Financial ratios are an important tool to help understand a firm's financial condition. Ratios can be derived from published financial statements and used to compare performance among peers as well as performance within a company over time. This article is devoted to exploring financial ratios in five categories: Profitability, Activity, Liquidity, Leverage and Market Value.
Financial ratios allow analysts to synthesize large amounts of financial and accounting information into metrics that can be easily compared and contrasted. Examination of these ratios can help to assess the financial health of a firm. There are numerous parties that utilize financial ratios to provide insight into company performance. Stockholders, potential investors, managers, lenders, creditors, regulatory agencies and competitors are each interested in different ratios.
Financial ratios are often used in benchmarking. Comparisons are made between the financial ratios of a firm and those of its peers or an industry standard. A financial ratio can be used as a yardstick for measuring how the firm stacks up against its competition. Internal comparisons are also commonly made. Looking at historical financial ratios over a period of time can uncover important trends. Financial ratios are an excellent tool for understanding if the company's performance is improving or declining. The results of the ratio analysis can indicate a positive trend or raise red flags for areas of concern.
Each financial ratio is a simple calculation. The inputs for these calculations can be found in a firm's published financial statements. An understanding of the accounting practices is necessary for each firm being compared. When comparing two companies, adjustments might need to be made so that the accounting information is represented in a similar way.
Various questions can be answered by analyzing financial ratios. Are profit margins improving or deteriorating? How well are assets being utilized by the organization? How liquid is the organization? Is the company a good credit risk? Does the company have the ability to meet its interest payments? How much are investors willing to pay for each dollar of earnings? What proportion of net income was paid out in dividends?
There are twenty commonly used financial ratios that are discussed in this article. These ratios fall into five distinct categories:
- Market Value
The following section of this article provides formulas for calculating each ratio and an explanation for why the ratio is valuable.
Profitability Ratios are a set of metrics which illustrate how well a firm is using its resources to earn income. These ratios are helpful in assessing how successful management is at controlling costs and ultimately generating profit for the firm.
Net Profits after Taxes and Net Sales numbers are found on a firm's income statement. Net Profit Margin provides information on how much of the firm's revenue makes its way to the bottom line. Profit margins should not be analyzed in isolation. Profit margins from two different companies cannot be simply compared to determine which one is "better." For example, different industries can have wildly different economic models and therefore standard profit margins will vary significantly. In addition, the net profit margin could be low due to some investment for the future. The profit margin also does not take into account the volume of sales. If a company's strategic approach was to be a low cost leader, then the margins might be low. However, the company could still have attractive profits due to the velocity and volume of sales. It is best to compare the profit margins of firms with similar competitive approaches in the same industry. This ratio is also helpful for a company to evaluate its own historical margins over time. Upward movement over time indicates a positive trend.
Net Sales and Operating Expense numbers are found on a firm's income statement. Return on Sales looks at the profit margin from an operational perspective. It excludes the impact of financing and interest payments. As with Net Profit Margin, be mindful of the situation of the firm and the industry when doing a comparison. Just as was seen with Net Profit Margin, upward movement over time indicates a positive trend.
Net Sales numbers are found on a firm's income statement. Cost of Goods Sold is usually found on the income statement. However in some cases, this information is not available in published financial statements. Gross Profit Margin shows the percentage of revenue left after subtracting out the expenses incurred producing the product (e.g., materials and labor). The same caveats for comparing Net and Operating Profit Margin also applies to Gross Profit Margin. The higher the Gross Profit Margin, the more funds available to cover overhead costs and yield a profit.
Net Profit after Taxes is found on a firm's income statement and Total Assets are found on the firm's balance sheet. To calculate Average Total Assets, simply add the previous year and current year's Total Assets and divide by 2. Return on Assets is a key profitability indicator. This ratio helps measure how effectively the company is utilizing its assets. The higher the number, the more effective the assets being employed. However, since the capital intensity of each industry differs so significantly, this ratio should not be used to compare firms in different industries.
Net Profit after Taxes is found on a firm's income statement and Stockholder's Equity is found on the firm's balance sheet. To calculate Average Stockholder's Equity, simply add the previous year and current year's Stockholder's Equity and divide by 2. Return on Equity provides a measure for how well the stockholder's capital contribution is being utilized and translated into profit.
Net Income after Preferred Stock Dividends is often found on a firm's income statement and Number of Shares of Common Stock Outstanding is often found on the firm's balance sheet. To calculate Average Number of Shares of Common Stock Outstanding, simply add the previous year and current year's Number of Shares of Common Stock Outstanding and divide by 2. The Earnings per Share ratio provides the profit generated for each share of stock. Investors like to see growth in this ratio year over year.
Activity Ratios provide insight into how effectively the assets of the organization are being managed. Putting together the results of several of these metrics will show how quickly the firm can convert assets into cash. Proficient asset utilization will lessen the need for additional capital.
Net Sales numbers are found on a firm's income statement and Total Assets are found on the firm's balance sheet. To calculate Average Total Assets, simply add the previous year and current year's Total Assets and divide by 2. This ratio measures how well the company is utilizing its assets to create revenue.
Inventory is found on the firm's balance sheet and Cost of Goods Sold is usually found on the income statement. However in some cases, this information is not available in published financial statements. To calculate Average Inventory, simply add the previous year and current year's Inventory and divide by 2. Days of Inventory reveals the number of days a product is held in inventory until it is sold. This ratio helps determine how successfully the organization is managing its inventory and it can reveal how accurate their forecasting is. Typically, lower numbers are viewed more favorably. However, if inventories are too low then it will hamper the firm's ability to react quickly to surges in demand.
Using the same information as the Days of Inventory ratio, we can come up with and Inventory Turnover metric. This metric reveals the number of times that inventory turns over in a year. If this number is high, it can indicate an efficient inventory management strategy. The more inventory that is turned over, the higher the sales and the less inventory carrying costs.
Accounts Receivable is found on the firm's balance sheet and Net Sales is found on the income statement. To calculate Average Accounts Receivable, simply add the previous year and current year's Accounts Receivable and divide by 2. Day's Receivables reveals the approximate number of days it takes to collect payment from customer after the sale. The duration of this collection period is extremely important because a longer collection period can put significant strain on the firm's cash flow. In general, a low ratio is viewed positively.
Accounts Payable is found on the firm's balance sheet and Net Sales is found on the income statement. To calculate Average Accounts Payable, simply add the previous year and current year's Accounts Payable and divide by 2. Day's Payable provides a metric for how long it takes the firm to pay its suppliers and creditors. How quickly the company pays has implications on the cash flow.
To get an idea of the cash conversion cycle for a firm, you can take Day's Receivables plus Days Inventory and then subtract Day's Payables. The result provides insight into how long funds are tied up before they are converted into cash. The shorter the cycle, the more liquid the company is.
Net Sales are found on the firm's income statement and Current Assets and Current Liabilities are found on the balance sheet. Current Assets less Current Liabilities is commonly referred to as Working Capital. To calculate Average Current Assets, simply add the previous year and current year's Current Assets and divide by 2. Use the same methodology for determining Average Current Liabilities. Working Capital Turnover measures how effectively the company is using its working capital to generate sales. A higher turnover indicates a more effective use of working capital funds.
Liquidity Ratios provide valuable information on how solvent the company is. These ratios can provide an estimate for the amount of cash the company can quickly come up with. Analyzing these metrics will show the effectiveness with which a firm meets its short-term obligations. Creditors and lenders can use these ratios to assess a firm's ability to repay short-term debts.
Current Assets and Current Liabilities are found on the firm's balance sheet. This ratio is a test of liquidity, or its ability to pay off current liabilities with current assets. A healthy company will have a ratio of at least 1. However, the specific benchmark for an attractive Current Ratio is dependent on the industry. Cash flow and liquid assets vary significantly between industries.
Cash, Short-Term Investments, Receivables and Current Liabilities are found on the firm's balance sheet. This ratio serves a similar purpose as the Current Ratio, but takes the assets one step closer to actual cash. This ratio only utilizes assets which can be reliably liquidated on very short notice. This ratio excludes assets such as inventory, which might take some time to sell off or may require significant discounts in order to close a sale quickly.
Leverage Ratios measure the amount of financial leverage, or debt, a company is saddled with. This is an important ratio for stockholders because they will only get paid once the debt obligations have been met. In the case of liquidation, stockholders must wait in line. A firm that has higher debt is usually considered more risky.
Total Assets and Total Debt are found on the firm's balance sheet. This ratio reveals the extent to which capital was borrowed in order to fund the firm's operations. The higher the Debt Ratio, the more levered the firm. Highly levered firms are considered riskier because of the possibility of being forced into bankruptcy if the firm has trouble meeting its interest or principle payments.
Total Debt and Total Stockholder's Equity are found on the firm 's balance sheet. The Debt to Equity Ratio is another way to communicate the extent of leverage a firm is employing. It also shows the mix of Debt versus Equity that was used to finance operations. In this ratio, healthy firms usually have a ratio less than 1.
EBIT (Earnings before Interest and Taxes) and Interest Expenses are found on the firm's income statement. This ratio determines whether or not a firm is able to pay its annual interest costs. The higher the ratio, the more cushion the firm has if profits dip below expectations. Lenders want to ensure that the firm can weather downturns and usually require a minimum Coverage Ratio of 2x to ensure creditworthiness.
Market Value Ratios
Market Value Ratios provide a mechanism for combining accounting and stock market information. Current stockholders and future investors may use this information to make a buy, sell or hold decisions.
Current Market Price per Share is published continuously while the markets are open. Due to the intense fluctuations of many stocks, the Market Price per Share is often calculated using an average over a specific period of time. The formula for Earnings per Share was given in the previous section of this article that discussed Profitability Ratios. The PE Ratio is of particular interest to investors because it measures the price investors are willing to pay for each dollar of earnings. Higher PE ratios indicate confidence in the firm's future and growth prospects.
Dividends paid out are found on a firm's Cash Flow statement. As seen with the PE ratio, Market Price per Share is often calculated using an average over a specific time. This ratio measure the return investors receive in the form of dividends. However, the dividend is only part of an investor's total return. Investors can benefit from the dividend as well as appreciation of the stock. Therefore, a low dividend yield in itself does not necessarily translate to a poor return for the investor.
Dividends paid out are found on a firm's Cash Flow statement. The formula for Earnings per Share was given in the previous section of this article which discussed Profitability Ratios. Dividend Payout Ratio indicates the percentage of net income that was paid out to investors in the form of dividends. Both the Dividend Yield and Dividend Payout provide an investor with insight into future dividend streams that may be paid out to common stock holders.
The DuPont Model was developed by F. Donaldson Brown, an employee of E.I. du Pont de Nemours & Company, in the 1920's. This formula integrates various ratios together to provide an integrative look at highlights from both the income statement and the balance sheet.
Although we already covered the formula for ROE in this article, the DuPont Model is a different way of looking at the equation. This model is one that a manager might find valuable because it requires examination into several key areas in one formula. This model touches on profitability (Net Profit Margin), activity/efficiency (Asset Turnover) and leverage (Assets/Equity).
Common Size Financial Statements
Common size financial statements are often used by analysts to make comparisons. In a common size Income Statement, all entries of the income statement will be expressed as a percentage of sales. In a common size Balance Sheet, all entries are expressed as a percentage of total assets. Presenting the data in this way highlights changes in the operations or capital structure. It is much easier to uncover inconsistencies when presented in these absolute terms. It also allows for easier comparisons of different sized firms.
Financial ratios are widely used in the business environment. However, these ratios are just one tool of many that should be utilized in a comprehensive business analysis. Financial ratios are a great starting point, but there are many other factors that must be considered. A robust examination must take into account such factors as a company's long term strategy and changes in the industry environment. These details will not be uncovered using financial ratios alone.
The financial ratios discussed in this article are lagging indicators. The performance results contained in the financial statements are based on past decisions. To truly understand the future financial health of a company and its sustainability, the rationale behind such decisions and the long term strategies must also be considered.
Finally, a deep understanding of the company's accounting practices is necessary for a ratio based analysis to be accurate. Since accounting practices vary from company to company, ratios might not always compare apples to apples. For example, the method used for accounting for inventory (LIFO or FIFO) would create different inventory amounts. In addition, financial ratios may be subject to manipulation. Firms may choose accounting practices that disguise certain charges or bolster revenue to make a ratio appear more favorable.
Financial ratios are most valuable when used as part multifaceted approach to analyzing a business.
Terms & Concepts
Accounts Payable: Outstanding balance of money a company owes to its creditors, suppliers and vendors for goods and services. This is generally of a short-term nature, requiring payment in less than 12 months.
Accounts Receivable: The balance of money owed to a company for the goods and services it provided. This is treated as a current asset on the balance sheet.
Asset: Anything having value that is owned by a company and that can be used to pay off debts. Categories of assets can include current assets (e.g., cash, accounts receivables, inventory), fixed assets (e.g., capital equipment, buildings) and intangible assets (e.g., goodwill, patents).
Debt: The amount of money the firm has borrowed from creditors.
Dividend: Portion of the company profits that is distributed to stockholders.
Equity: Stockholders' ownership interest in a corporation (includes both common and preferred stockholders).
Leverage: The extent to which a business is using borrowed capital in its operations.
Liquidity: The degree to which assets can quickly and reliably be converted to cash.
Akbulut, R., & Aktas, M. (2013). Proper financial strategies for the multinational firms against the global economic crisis. Journal of Alanya Faculty of Business/Alanya Isletme Fakültesi Dergisi, 5(2), 1-8. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91521008&site=ehost-live
Ben Chin-Fook, Y., Mohamad, Z., & K-Rine, C. (2013). The application of principal component analysis in the selection of industry specific financial ratios. British Journal of Management & Economics, 3(3), 242-252. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90544975&site=ehost-live
Bodie, Z., & Merton, R.C. (1998). Finance. Upper Sadd le River, New Jersey: Prentice-Hall.
Brealey, R.A., & Myers, S.C. (1996). Principles of corporate finance. New York: McGraw-Hill.
Bruns, W. (1992). Introduction to financial ratios and financial statement analysis. Harvard Business School Note, 9-193-029, 1-15.
Harris, P., Stahlin, W., Arnold, L., & Kinkela, K. (2013). GAAP vs. IFRS treatment of leases and the impact on financial ratios. Review of Business & Finance Studies, 4(2), 97-99. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89602788&site=ehost-live
Healy, P.M. & Cohn, J. (2000) Financial statement and ratio analysis. Harvard Business School Note, 9-101- 029, 1-6.
Today's challenging global economy puts the spotlight on financial statement analysis. (2009). Managing Credit, Receivables & Collections, 2009(1), 1-7. Retrieved on February 13, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=35937402&site=ehost-live
Beaver, W.H. & Horngren, J.E. (1991). Ten commandments of financial statement analysis. Analysts Journal, 47(1), 9-20. Retrieved on February 13, 2009, from EBSCO Online Database Business Source Complete. http://search.ebsco-host.com/login.aspx?direct=true&db=bth&AN=7026716&site=ehost-live
Dennis, M. (2006). Key financial ratios for the credit department. Business Credit, 108(10), 62. Retrieved on February 13, 2009, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23101631&site=ehost-live
Gibson, C. (1985). How chartered financial analysts view financial ratios. Financial Analysts Journal, 43(3), 74-77. Retrieved on February 13, 2009, from EBSCO Online Database Business Source Complete. http://search.ebsco-host.com/login.aspx?direct=true&db=bth&AN=6657241&site=ehost-live
Soliman, M.T. (2008). The use of DuPont analysis by market participants. Accounting Review, 83(3), 823 - 853. Retrieved on February 13, 2009, from EBSCO Online Database Business Source Complete. http://search.ebsco-host.com/login.aspx?direct=true&db=bth&AN=31834114&site=ehost-live
Essay by Heather Wall Beckham, MBA
Heather Wall Beckham is the former Vice President of Strategic Planning for the Turner Division of Time Warner. She has also served as a strategic consultant with Bain & Company, a financial analyst with Ford Motor Company, and an adjunct professor in the Economics and Business Department of Agnes Scott College. She holds an undergraduate degree from Duke University and an MBA from Harvard Business School.