financial ratios doc

8/13/2019 Financial Ratios Doc

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Financial RatiosFinancial ratios are relationships determined from a company's financial information and used for

comparison purposes. Examples include such often referred to measures as return on investment (ROI),

return on assets (ROA), and debt-to-equity, to name just three. These ratios are the result of dividing one

account balance or financial measurement with another. Usually these measurements or account balances are

found on one of the company's financial statements

balance sheet, income statement, cashflow statement,

and/or statement of changes in owner's equity. Financial ratios can provide small business owners and

managers with a valuable tool with which to measure their progress against predetermined internalgoals,a

certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful means

of identifying trends in their early stages. Ratios are also used by bankers, investors, and business analysts to

assess a company's financial status.

Ratios are calculated by dividing one number by another, total sales divided by number ofemployees,for

example. Ratios enable business owners to examine the relationships between items and measure that

relationship. They are simple to calculate, easy to use, and provide business owners with insight into what is

happening within their business, insights that are not always apparent upon review of the financial statements

alone. Ratios are aids to judgment and cannot take the place of experience. But experience with reading ratios

and tracking them over time will make any manager a better manager. Ratios can help to pinpoint areas that

need attention before the looming problem within the area is easily visible.

Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners

and managers only need to be concerned with a small set of ratios in order to identify where improvements

are needed.

It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the

business at the time that the underlying figures were prepared. For example, a retailer calculating ratios

before and after the Christmas season would get very different results. In addition, ratios can be misleading

when taken singly, though they can be quite valuable when a small business tracks them over time or uses

them as a basis for comparison against company goals or industry standards.

Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on

a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then

the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining whichratios to compute depends on the type of business, the age of the business, the point in the business cycle, and

any specific information sought. For example, if a small business depends on a large number of fixed assets,

ratios that measure how efficiently these assets are being used may be the most significant. In general,

financial ratios can be broken down into four main categories1) profitability or return on investment; 2)

liquidity; 3) leverage, and 4) operating or efficiencywith several specific ratio calculations prescribed

within each.

PROFITABILITY OR RETURN ON INVESTMENT RATIOS
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Profitability ratios provide information about management's performance in using the resources of the small

business. Many entrepreneurs decide to start their own businesses in order to earn a better return on their

money than would be available through a bank or other low-risk investments. If profitability ratios

demonstrate that this is not occurringparticularly once a small business has moved beyond the start-up

phasethen entrepreneurs for whom a return on their money is the foremost concern may wish to sell the

business and reinvest their money elsewhere. However, it is important to note that many factors can influence

profitability ratios, including changes in price, volume, or expenses, as well as the purchase of assets or the

borrowing of money. Some specific profitability ratios follow, along with the means of calculating them and

their meaning to asmall business owneror manager.

Gross profi tabil ity:Gross Profits/Net Salesmeasures the margin on sales the company is achieving. It can

be an indication of manufacturing efficiency, or marketing effectiveness.

Net prof itability:Net Income/Net Salesmeasures the overall profitability of the company, or how much is

being brought to the bottom line. Strong gross profitability combined with weak net profitability may indicate

a problem with indirect operating expenses or non-operating items, such as interest expense. In general terms,

net profitability shows the effectiveness of management. Though the optimal level depends on the type of

business, the ratios can be compared for firms in the same industry.

Return on assets:Net Income/Total Assetsindicates how effectively the company is deploying its assets.

A very low return on asset, or ROA, usually indicates inefficient management, whereas a high ROA means

efficient management. However, this ratio can be distorted by depreciation or any unusual expenses.

Return on investment 1:Net Income/Owners' Equityindicates how well the company is utilizing its equity

investment. Due to leverage, this measure will generally be higher than return on assets. ROI is considered to

be one of the best indicators of profitability. It is also a good figure to compare against competitors or an

industry average. Experts suggest that companies usually need at least 10-14 percent ROI in order to fund

future growth. If this ratio is too low, it can indicate poor management performance or a highly conservativebusiness approach. On the other hand, a high ROI can mean that management is doing a good job, or that the

firm is undercapitalized.

Return on investment 2:Dividends +/- Stock Price Change/Stock Price Paidfrom the investor's point of

view, this calculation of ROI measures the gain (or loss) achieved by placing an investment over a period of

time.

Earnings per share: Net Income/Number of Shares Outstandingstates a corporation's profits on a per-

share basis. It can be helpful in further comparison to the market price of the stock.

I nvestment turnover:Net Sales/Total Assets

measures a company's ability to use assets to generate sales.Although the ideal level for this ratio varies greatly, a very low figure may mean that the company maintains

too many assets or has not deployed its assets well, whereas a high figure means that the assets have been

used to produce good sales numbers.

Sales per employee:Total Sales/Number of Employeescan provide a measure of productivity. This ratio

will vary widely from one industry to another. A high figure relative to one's industry average can indicate

either good personnel management or good equipment.

LIQUIDITY RATIOS

Liquidity ratios demonstrate a company's ability to pay its current obligations. In other words, they relate tothe availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All
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small businesses require a certain degree of liquidity in order to pay their bills on time, though start-up and

very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate

poor management or a need for additional capital. Any company's liquidity may vary due to seasonality, the

timing of sales, and the state of the economy. But liquidity ratios can provide small business owners with

useful limits to help them regulate borrowing and spending. Some of the best-known measures of a

company's liquidity include:

Curr ent ratio: Current Assets/Current Liabilities

measures the ability of an entity to pay its near-termobligations. "Current" usually is defined as within one year. Though the ideal current ratio depends to someextent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratiomeans that the company may not be able to pay its bills on time, while a higher ratio means that the companyhas money in cash or safe investments that could be put to better use in the business.Quick ratio (or " acid test" ):Quick Assets (cash, marketable securities, and receivables)/CurrentLiabilitiesprovides a stricter definition of the company's ability to make payments on current obligations.Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poorcollection program for accounts receivable. If it is lower, it may indicate that the company relies too heavilyon inventory to meet its obligations.Cash to total assets:Cash/Total Assetsmeasures the portion of a company's assets held in cash or

marketable securities. Although a high ratio may indicate some degree of safety from a creditor's viewpoint,excess amounts of cash may be viewed as inefficient.Sales to receivables (or turnover ratio):Net Sales/Accounts Receivablemeasures the annual turnover ofaccounts receivable. A high number reflects a short lapse of time between sales and the collection of cash,while a low number means collections take longer. Because of seasonal changes this ratio is likely to vary.As a result, an annual floating average sales to receivables ratio is most useful in identifying meaningfulshifts and trends.Days' receivables ratio:365/Sales to receivables ratiomeasures the average number of days that accountsreceivable are outstanding. This number should be the same or lower than the company's expressed creditterms. Other ratios can also be converted to days, such as the cost of sales to payables ratio.Cost of sales to payabl es:Cost of Sales/Trade Payablesmeasures the annual turnover of accounts payable.Lower numbers tend to indicate good performance, though the ratio should be close to the industry standard.Cash turnover:Net Sales/Net Working Capital (current assets less current liabilities)reflects thecompany's ability to finance current operations, the efficiency of its working capital employment, and themargin of protection for its creditors. A high cash turnover ratio may leave the company vulnerable tocreditors, while a low ratio may indicate an inefficient use of working capital. In general, sales five to sixtimes greater than working capital are needed to maintain a positive cash flow and finance sales.

LEVERAGE RATIOS

Leverage ratios look at the extent to which a company has depended upon borrowing to finance itsoperations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage ratioscompare assets or net worth with liabilities. A high leverage ratio may increase a company's exposure to riskand business downturns, but along with this higher risk also comes the potential for higher returns. Some ofthe major measurements of leverage include:

Debt to equi ty ratio:Debt/Owners' Equityindicates the relative mix of the company's investor-suppliedcapital. A company is generally considered safer if it has a low debt to equity ratiothat is, a higher

proportion of owner-supplied capitalthough a very low ratio can indicate excessive caution. In general,debt should be between 50 and 80 percent of equity.Debt ratio:Debt/Total Assetsmeasures the portion of a company's capital that is provided by borrowing. Adebt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratiois similar, and can easily be converted to, the debt to equity ratio.Fixed to worth ratio:Net Fixed Assets/Tangible Net Worthindicates how much of the owner's equity has

been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets


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(physical assets like cash, inventory, property, plant, and equipment) are included in the calculation, and thatthey are valued less depreciation. Creditors usually like to see this ratio very low, but the large-scale leasingof assets can artificially lower it.I nterest coverage:Earnings before Interest and Taxes/Interest Expenseindicates how comfortably thecompany can handle its interest payments. In general, a higher interest coverage ratio means that the small

business is able to take on additional debt. This ratio is closely examined by bankers and other creditors.

EFFICIENCY RATIOS

By assessing a company's use of credit, inventory, and assets, efficiency ratios can help small business

owners and managers conduct business better. These ratios can show how quickly the company is collectingmoney for its credit sales or how many times inventory turns over in a given time period. This informationcan help management decide whether the company's credit terms are appropriate and whether its purchasingefforts are handled in an efficient manner. The following are some of the main indicators of efficiency:

Annual inventory turnover:Cost of Goods Sold for the Year/Average Inventoryshows how efficiently thecompany is managing its production, warehousing, and distribution of product, considering its volume ofsales. Higher ratiosover six or seven times per yearare generally thought to be better, although extremelyhigh inventory turnover may indicate a narrow selection and possibly lost sales. A low inventory turnoverrate, on the other hand, means that the company is paying to keep a large inventory, and may be overstockingor carrying obsolete items.

I nventory holding period:365/Annual Inventory Turnover

calculates the number of days, on average, thatelapse between finished goods production and sale of product.

Inventory to assets ratioInventory/Total Assetsshows the portion of assets tied up in inventory. Generally,a lower ratio is considered better.Accounts receivable turnover Net (credit) Sales/Average Accounts Receivablegives a measure of howquickly credit sales are turned into cash. Alternatively, the reciprocal of this ratio indicates the portion of ayear's credit sales that are outstanding at a particular point in time.Collection period365/Accounts Receivable Turnovermeasures the average number of days the company'sreceivables are outstanding, between the date of credit sale and collection of cash.

SUMMARY

Although they may seem intimidating at first glance, all of the aforementioned financial ratios can be derivedby simply comparing numbers that appear on a small busi-ness's income statement and balance sheet. Smallbusiness owners would be well-served by familiarizing themselves with ratios and their uses as a trackingdevice for anticipating changes in operations.

Financial ratios can be an important tool for small business owners and managers to measure their progresstoward reaching company goals, as well as toward competing with larger companies. Ratio analysis, when

performed regularly over time, can also help small businesses recognize and adapt to trends affecting theiroperations. Yet another reason small business owners need to understand financial ratios is that they provideone of the main measures of a company's success from the perspective of bankers, investors, and businessanalysts. Often, a small business's ability to obtain debt or equity financing will depend on the company's

financial ratios.

Despite all the positive uses of financial ratios, however, small business managers are still encouraged toknow the limitations of ratios and approach ratio analysis with a degree of caution. Ratios alone do not makegive one all the information necessary for decision making. But decisions made without a look at financialratios, the decision is being made without all the available data.

RATES OF RETURN

There are two measures of profitability common in the financial community, return on

assets (ROA) and return on equity (ROE).


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ROA= net income / total average assets

ROE= net income / total stockholders equity

Assets and equity, as used in these two common indexes, are both measured in terms ofbook value. Thus, if assets were acquired some time ago at a low price, the currentperformance of the organization may be overstated by the use of historically valueddenominators. As a result, the accounting returns for any investment generally do not correlate

well with the true economic internal rate of return for that investment.

Difficulties with using either ROA and ROE as a performance measure can be seen inmerger transactions. Suppose we have an organization that has been earning a net income of$500 on assets with a book value of $1000, for a hefty ROA of 50 percent. That organizationis now acquired by a second firm, which then moves the new assets onto its books at theacquisition price, assuming the acquisition is treated using the purchase method of ac-counting. Of course, the acquisition price will be considerably above the $1,000 book value ofassets, for the potential acquirer will have to pay handsomely for the privilege of earning $500on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the acquisition, itwill appear that the returns of the acquired firm have fallen. The firm continues to earn $500,

but the asset base is now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA maybe less as a result of other factors, such as increased depreciation of the newly acquiredassets. Yet in fact nothing has happened to the earnings of the firm . All that has changed is itsaccounting, not its performance.

Another fundamental problem with ROA and ROE measures comes from the tendencyof analysts to focus on performance in single years, years that may be idiosyncratic. At aminimum, one should examine these ratios averaging over a number of years to isolate

idiosyncratic returns and try to find patterns in the data.

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STOCK MARKET RATIOS

Several ratios are calculated not from the income statements and balance sheets oforganizations, but from data associated with their stock market performance. The three mostcommon ratios are earnings per share(EPS), theprice-earnings ratio(P/E), and the dividend-

yield ratio:

EPS= (net income - preferred dividends) /

common shares outstanding

P/E= market price per share / earnings per share

Dividend yield= annual dividends / price per share

EPS is one of the most widely used statistics. Indeed, it is required to be given in theincome statements of publicly traded firms. As we can see, the ratio tells us how much the
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firm has earned per share of stock outstanding. As it turns out, this is not generally a veryhelpful statistic. It says nothing about how many assets a firm used to generate those earnings,and hence nothing about profitability. Nor does it tell us how much the individual stockholderhas paid per share for the rights over that annual earning. Further, accounting practices in thecalculation of earnings may distort these ratios. And finally, the treatment of inventories isagain problematic.

The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily

newspapers. A high P/E tends to indicate that investors believe the future prospects of the firmare better than its current performance. They are in some sense paying more per share than thefirm's current earnings warrant. Again, earnings are treated differently in different accounting

practices.

Finally, from the perspective of some stockholders at least, dividend policy may beimportant. The dividend-yield ratio tells us how much of its earnings the firm pays out individends versus reinvestment. Rapidly growing firms in new areas tend to have low dividend-yield ratios; more mature firms tend to have higher ratios.

SUMMARY

In this note, we have briefly reviewed a variety of ratios commonly used in strategicplanning. All of these ratios are subject to manipulation through opportunistic accountingpractices. Nevertheless, taken as a group and used judiciously, they may help to identify firmsor business units in particular trouble. Finding profitable new ventures requires rather morework.

Theprice-to-earnings ratio(orp/e ratiofor short) is the most popular way to measure the relative valuation of

two stocks. It tells the investor how muchWall Streetis willing to pay for $1 of earnings. A $10 stock with

$1EPS(earnings per share) is going to have a P/E of 10 ($10 stock price divided by $1 EPS = 10 p/e). You canalso invert thisfinancial ratioto calculate something known as the earnings yield. This will allow you to compareshares of a company to other investments such asbondsorreal estate. Theearnings yieldis calculated bysimply dividing 1 by the p/e ratio in this case, 1/10 = 0.10, or 10%. A stock with a 10 p/e is going to have a10% earnings yield. That might be very attractive if bonds are yielding only 4%. (For more information on usingthis as an indicator of overvalued or undervalued stock markets, readLong Term Treasury Bond Yields vsEarnings Yields - Using the Risk Premium as a Quick and Dirty Gauge of Market Valuations.

One of the limitations of the p/e ratio is that it doesnt factor in growth in underlying earnings. Back when SamWaltonwas rolling Wal-Mart stores throughout the United States, his customers could have told you that the

cookie-cutter formula was going to continue to be rolled out throughout the nation. The gains in annual profitfrom year-to-year were eye-popping. The result? An astronomical p/e ratio. Still, when factoring in futuregrowth, Wal-Mart was one of the cheapest stocks available on a value basis because the future cash flows morethan justified that level of valuation after all $10,000 invested back during theIPOwithdividends reinvestedis now

worth north of $10,000,000 and throws off at least $170,000 in cash dividends each year.ThePEG Ratioto the Rescue

There is a way to adjust for the shortcomings of the p/e ratio and its called the PEG ratio. It stands for the price-to-earnings-to-growth ratio. To calculate the PEG ratio simply take the p/e ratio and divide the growth inearnings per share.

Imagine that we have two companies Company ABC and Company XYZ. The first, Company ABC, trades at $20per share and has $1.50 in per share earnings with conservatively estimated future growth of 3% per annum.The second, Company XYZ, trades at $60 per share, has $4 in per share earnings and has conservativelyestimated future growth of 5% per annum. Which stock is the cheaper one?

Using the PEG ratio we can answer that question. We would simply plug in the numbers to the PEG ratio formula

and get the following:
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Company ABC: $20 per share divided by $1.50 = 13.33 p/e ratio divided by 3% growth = 4.443 Company XYZ:$60 per share divided by $4.00 = 15.00 p/e ratio divided by 5% growth = 3.000

In this case, Company XYZ appears cheaper at $60 per share than Company ABC does at $20 per share despitehaving a higher p/e ratio as a result of the future growth in earnings. The guideline to use is that the lower thePEG ratio, the cheaper the stock.

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