Boost Your Business With Financial Ratios

INTRODUCTION TO FINANCIAL RATIOS

Financial ratios are analytical tools that use data from financial statements to assess a company’s performance and financial position. Financial ratios provide a standardized way to asses a company’s financial performance and to compare companies of different sizes and industries across different time periods.

IMPORTANCE OF FINANCIAL RATIOS

Financial ratios are important for several reasons:

1. They facilitate comparison between companies or industries
2. They simplify complex financial data
3. They can be used to identify trends over time
4. They highlight areas of strength or weakness in a company’s operations
5. They allow for quick assessment of a company’s financial position
6. They aid in decision-making for investors, creditors, and management

FINANCIAL RATIO CATEGORIES

Financial ratios fall into several categories.

1. Liquidity
2. Profitability
3. Leverage
4. Efficiency
5. Market Value

Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term obligations, that is, whether it is able to pay for current operating expenses and service debt.

Key liquidity ratios include:

• Current ratio
• Quick ratio (acid test ratio)
• Cash ratio

a) Current Ratio

Current Assets / Current Liabilities

• Current ratio measures the amount a company has in current assets for every $1 in current liabilities.
• A good current ratio should be above one.

b) Quick Ratio (Acid Test)

(Current Assets — Inventory) / Current Liabilities

• Quick ratio measures a company’s ability to meet short-term obligations, without relying on sales of inventories.
• An ideal quick ratio should be above one.
• The quick ratio is a more conservative measure than the current ratio. A company could have a quick ratio below one and still be able to meet its short-term obligations.
• The quick ratio varies by industry, and companies in some industries will be able to meet their short-term obligations despite a lower than average quick ratio.

c) Cash Ratio

Cash and Cash Equivalents / Current Liabilities

• The cash ratio is the most conservative of the liquidity ratios, and shows a company’s ability to pay off short-term debts immediately.
• Ideally, the cash ratio should between 0.5 to 1 to be considered good.
• The cash ratio varies by industry, and companies in some industries will still be able to meet their short-term obligations despite a lower than average cash ratio.

d) Cash-Conversion Cycle (CCC)

Days Inventory Outstanding + Days Sales Outstanding — Days Payables Outstanding

• The cash-conversion cycle measures how long it takes for a company to convert inventory back into cash.

Profitability Ratios

Profitability ratios are used to assess a company’s ability to generate profits relative to sales, assets and equity.

Key profitability ratios include:

1. Gross profit margin
2. Net profit margin
3. Return on assets
4. Return on equity
5. EBITDA margin

a) Gross Profit Margin

((Revenue — Cost of Goods Sold) / Revenue) x 100

• Gross profit margin measures the percentage of revenue that exceeds cost of goods sold.
• A higher gross profit margin indicates better efficiency in production and pricing.

b) Net Profit Margin

(Net Income / Revenue) x 100

• Net profit margin shows how much profit is generated from each dollar of sales.

c) Return on Assets (ROA)

(Net Income / Average Total Assets) x 100

• Return on assets measures how efficiently a company uses its assets to generate profits.

d) Return on Equity (ROE)

(Net Income / Average Shareholders’ Equity) x 100

• Return on equity measures how effectively management is using shareholders’ investments.

e) EBITDA Margin

EBITDA Margin = (EBITDA / Revenue) x 100

• EBITDA means earnings before interest, taxes, depreciation and amortization.
• EBITDA strips out non-operating expenses such as interest and taxes and non-cash expenses such as depreciation and amortization, and is a better reflection of how the company’s operations are performing.

Leverage or Solvency Ratios

Leverage ratios are used to evaluate a company’s debt levels and ability to meet financial obligations.

Key leverage ratios include:

1. Debt-to-equity
2. Interest coverage
3. Debt-to-EBITDA

a) Debt-to-Equity Ratio

Total Liabilities / Shareholders’ Equity

• Lower debt-to-equity ratio means a company has less financial risk.

b) Interest Coverage Ratio

EBIT / Interest Expense

• The interest coverage ratio shows whether a company has enough earnings to pay interest on outstanding debt.
• EBIT means earnings before interest and taxes.
• A higher ratio is better.

c) Debt-to-EBITDA Ratio

Total Debt / EBITDA

• This ratio indicates how many years it would take to pay off all debt if EBITDA is used entirely for debt repayment.
• A lower ratio is better.

Efficiency Ratios

Efficiency ratios measure how well a company uses its assets and manages its liabilities. The higher these ratios are the more efficient a company is using its assets.

Key efficiency ratios include:

1. Inventory turnover
2. Accounts receivable turnover
3. Asset turnover

a) Inventory Turnover

Cost of Goods Sold / Average Inventory

• Higher inventory turnover indicates more efficient inventory management

b) Accounts Receivable Turnover

Revenue / Average Accounts Receivable

• The accounts receivable turnover ratio measures how quickly a company collects payment from customers.
• Higher accounts receivable turnover indicates faster collection of receivables.

c) Asset Turnover Ratio

Revenue / Average Total Assets

• Asset turnover indicates how efficiently a company uses its assets to generate revenue.
• A higher ratio indicates more efficient use of assets to generate revenue.

Market Value Ratios

Market value ratios assess a company’s stock price relative to financial metrics.

Key market value ratios include:

1. Price-to-earnings (P/E) ratio
2. Price-to-book (P/B) ratio
3. Dividend yield

a) Price-to-Earnings (P/E) Ratio

Market Price per Share / Earnings per Share

• The P/E ratio indicates how much investors are willing to pay for each dollar of earnings.
• The P/E ratio is one of the most popular ratios used among investors to gauge how a company’s share price is performing relative to its earnings.

b) Price-to-Book (P/B) Ratio

Market Price per Share / Book Value per Share

• The P/B ratio compares a company’s market value to its book value.
• Book value is (Total Assets — Intangible Assets — Total Liabilities) and shows the historical cost of a company’s physical assets.
• The P/B ratio measures how much investors are willing to pay for each dollar of a company’s physical assets.
• Intangible assets are excluded from the calculation because they are not physical assets.

c) Dividend Yield

Annual Dividends per Share / Market Price per Share

• The dividend yield shows the return on investment for dividend-paying stocks. Not all companies pay dividends on their stock.

INTERPRETING FINANCIAL RATIOS

Take the following steps to interpret financial ratios:

1. Compare ratios to industry benchmarks. If ratios are significantly higher or lower than industry norms, investigate further to identify any issues with the company’s operations.
2. Analyze trends in ratios over time.
3. Consider the company’s business model and strategy when analyzing ratios.
4. Use multiple ratios for a comprehensive view.
5. Be aware of potential limitations or manipulations.

LIMITATIONS OF FINANCIAL RATIOS

Financial ratios do not come in a foolproof case. Ratios should be analyzed on a combined basis, and not in isolation. One ratio by itself will not tell the story of what is happening in a business.

Here are some things to consider about ratios:

1. Ratios are based on historical data, and may not accurately predict future performance.
2. Different industries may have different benchmarks for ratios.
3. Ratios can be affected by accounting methods or one-time events, so be on the lookout for these.
4. Ratios may not capture intangible assets or market position.
5. Ratios should be used in conjunction with other analytical methods.

PRACTICAL APPLICATION

Below is an example of how to apply ratios in practice.

Example: ABC Company

• Current Assets: $1,000,000
• Current Liabilities: $800,000
• Inventory: $175,000
• Revenue: $1,500,000
• Net Income: $250,000
• Total Assets: $1,250,000
• Shareholders’ Equity: $1,000,000

Calculating and Interpreting Ratios

1. Current Ratio = 1,000,000 / 800,000 = 1.25

Interpretation: The company has $1.25 in current assets for every $1 in current liabilities, indicating good short-term liquidity.

2. Quick Ratio = (1,000,000–175,000) / 800,000 = 1.03

Interpretation: The company can cover its short-term liabilities without relying on inventories.

3. Net Profit Margin = 250,000 / 1,500,000 = 0.17 or 17%

Interpretation: The company generates $0.17 of profit for every dollar of revenue.

4. Return on Assets (ROA) = 250,000 / 1,250,000 = 0.20 or 20%

Interpretation: The company generates 20 cents of profit for every dollar of assets.

5. Return on Equity (ROE) = 250,000 / 1,000,000 = 0.25 or 25%

Interpretation: The company generates 25 cents of profit for every dollar of shareholders’ equity.

Financial ratios are powerful tools for analyzing a company’s financial health and performance. However, they should be used as part of a broader analysis that includes understanding the company’s business model, industry trends, and economic conditions.

When used correctly, these ratios can provide valuable insights for investors, creditors, and management alike, allowing them to make better investment and management decisions.

Financial ratios should be in every business’ toolbox. Learning to use them will put you ahead of the financial game.