
Turnover x 100Total Assets
A measure of how effectively a company uses its total assets to generate sales.
Fixed Asset Investment
Tangible Fixed Assets
Total Assets
Shows what proportion of the companies assets are profit generating fixed assets (e.g. plant and machinery).
Monthly/Turnover
Turnover12
Expresses average monthly sales.
Gearing Ratio
(Long Term Borrowings + Short term Loans + Overdraft) - Cash x 100Shareholders Funds
Gearing is a comparison between the amount of borrowings a company has to its shareholders funds (net worth). The result of the calculation will show as a percentage the proportion of capital available within the company in relation to that owed to sources outside the company. Lower figures are more acceptable, showing that the company is predominantly financed by equity whilst high gearing shows an over reliance on borrowings for a significant proportion of the company's capital requirements.
High gearing is significantly more dangerous at times of high or rising interest rates and also low profitability. Businesses that rely on a great deal of tangible assets (such as heavy manufacturing) or have to replace fixed assets more frequently than other industries are expected to have higher gearing figures.
The transport industry shows an average gearing level of 150%, with the poorer performers suffering levels up to 380%. The service sector has an average gearing level of 100%, with the upper quartile of companies showing negative gearing (i.e. surplus of cash over borrowing). The construction industry, where borrowing is usually taken out against work in progress as well as tangible fixed assets such as plant and machinery, shows an average of 130% gearing, with the better performers averaging 30% and the poorer performing businesses showing gearing levels in excess of 400%.
Total Debt
Current Liabilities + Long Term LiabilitiesShareholders Funds
This ratio compares total liabilities to shareholders funds. It is useful when considered over a period of time, i.e. in successive years' accounts. An increasing ratio would indicate that borrowing is making a higher contribution to the capital base of the business than shareholders funds. This may cause problems, particularly if profit margins are also in decline.
The manufacturing sector shows an average total debt ratio 1.4, with the lower quartile companies averaging around 3.4 and the upper quartile showing a ratio of 0.4. The retail sector shows an average of 1.1, with the better performers in retail averaging 0.2: the construction industry averages around 1.5, with the upper quartile averaging around 0.25.
Current Debt
Current LiabilitiesShareholders Funds
This ratio compares current liabilities to shareholders funds and is a useful ratio when considered over a period of time, i.e. in successive years' accounts. An increasing ratio would indicate that borrowing is making a higher contribution to the capital base of the business than shareholders funds. This may cause problems, particularly if profit margins are also in decline.
The manufacturing sector shows an average current debt ratio of 1.1, with the lower quartile companies averaging around 3.0 and the upper quartile showing a ratio of 0.3. The retail sector shows an average of 0.9, with the better performers in retail averaging 0.1: the construction industry averages around 1.3, with the upper quartile averaging around 0.20.
Total Long Term Debt
Long Term LiabilitiesTotal Assets - Current Liabilities
Shows what proportion of permanent capital has been provided by long term lenders.
Shareholders Equity
Shareholders FundsLong Term Liabilities
Shows how many pounds worth of shareholders funds exist for every pound worth of long term debt.
Credit Gearing
Credit Limit x 100Shareholders Funds
Expresses the suggested credit limit as a percentage of shareholders funds.
Profit Margin (Return on Sales)
Profit Before Tax x 100Turnover
Measures the margin of profitability on sales throughout the year. This is the main indicator when measuring the efficiency of the operation, a very good indicator of the business's ability to withstand falling prices, rising costs or declining sales.
A normal figure for a manufacturing industry would be between 6% and 8%, while high volume/low margin activities like food retailing can run very satisfactorily at around 3%. Retailers generally will have a lower profit margin than most industries.
Highest margins of all are usually experienced in service industries where margins above 10% are enjoyed.
The percentage should be relatively constant and any reason for decline investigated. Reasons for change could be a reduction in selling prices or increase in cost of sales.
Profit/Capital Employed (Return on Capital Employed)
Profit before Tax x 100
Total Assets - Current Liabilities
This ratio measures whether or not a company is generating adequate profits in relation to the funds invested in it and is a key indicator of investment performance. A business could have difficulty servicing its borrowings if a low return is being earned for any length of time. In manufacturing we would expect to see figures in excess of 10% rising to over 25% at the top end. In retail lower figures would be experienced, ranging between 5% and 15%. Construction figures show an average of about 7% increasing to over 35% for the top performers.
Profit/Assets
Profit Before Taxation x 100Total Assets
This is a useful indicator as to whether a business is using its assets well and getting the most value out of capital expenditure. Companies using their assets well will have a relatively high return, while those less well-run businesses will have a relatively low return.
In manufacturing and transport average figures run at about 4% rising to around 10% in the best companies. In construction average figures are lower at around 2% and for wholesalers and retailers we would expect figures between 2% and 8% as an average.
Return on Shareholders Funds
Profit Before Tax x 100Shareholders Funds
Indicates whether or not a company is generating adequate profits in relation to the resources invested in it by shareholders.
Employee Ratios
The employee ratios show the productivity of the company's employees and can be of value if yearly fluctuations are examined within the same industry type.
Profit/Employee:Profit Before TaxNo. of Employees
Sales/Employee:Turnover
No. of EmployeesCapital Employed/Employee::
Total Assets - Total LiabilitiesNo. of Employees
Fixed Assets/Employee:Tangible Fixed Assets
No. of EmployeesShareholders Funds/Employee:
Shareholders FundsNo. of Employees
Export/Employee:Export
No. of Employees