Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.
Uses of Financial Ratios:
Analysis of financial ratios serves two main purposes:
1. Track company performance: Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.
2. Make comparative judgments regarding company performance: Comparing financial ratios with that of major competitors is done to identify whether the company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investors to determine which company’s assets are being used most efficiently.
Users of Financial Ratios:
Users of financial ratios include parties external and internal to the company:
1. External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
2. Internal users: Management team, employees, and owners
Categories of Financial Ratios:
Financial ratios are grouped into the following categories:
a. Liquidity ratios
b. Leverage ratios
c. Efficiency ratios
d. Profitability ratios
e. Market value ratios
LIQUIDITY RATIOS: Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:
1. Current Ratio: The current ratio measures a company’s ability to pay off short-term liabilities with current assets:
Current ratio = Current assets / Current liabilities
2. Quick Ratio: The quick ratio measures a company’s ability to pay off short-term liabilities with quick assets:
Quick ratio = Current assets – Inventories / Current liabilities
3. Cash Ratio: The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:
Cash ratio = Cash and Cash equivalents / Current Liabilities
4. Defensive Interval Ratio: Defensive interval ratio is a liquidity ratio that measures the number of days for which the company’s current quick assets can finance its daily operating cash expenditures assuming it is not expected to receive any cash inflows during the period.
Defensive interval ratio = (cash + marketable securities + receivables)/ average daily expenditures… Average daily Expenditures = (total expenses – Depreciation) / 360
LEVERAGE RATIOS: Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:
1. Debt to total assets: The debt ratio measures the relative amount of a company’s assets that are provided from debt:
Debt ratio = Total liabilities / Total assets
2. Debt to equity ratio: The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders equity:
Debt to equity ratio = Total liabilities / Shareholder’s equity
3. Long term debt to equity ratio: This ratio indicates how much long term debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
Long Term Debt / Shareholder’s Equity
4. Cash debt coverage ratio: Cash debt coverage ratio shows how much of the company’s total liabilities can be covered (paid) with operating cash flow.
Cash flow from operations / Average Total Liabilities
5. CFO to dividend ratio: It measures the firm’s ability to make dividend payments from operating cash flow.
Cash flow from operations / dividends paid
6. Investing and financing ratio: This ratio measures how easily a company can finance its investing and financing activities with its operating cash flow.
Cash flow from operations / (cash outflows from investing and financing activities)
7. Degree of operating leverage ratio: A type of leverage ratio summarizing the effect a particular amount of operating leverage has on a company’s earnings before interest and taxes (EBIT). Operating leverage involves using a large proportion of fixed costs to variable costs in the operations of the firm. The higher the degree of operating leverage, the more volatile the EBIT figure will be relative to a given change in sales, all other things remaining the same.
Percentage change in EBIT / Percentage Change in Revenue
8. Degree of financial leverage ratio: This ratio measures the sensitivity of Net Income to changes in EBIT as a result of changes in organization debt; also the Degree of Financial Leverage (DFL) measures the percentage change in EPS for a unit change in earnings before interest and taxes (EBIT).
Percentage change in Net Income / Percentage change in EBIT
9. Degree of total leverage ratio: It is a leverage ratio that summarizes the combined effect the degree of operating leverage (DOL), and the degree of financial leverage has on earnings per share (EPS) or Net Income, given a particular change in sales. This ratio can be used to help determine the most optimal level of financial and operating leverage to use in any firm.
Percentage change in Net Income / Percentage change in Revenue
10. Interest coverage ratio: The interest coverage ratio determines how easily a company can pay its interest expenses:
Interest coverage ratio = Operating income / Interest expenses
11. Cash coverage ratio: This ratio measures the coverage of cash generated during the period to interest expense.
Cash coverage ratio = (EBIT + Depreciation) / Interest Expense
12. Sustainable growth rate ratio: This ratio reflects the company’s maximum growth rate in sales using internal financial resources and without having to increase debt or issue new equity.
Sustainable growth rate ratio = Return on Equity * (1-Dividend Payout Ratio). Return on Equity = Net Income / Average Shareholders’ Equity. Dividend Payout Ratio = Dividends to Common Shareholders / Net Income
EFFICIENCY RATIOS: Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:
1. Asset turnover ratio: The asset turnover ratio measures a company’s ability to generate sales from assets:
Asset turnover ratio = Net sales / Total assets
2. Inventory turnover ratio: The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:
Inventory turnover ratio = Cost of goods sold / Average inventory
3. Receivables turnover ratio: The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:
Receivables turnover ratio = Net credit sales / Average accounts receivable
4. Day sales in inventory ratio: The days sales in inventory ratio measures the average number of days that a company holds onto its inventory before selling it to customers:
Days sales in inventory ratio = 365 days / Inventory turnover ratio
5. Payables turnover ratio: The accounts payable turnover ratio measures how many times a company can turn payables into cash over a given period:
Payables turnover ratio = Net credit purchases / Average accounts payable
PROFITABILITY RATIOS: Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:
1. Gross margin ratio: The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying off its cost of goods sold:
Gross margin ratio = Gross profit / Net sales
2. Operating margin ratio: The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:
Operating margin ratio = Operating income / Net sales
3. Return on asset ratio: The return on assets ratio measures how efficiently a company is using its assets to generate profit:
Return on assets ratio = Net income / Total assets
4. Return on equity ratio: The return on equity ratio measures how efficiently a company is using its equity to generate profit:
Return on equity ratio = Net income / Shareholder’s equity