Common Financial Ratios
Central to financial analysis is the calculation of financial ratios. A ratio has a numerator and a denominator, which converts the financial data to a percentage. This provides one approach to standardize financial information for useful comparisons. The major ratio categories and the questions they attempt to answer are: Liquidity Activity Leverage Performance Does the company have enough cash and current assets to pay obligations as they come due? How efficient are the operations of the company? What is the mix of equity to debt? How profitable is the company?
Common liquidity ratios are: Ratio Current Quick (Acid Test) Calculation Current Assets / Current Liabilities (Cash + Marketable Securities + Net Receivables) / Current Liabilities (Cash + Marketable Securities) / Current Liabilities Cash Flows from Operations / Current Liabilities Discussion Standard ratio to evaluate working capital. This ratio eliminates inventory and other current assets from the denominator, focusing on “near cash” and receivables. Only cash and cash equivalents considered for payment of current liabilities. Evaluates cash-related performance (as measured from the Statement of Cash Flows) relative to current liabilities.
Cash
Operating Cash Flow
Common activity ratios are:
Ratio Inventory Turnover
Ratio COGS / Average Inventory Sales / Average Accounts Receivables Sales / Average Accounts Payables Sales / Average Working Capital Sales / Average Fixed Assets Sales / Average Total Assets
Receivables Turnover
Payables Turnover Working Capital Turnover Fixed Asset Turnover Total Asset Turnover
Discussion Measures inventory management. Inventory should be turned over rapidly, rather than accumulating in warehouses. Measures the effectiveness of credit policies and needed level of receivables investment for sales. (Also called the collection period). Payables represent a financing source for operations. Measures how much working (operating) capital is needed for sales. Measures the efficiency of net fixed asset (property, plant & equipment after accumulated depreciation) investments. Represents the overall (comprehensive) efficiency of assets to sales.
Activity ratios can be converted to days “held,” measures that are easily compared across firms: Ratio Average Days Inventory in Stock Average Days Receivables Outstanding Average Days Payable Outstanding Length of Operating Cycle Calculation 365 / Inventory Turnover 365 / Receivables Turnover 365 / Payables Turnover 365 [(1 / Inventory Turnover) + (1 / Receivables Turnover)] ; equivalent to average days inventory + average days receivables outstanding
Common leverage ratios are:
Ratio Debt to Equity
Calculation Total Liabilities / Total Stockholders’ Equity Total Liabilities / Total Assets (Net Income + Interest Expense + Tax Expense) / Interest Expense Long-term Liabilities / Total Stockholders’ Equity Total Liabilities at Book Value / Total Equity at Market Value
Debt Ratio Interest Coverage (Times Interest Earned) Long-term Debt to Equity Debt to Market Equity
Discussion Direct comparison of debt to equity stakeholders and the most common measure of capital structure. A broader definition, stating debt as a percent of assets. This is a direct measure of the firm’s ability to meet interest payments, indicating the protection provided from current operations. A long-term perspective of debt and equity positions of stakeholders Market valuation may represent a better measure of equity than book value. Most firms have a market premium relative to book value.
Common profitability ratios are: Ratio Gross Margin Discussion This captures the relationship between sales and manufacturing (or merchandising) costs. (Also, called the gross profit margin.) Net Income / Sales Measures the relationship of the bottom line to sales and thus captures sales to total costs of sales. (Also called the net profit margin). Net Income / Average Measures the firm’s efficiency in Total Assets using assets to generate earnings. Alternatively stated, it captures earnings to all providers of capital Earnings Before Interest & Measures earnings from operations Taxes / Average Total on a pretax and pre-interest expense Assets basis. Net Income / Average Measures earnings to owners as Total Stockholders’ Equity measured by net assets. Common Dividends / Net Measures the percent of earnings Income paid out to common stockholders. Calculation (Sales – COGS) / Sales
Return on Sales
Return on Assets
Pretax Return on Assets Return on Total Equity Dividend Payout Du Pont Model:
Ratio Profitability (Return on Sales) x Activity (Asset Turnover) = Return on Assets x Solvency (Common Equity Leverage) = Return on Equity Below are some alternative ratios: Liquidity Cash to Current Assets Cash Position Current Liability Position Leverage Bonded Debt to Equity Debt to Tangible Net Worth Activity Cash Turnover Payables Turnover Profit Operating Profit Margin Pretax Profit Margin Return on Common Equity Financial Leverage Index A Summary of Market Ratios
Calculation Net Income / Sales Sales / Average Total Assets Net Income / Average Total Assets Average Total Assets / Average Common Equity Net Income / Average Common Equity
(Cash + Marketable Securities) / Current Assets Cash / Total Assets Current Liabilities / Total Assets Bonded Debt / Stockholders’ Equity Total Liabilities / (Common Equity – Intangible Assets) Sales / Average Cash (which usually includes marketable securities) Sales / Average Accounts Payable Income From Continuing Operations (After Tax) / Sales Income Before Tax / Sales (Net Income – Preferred Dividends) / Average Common Equity Return on Equity / Return on Assets
Book Value Per Share Earnings- based Growth Models
Market-to-book
Price Earnings Ratio (PE) Price Earnings Growth Ratio (PEG) Sales-to-market Value Dividend Yield
Measure of market premium paid for earnings and future expectations PE / Earnings Growth Rate PE compared to earnings growth rates, a measure of PE “reasonableness” Sales / (Stock Price x Number of A sales activity ratio based on Shares Outstanding) market price Dividends Per Share / Stock Price Direct cash return on stock investment
Total Stockholders’ Equity / Number of Shares Outstanding P = kE / (r-g), where E=earnings, k=dividend payout rate, r=discount rate, & g=earnings growth rate (Stock Price x Number of Shares Outstanding) / Total Stockholders’ Equity Stock Price / EPS
Equity or net assets, as measured on the balance sheet Valuation models that discount earnings and dividends by a discount rate adjusted for future earnings growth Measure of accounting-based equity