# Financial Ratios

Editor: Sonya D. Hill
Date: 2012
Publisher: Gale, a Cengage Company
Document Type: Topic overview
Pages: 7
Content Level: (Level 4)

Full Text:
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# Financial Ratios

Financial ratios are one of the most common tools of managerial decision making. A ratio is the comparison of one number to another—mathematically, a simple division problem. Financial ratios involve the comparison of various figures from financial statements in order to gain information about a company's performance. It is the interpretation, rather than the calculation, that makes financial ratios a useful tool for business managers. Ratios may serve as indicators, clues, or red flags regarding noteworthy relationships between variables used to measure the firm's performance in terms of profitability, asset utilization, liquidity, leverage, or market valuation.

## FINANCIAL SOURCES

Financial ratios do not produce original data;, they only create new representations of data that already exists. Ratios are derived from several different financial documents. The balance sheet, income statement, and statement of cash flows are all used to create ratios. The balance sheet shows all of the companies assets and liabilities at a fixed moment in time. The income statement shows how much money the business made and how much it spent over a length of time, and the cash flows statement shows how exactly money entered and left the company. The fourth financial statement, the equity statement, is not used as often in computing ratios, since analysts can get most information they need from the first three documents.

## APPLICATIONS

Financial ratios are used in investment, performance, and lending decisions. External viewers of financial ratios have the most experience in the investment perspective. Many ratios give a useful snapshot of the business and how it is doing. Experienced investors can use these ratios to find successful business to invest in, or even better, businesses that show promising growth but are not yet widely recognized.

Internally, financial ratios are used by business leaders to gauge the performance of business initiatives. A manager that can successfully use funding will manage to produce more profit overall than the cost of running an area of the business, something that financial ratios will clearly show. Businesses can also use ratios to plan for the future, adjusting their sources of capital and altering their funding decisions to appeal to investors.

Lenders look at businesses much like investors do. They want evidence that the business keeps enough cash to pay back loans and has a healthy balance of debt and equity. Lenders often examine this information through financial ratios. A business that has strong ratios which show a firm base of assets dependable revenue can negotiate with lenders very successfully.

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## PROFITABILITY, LIQUIDITY, AND SOLVENCY

The financial ratios are closely connected with the ideas of profitability, liquidity, and solvency. Profitability refers to the return that a business earns on its activities and capital. As Justin Goodel Longernecker and associates discuss in Small Business Management, “Is the business providing a good rate of return on its assets? There is no more important question when it comes to determining if a business is strong economically.” Profitability has both long-term and short-term aspects. In the long term, a business should be competitively profitable—it should earn more than the total of its capital and do well enough to compete with other businesses in the industry. In the short term, businesses should be profitable enough to pay its variable costs.

Liquidity refers to how easily a business can pay out cash obligations within a specific time frame. Within the short term, the business should have enough cash or readily convertible assets to pay short-term debts. In the long term, the business should have enough value in assets that can be sold to pay off long-term debts (although some industries are used to operating with low liquidity). Liquidity measurements often come from statements of cash flows.

Solvency is the net worth of the business. It is an important quality when the business is trying to secure debt or simply trying to survive challenging economic times. Businesses that are solvent tend to have lower debt numbers and more capital raised from equity, as well as a greater number of business-owned assets than other businesses.

## USES OF TREND ANALYSIS AND RATIO ANALYSIS

Trend analysis is a vital component of any financial ratio study. Financial ratios are not static: they change based on a number of different factors, and often wax or wane with economic changes. Trend analysis is the practice of comparing financial ratios with the same ratios created at different points in the past. By charting a timeline of the same ratio, businesses can see how it is affected by outside events and how pertinent current changes are. Trend analysis provides much-needed background for ratios and helps businesses spot problems it could not using only present-day ratios.

There are basically two uses of financial ratio analysis: to track individual firm performance over time, and to make comparative judgments regarding firm performance. Firm performance is evaluated using trend analysis—calculating individual ratios on a per-period basis, and tracking their values over time. This analysis can be used to spot trends that may be cause for concern, such as an increasing average collection period for outstanding receivables or a decline in the firm's liquidity status. In this role, ratios serve as red flags for troublesome issues or as benchmarks for performance measurement.

Another common usage of ratios is to make relative performance comparisons. For example, comparing a firm's profitability to that of a major competitor or observing how the firm stacks up versus industry averages enables the user to form judgments concerning key areas such as profitability or management effectiveness. Financial ratios are used by parties both internal and external to the firm. External users include security analysts, current and potential investors, creditors, competitors, and other industry observers. Internally, managers use ratio analysis to monitor performance and pinpoint strengths and weaknesses from which specific goals, objectives, and policy initiatives may be formed.

## PROFITABILITY RATIOS

Perhaps the type of ratios most often used and considered by those outside a firm are profitability ratios. Profitability ratios provide measures of profit performance that serve to evaluate the periodic financial success of a firm. One of the most widely used financial ratios is net profit margin, also known as return on sales.

Return on sales provides a measure of bottom-line profitability. For example, a net profit margin of 6 percent means that for every dollar in sales, the firm generated six cents in net income.

Two other margin measures are gross profit margin and operating margin.

Gross margin measures the direct production costs of the firm. A gross profit margin of 30 percent would indicate that for each dollar in sales, the firm spent 70 cents in direct costs to produce the good or service that the firm sold.

Operating margin goes one step further, incorporating nonproduction costs such as selling, general, and administrative expenses of the firm. Operating profit is also commonly referred to as earnings before interest and taxes, or EBIT. An operating margin of 15 percent would indicate that the firm spent an additional 15 cents out of every dollar in sales on nonproduction expenses, such as sales commissions paid to the firm's sales force or administrative labor expenses.

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 Asset Utilization Ratios Profitability Ratios Gross profit margin Return on assets Operating margin Return on equity Net profit margin

Asset Utilization Ratios Profitability Ratios

Two very important measures of the firm's profitability are return on assets and return on equity.

Return on assets (ROA) measures how effectively the firm's assets are used to generate profits net of expenses. An ROA of 7 percent would mean that for each dollar in assets, the firm generated seven cents in profits. This is an extremely useful measurement for any firm's management performance as it is the job of managers to utilize the assets of the firm to produce profits.

Return on equity (ROE) measures the net return per dollar invested in the firm by the owners, the common shareholders. An ROE of 11 percent means the firm is generating an 11-cent return per dollar of net worth.

In each of the profitability ratios mentioned above, the numerator in the ratio comes from the firm's income statement. Hence, these are measures of periodic performance, covering the specific period reported in the firm's income statement. Therefore, the proper interpretation for a profitability ratio such as an ROA of 11 percent would be that, over the specific period, the firm returned 11 cents on each dollar of asset investment.

## ASSET UTILIZATION RATIOS

Asset utilization ratios provide measures of management effectiveness. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilization ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues. An example is the total asset turnover (TAT) ratio.

This ratio offers managers a measure of how well the firm is utilizing its assets in order to generate sales revenue. An increasing TAT would be an indication that the firm is using its assets more productively. For example, if the TAT for 2009 was 2.2×, and for 2010 it was 3×, the interpretation would follow that in 2010, the firm generated three dollars in sales for each dollar of assets, and an additional 80 cents in sales per dollar of asset investment over the previous year. Such change may be an indication of increased managerial effectiveness.

A similar measure is the fixed asset turnover (FAT) ratio.

Fixed assets (such as plant and equipment) are often more closely associated with direct production than are current assets (such as cash and accounts receivable), so many analysts prefer this measure of effectiveness. A FAT of 1.6× would be interpreted as the firm generating \$1.60 in sales for every \$1.00 it had in fixed assets.

Two other asset utilization ratios concern the effectiveness of a firm's asset management. Inventory is an important economic variable for management to monitor since dollars invested in inventory have not yet resulted in any return. Inventory is an investment, and it is important for the firm to maximize its inventory turnover. The inventory turnover ratio is used to measure this aspect of performance.

Cost of goods sold (COGS) derives from the income statement and indicates the expense dollars attributed to the actual production of goods sold during a specified period. Inventory is an asset on the balance sheet. Because the balance sheet represents the firm's assets and liabilities at one point in time, an average figure is often used from two successive balance sheets. Managers attempt to increase this ratio, since a higher turnover ratio indicates that the firm is going through its inventory more often due to higher sales. A turnover ratio of 4.75×, or 475 percent, means the firm sold and replaced its inventory stock more than four and one-half times during the period measured on the income statement.

One of the most critical ratios that management must monitor is days sales outstanding (DSO), also known as average collection period.

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 Asset Utilization Ratios Total asset turnover Days sales outstanding Inventory turnover Fixed asset turnover

Asset Utilization Ratios

This represents a prime example of the use of a ratio as an internal monitoring tool. Managers strive to minimize the firm's average collection period, since dollars received from customers become immediately available for reinvestment. Periodic measurement of the DSO will “red flag” a lengthening of the firm's time to collect outstanding accounts before customers get used to taking longer to pay. A DSO of 36 means that, on average, it takes 36 days to collect on the firm's outstanding accounts. This is an especially critical measure for firms in industries where extensive trade credit is offered, but any company that extends credit on sales should be aware of the DSO on a regular basis.

## LEVERAGE RATIOS

Leverage ratios, also known as capitalization ratios, measure the firm's use of debt financing. These are extremely important for potential creditors who are concerned with the firm's ability to generate the cash flow necessary to make interest payments on outstanding debt. Thus, these ratios are used extensively by analysts outside the firm to make decisions concerning the provision of new credit or the extension of existing credit. It is also important for management to monitor the firm's use of debt financing. The commitment to service outstanding debt is a fixed cost to a firm, resulting in decreased flexibility and higher break-even production rates. Therefore, the use of debt financing increases the risk associated with the firm. Managers and creditors must constantly monitor the trade-off between the additional risk that comes with borrowing money and the increased opportunities that new capital provides. Leverage ratios provide a means of such monitoring.

Perhaps the most straightforward measure of a firm's use of debt financing is the total-debt ratio.

There are only two ways to finance the acquisition of any asset: debt (using borrowed funds) and equity (using funds from internal operations or selling stock in the company); total debt ratio covers both. A debt ratio of 35 percent means that for every dollar of assets the firm has, 35 cents were financed with borrowed money. The natural corollary is that the other 65 cents came from equity financing. This is known as the firm's capital structure—35 percent debt and 65 percent equity. Greater debt means greater leverage, and more leverage means more risk. How much debt is too much is highly subjective, and opinions vary from one manager to another. To a large extent, the nature of the business will determine debt risk. Large manufacturers, who require heavy investment in fixed plant and equipment, will require higher levels of debt financing than will service firms such as insurance or advertising agencies.

The total debt of a firm consists of both long- and short-term liabilities. Short-term (or current) liabilities are often a necessary part of daily operations and may fluctuate regularly depending on factors such as seasonal sales. Many creditors prefer to focus their attention on the firm's use of long-term debt. Thus, a common variation on the total debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the numerator.

Similarly, many analysts prefer a direct comparison of the firm's capital structure. Such a measure is provided by the debt-to-equity ratio.

This is perhaps one of the most misunderstood financial ratios, as many confuse it with the total debt ratio. A debt-to-equity ratio of 45 percent would mean that for each dollar of equity financing, the firm has 45 cents in debt financing. This does not mean that the firm has 45 percent of its total financing as debt; debt and equity percentages, together, must amount to 100 percent of the firm's total financing. A little algebra will illustrate this point. Let x = the percent of equity financing (in decimal form), so 0.45x is the percent of debt financing. Then x + 0.45 x = 1, and x = 0.69. So, a debt to equity ratio of 45 percent indicates that each dollar of the firm's assets is financed with 69 cents of equity and 31 cents of debt. The point here is to caution against confusing the interpretation of the debt-to-equity ratio with that of the total debt ratio.

Two other leverage ratios that are particularly important to the firm's creditors are the times-interest-earned and the fixed-charge coverage ratios. These measure the firm's ability to meet its ongoing commitment to service debt previously borrowed. The times-interest-earned (TIE) ratio, also known as the EBIT (earnings before interest and tax) coverage ratio, provides a measure of the firm's ability to meet its interest expenses with operating profits.

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 Leverage Ratios Total debt ratio Times interest earned Long-term debt ratio Fixed charge coverage Debt-to-equity ratio

Leverage Ratios

For example, a TIE of 3.6× indicates that the firm's operating profits from a recent period exceeded the total interest expenses it was required to pay by 360 percent. The higher this ratio, the more financially stable the firm and the greater the safety margin in the case of fluctuations in sales and operating expenses. This ratio is particularly important for lenders of short-term debt to the firm, since short-term debt is usually paid out of current operating revenue.

Similarly, the fixed charge coverage ratio, also known as the debt service coverage ratio, takes into account all regular periodic obligations of the firm.

The adjustment to the principal repayment reflects the fact that this portion of the debt repayment is not tax deductible. By including the payment of both principal and interest, the fixed charge coverage ratio provides a more conservative measure of the firm's ability to meet fixed obligations.

## LIQUIDITY RATIOS

Managers and creditors must closely monitor the firm's ability to meet short-term obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-term debt. Current liabilities represent obligations that are typically due in one year or less. The current and quick ratios are used to gauge a firm's liquidity.

A current ratio of 1.5× indicates that for every dollar in current liabilities, the firm has \$1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used to satisfy the liabilities if the firm ran short of cash. However, some current assets are more liquid than others. Obviously, the most liquid current asset is cash. Accounts receivable are usually collected within one to three months, but this varies by firm and industry. The

 Liquidity Ratios Current ratio Quick ratio

Liquidity Ratios

least liquid of current assets is often inventory. Depending on the type of industry or product, some inventory has no ready market. Since the economic definition of liquidity is the ability to turn an asset into cash at or near fair market value, inventory that is not easily sold will not be helpful in meeting short-term obligations. The quick (or acid test) ratio incorporates this concern.

By excluding inventories, the quick ratio is a more strident liquidity measure than the current ratio. It is a more appropriate measure for industries that involve long product production cycles, such as manufacturing.

## MARKET VALUE RATIOS

Managers and investors are interested in market ratios, which are used in valuing the firm's stock. The price-earnings ratio and the market-to-book value ratio are often used in the valuation analysis. The price/earnings ratio, universally known as the PE ratio, is one of the most heavily quoted statistics concerning a firm's common stock. It is reported in the financial pages of newspapers along with the current value of the firm's stock price.

Caution is warranted in the calculation of PE ratios. Analysts use two different components in the denominator: trailing earnings and forecast earnings. Trailing earnings refer to the firm's reported earnings, per share, over the last 12 months of operation. Forecast earnings are based on security analyst forecasts of what they expect the firm to earn in the coming 12-month period. Neither definition is more correct than the other; one should simply pay attention to which measure is used when consulting published PE ratios. A PE ratio of 16 means investors are willing to pay \$16 for \$1 worth of earnings. PE ratios are used extensively, on a comparative basis, to analyze investment alternatives. In investment lingo, the PE ratio is often referred to as the firm's “multiple.” A high PE is often indicative of investors' belief that the firm has very promising growth prospects, while firms in more mature industries often trade at lower multiples.

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 Market Value Ratios Price/earnings ratio Market-to-book ratio

Market Value Ratios

A related measure used for valuation purposes is the market-to-book value ratio. The book value of a firm is defined as:

Technically, the book value represents the value of the firm if all the assets were sold off and the proceeds used to retire all outstanding debt. The remainder would represent the equity that would be divided, proportionally, among the firm's shareholders. Many investors like to compare the current price of the firm's common stock with its book, or break-up, value.

This is also known as the price/book ratio. If the ratio is greater than one, which is often the case, then the firm is trading at a premium to book value. Many investors regard a market-to-book ratio of less than one an indication of an undervalued firm. Interpretation of market ratios—high PEs versus low PEs—is highly subjective. Nonetheless, these measures provide information that is valued both by managers and investors regarding the market price of a firm's stock.

## COMMON SIZE RATIOS

Common size ratios are used to contrast and compare the financial statements of large and small enterprises. Using the common size ratio, an analyst can determine which variables and which trends are affecting businesses of all sizes, and which of these is affecting small business more than larger business (and vice versa). Common size ratios are used to compare data about inventory, total assets, cost of goods sold, gross profit, overhead and production costs, and overall yearly revenue from one firm to another, usually one significantly larger than the other.

The comparison of one company to another company using common size ratios is sometimes called a cross-sectional analysis and will include industry averages to draw a comparison for both entities. Often the common size ratio will use comparative data about an industry's leader by which to compare another smaller, more modest operation to see how it might be progressing.

## CAUTIONS ON THE USE AND INTERPRETATION OF FINANCIAL RATIOS

Financial ratios represent tools for insight into the performance, efficiency, and profitability of a firm. However, ratio calculation and interpretation can be confusing. For example, does a firm's profit margin refer to gross profit margin, operating margin, or net profit margin? Is debt ratio a reference to total debt ratio, long-term debt ratio, or debt-to-equity ratio? Confusing these can make the use of ratio analysis a frustrating experience.

Future vs. Past Information. Financial ratios should be interpreted with care. A net profit margin of 12 percent may be outstanding for one type of industry and mediocre to poor for another. This highlights the fact that individual ratios should not be interpreted in isolation. Trend analyses should include a series of identical calculations, such as following the current ratio on a quarterly basis for two consecutive years. Ratios used for performance evaluation should always be compared to some benchmark, either an industry average or the identical ratio for the industry leader.

Another factor in ratio interpretation is identifying whether individual components, such as net income or current assets, originate from the firm's income statement or balance sheet. The income statement reports performance over a specified time period, while the balance sheet gives static measurement at a single point in time. These issues should be recognized when interpreting the results of ratio calculations.

Halo Effect. The halo effect occurs when an organization or individual encounters a positive or negative piece of information and applies the positive or negative viewpoint to everything around it. If an investor comes across a negative link between a financial ratio and the condition of the business, the investor is likely to apply that negative viewpoint to any business with a similar ratio, even though circumstances may be completely different. Likewise, internally businesses may focus only on the broad meaning of the ratio without paying attention to the details that created the ratios in the first place, details which may allay fears or point to specific issues.

Accounting Changes. If accounting policies remained the same year after year, trend analysis and ratio comparison would be easy activities. Unfortunately, accounting policies change in respond to general trends and government

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regulation, making it difficult to interpret ratios precisely over long periods of time. Previous accounting methods may create different ratios based on how income and expensives are tallied. Also, accounting methods vary from country to country, making it difficult to compare international companies based on the same rubric of ratios.

Adjustments and Industry Differences. Adjustments are made to financial documents to correct for nonrecurring items and other minor details. Taken as a whole, these adjustments can add up to sizable differences in the financial documents and affect many different ratios. Analyzers must always be aware if the financial documents they are pulling data from are versions from before or after adjustments, and they must make sure they compare ratios from the same types of documents used by other organizations.

## FORECASTING

Despite these issues, financial ratios are useful for internal and external evaluations of a firm's performance. A working knowledge and ability to use and interpret ratios remains a fundamental aspect of effective financial management. Financial ratios were widely used and highly valued during the stock market decline of 2000, when the bottom dropped out of the soaring dot-com economy. Throughout the long run-up, some financial analysts warned that the stock prices of many technology companies—particularly Internet start-up businesses—were overvalued based on the traditional rules of ratio analysis. Yet investors largely ignored such warnings and continued to flock to these companies in hopes of making a quick return.

Conversely, the 2008 crossroads in energy and fuel management—and China's growing need for oil and other raw materials—has been largely forecasted and interpreted using financial ratios. Investors and analysts alike have weathered rough parts of this supply and demand crisis by evaluating market circumstances with ratios and facing the truth rather than ignoring it.

In the end, it becomes clear that the old rules still apply, and that financial ratios remain an important means of measuring, comparing, and predicting a firm's performance.

## BIBLIOGRAPHY

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### Source Citation

Source Citation

Gale Document Number: GALE|CX4016600121