Financial Ratios

Natalie A. Manley

12-09-99

Financial ratios are a useful tool in interpreting financial statements. The information derived from the analysis of the financial data is relied on heavily by investors and managers. There are four main categories of financial ratios: (1) Liquidity, (2) Profitability, (3) Leverage, and (4) Activity/Efficiency. It is important to remember that when using financial ratios to assess the overall financial stability a company, more than one ratio should be considered when formulating an accurate opinion. For example, a company's solvency ratios may be ideal, but if the ratios that help analyze profitability and activity are bad (profits are down and sales are stagnant), a much different opinion would be formulated. It is also important to realize that financial ratios are a tool and once this tool has been acquired, it will require hard work and diligence to obtain results.

It is easy to calculate a ratio. It requires some basic mathematical skills and access to the numbers you are interested in. The challenge is interpreting the results.

Financial ratios generate powerful information and are used in comparisons within the firm itself, with the firm's close competitors, and within the industry. A firm may employ the use of ratios in tracking it's own patterns over the course of business for several years. This information could provide critical information that will enable a firm to realize trends over its history and allow it to implement changes. Financial ratio analysis is an effective instrument when comparing two or more firms within the same industry. These results can provide good gauge of how a firm performed with relation to another, regarding its financial issues. Lastly, the financial ratios of a firm can be compared to the industry average. This information is vital when assessing how the firm stacks up against all the others within the same industry. This information is generally found in publications such as Moody's Industrial Manual. These publications provide segmented information, separated into categories by profit levels or some other comparable means.

This enables the user to compare its ratios with those that are considered most similar.

Liquidity Ratios:

"An entity's ability to maintain its short-term debt-paying ability is important to all users of financial statements. If an entity cannot maintain a short-term debt-paying ability, it will not be able to maintain a long-term debt-paying ability, nor will it be able to satisfy its stockholders" (Gibson, p.253). It is safe to assume that current liabilities will be paid with cash generated by current assets. A profitable company still may have difficulty paying its short-term debt. Many companies use accrual accounting and are able to report high profits but are unable to meet its current obligations. The liquidity ratios look at aspects of the company's assets and their relationship to current liabilities. An example of Liquidity ratios is as follows:

(1) Current Ratio: This ratio measures the firm's ability to meet its current debt. A simple calculation of Current Assets, divided by Current Liabilities will enable the user to compare this ratio to that of the industry or other competitors. Historically, the guideline for the current ratio has been approximately 2.00, but in more recent times the current ratio has risen. This is an indication that the liquidity of firms has declined.

Profitability Ratios:

Profitability ratios are designed to evaluate the firm's ability to generate earnings. According to Gibson (1997), "Analysis of profit is of vital concern to stockholders since they derive revenue in the form of dividends. Further, increased profits can cause a rise in market price, leading to capital gains. Profits are also important to creditors because profits are one source of funds for debt coverage. Management uses profit as a performance measure." (p. 385). There are several ratios that may be used to measure profitability and the income statement contains several figures that may be used for profitability analysis. An example of Profitability measures is as follows:

(1) Net Profit Margin: This ratio gives a measure of net income dollars generated by each dollar of sales. Computed, it is Net Income before Minority Share of Earnings and Nonrecurring Items, divided by Net Sales. The higher the ratio the better as higher profits generated by any means is positive.

(2) Return on Assets: This ratio measures the firm's ability to utilize its assets to create profits by comparing profits with the assets that generate profits. This formula is Net Income before Minority Share of Earnings and Nonrecurring Items, divided by average total assets. The most accurate average should be taken from month-end figures, however this information is not available to the outside user. Using the beginning and ending figures will provide an adequate approximation by will not reflect the changes being felt during the month (Gibson, p. 389)

Leverage Ratios:

"While liquidity ratios assist analysts in examining a company's ability to pay short-term debt, overall the leverage or solvency ratios indicate the relative size of the claims of long-term creditors, compared to the claims or property rights of owners" (Friedlob and Welton, 1995, p. 133). In addition to the profitability of the firm the amount of debt in relation to the size of the firm should be analyzed. An example of Debt ratios is as follows:

(1) Debt Ratio: This is a simple but effect ratio that indicates the firm's longterm debt-paying ability. This ratio indicates the percentage of asset financed by creditors, and helps to determine how well the creditors are protected in case of insolvency. The formula is Total Liabilities, divided by Total Assets.

Activity Ratios:

Activity ratios also known as efficiency or turnover ratios usually consist of the sales figure in the numerator and the balance of an asset in the denominator. These ratios measure management's effectiveness at using its assets. For example:

(1) Accounts Receivable Turnover: An indicator of how quickly the firm is collecting from its credit sales. This calculation is Average Gross Receivables, divided by the Net Sales, divided by 365. The results from this ratio may cause the firm to rethink its credit terms.

(2) Inventory Turnover: This is another powerful ratio. It indicates the liquidity of the inventory. This is calculated by dividing the Cost of Goods Sold by the Average Inventory. Although monthly inventory totals would generate the best average, they are usually unavailable to an outside investor. Often times the beginning and ending inventory totals are the best available numbers.

(3) Total Asset Turnover: Is the ratio that measures the firm's ability to generate sales through the use of its assets. It is computed Net Sales, divided by Average Total Assets. There are factors that could cause this ratio to be understated and this would occur if, for example, the investments (an asset on the company's books) were included in the denominator of the fraction. Investments are assets but do not relate to net sales. Including them in the denominator would cause the ratio to be lower and cause a distortion in facts upon interpretation (Gibson, p. 388).

There are many types of financial ratios available to use when evaluating financial information. Being able to effectively interpret the numbers is vital element to this method of research. The information derived from a good understanding of the ratios and a thorough use of the ratios available can prove to be invaluable tool for investors and managers.

Bibliography

Cooke, Robert A. (1993). The McGraw Hill 36-Hour Course In Finance For Nonfinancial Managers. New York: McGraw-Hill, Inc.

Friedlob, George Thomas Ph.D. & Welton, Ralph E. Ph.D.(1989) Keys To Reading An Annual Report. Hauppauge, New York: Barron's .

Financial ratios are indicators used to analyze an entity??s financial performance. Financial ratios are used by bankers, creditors, shareholders and accountants to evaluate data presented on an entity??s financial statements. Depending on the results of the evaluations, bankers and creditors may choose to extend or retract financing and potential shareholders may adjust the level of commitment in a company. Financial ratios are important tools that judge the profitability, efficiency, liquidity and solvency of an entity. Profitability Ratios Profitability ratios help users of an entity??s financial statements determine the overall effectiveness of management regarding returns generated on sales and investments. Commonly used profitability ratios are gross profit margin, operating profit margin and net profit margin. Gross profit margin measures profitability after considering cost of goods sold, while operating profit margin measures profitability based on earnings before interest and tax expense. Net profit margin is often referred to as the bottom line and takes all expenses into account. Efficiency Ratios Ratios that measure the effectiveness of management??s decision making are referred to as efficiency ratios. Efficiency ratios evaluate turnover and the return on investments. Examples of efficiency ratios are inventory turnover, sales to receivables and return on assets. Inventory turnover measures the number of times an entire stock of inventory is repurchased while sales to receivables compares trade receivables to revenues. In both situations, a higher number indicates a higher level of efficiency when selling inventory and collecting receivables. Return on assets compares net income before taxes to total assets and helps show the efficiency of management when using assets to generate profits. Liquidity Ratios Liquidity ratios help financial statement users evaluate a company??s ability to meet its current obligations. In other words, liquidity ratios evaluate the ability of a company to convert its current assets into cash and pay current obligations. Common liquidity ratios are the current ratio and the quick ratio. The current ratio is calculated by dividing current assets by current liabilities.

According to Thomson Reuters, a general rule of thumb is to have a current ratio of 2. The quick ratio, or acid test, helps determine a company??s ability to pay obligations that are due immediately. Solvency Ratios Solvency, or leverage, ratios, judge the ability of a company to raise capital and pay its obligations. Solvency ratios, which include debt to worth and working capital, determine whether an entity is able to pay all of its debts. In practice, bankers often include leverage ratios as debt covenants in contract agreements. Bankers want to ensure the entity can maintain operations during difficult financial periods. The debt to worth ratio calculation is total liabilities divided by net worth. Working capital is calculated by subtracting current liabilities from current assets.

Working Capital Liquidity ratios Definition Working capital is the amount by which the value of a company's current assets exceeds its current liabilities. Also called net working capital. Sometimes the term "working capital" is used as synonym for "current assets" but more frequently as "net working capital", i.e. the amount of current assets that is in excess of current liabilities. Working capital is frequently used to measure a firm's ability to meet current obligations. It measures how much in liquid assets a company has available to build its business. Working capital is a common measure of a company's liquidity, efficiency, and overall health. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between an entity's short-term assets (inventories, accounts receivable, cash) and its short-term liabilities. Calculation (formula) Working capital (net working capital) = Current Assets - Current Liabilities Both variables are shown on the balance sheet (statement of financial position). Print Email

Norms and Limits The number can be positive (acceptable values) or negative (unsafe values), depending on how much debt the company is carrying. Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. Analysts are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Though in some businesses (such as grocery retail) working capital can be negative (such business is being partly funded by its suppliers). Exact Formula in the ReadyRatios Analytic Software (based ontheIFRS statement format). Working capital (net working capital) = F1[CurrentAssets] F1[CurrentLiabilities] F1 Statement of financial position (IFRS).

Quick Ratio Liquidity ratios Definition The quick ratio is a measure of a company's ability to meet its short-term obligations using its most liquid assets (near cash or quick assets). Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Quick ratio is viewed as a sign of a company's financial strength or weakness; it gives information about a companys short term liquidity. The ratio tells creditors how much of the company's short term debt can be met by selling all the company's liquid assets at very short notice. The quick ratio is also known as the acid-test ratio or quick assets ratio. Calculation (formula) The quick ratio is calculated by dividing liquid assets by current liabilities: Quick ratio = (Current Assets - Inventories) / Current Liabilities Print Email

Calculating liquid assets inventories are deducted as less liquid from all current assets (inventories are often difficult to convert to cash). All of those variables are shown on the balance sheet (statement of financial position). Alternative and more accurate formula for the quick ratio is the following: Quick ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable) / Current Liabilities The formula's numerator consists of the most liquid assets (cash and cash equivalents) and high liquid assets (liquid securities and current receivables). Norms and Limits The higher the quick ratio, the better the position of the company. The commonly acceptable current ratio is 1, but may vary from industry to industry. A company with a quick ratio of less than 1 can not currently pay back its current liabilities; it's the bad sign for investors and partners. Exact Formula in the ReadyRatios Analytic Software (based ontheIFRS statement format). Quick ratio = (F1[CashAndCashEquivalents]+ F1[OtherCurrentFinancialAssets]+ F1[TradeAndOtherCurrentReceivables])/ F1[CurrentLiabilities] F1 Statement of financial position (IFRS).

Net Working Capital Liquidity ratios Print Email

Net working capital (NWC) = current assets minus current liabilities. See working capital. Share: See also

Current Ratio Liquidity ratios Definition The current ratio is balance-sheet financial performance measure of company Print Email

liquidity. The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio. Calculation (formula) The current ratio is calculated by dividing current assets by current liabilities: The current ratio = Current Assets / Current Liabilities Both variables are shown on the balance sheet (statement of financial position). Norms and Limits The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio. Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow. If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management. All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months. Exact Formula in the ReadyRatios Analytic Software Current ratio = F1[CurrentAssets]/F1[CurrentLiabilities] F1 Statement of financial position (IFRS).

Cash Ratio Liquidity ratios Definition Cash ratio (also called cash asset ratio) is the ratio of a company's cash and cash equivalent assets to its total liabilities. Cash ratio is a refinement of quick ratio and indicates the extent to which readily available funds can pay off current liabilities. Potential creditors use this ratio as a measure of a company's liquidity and how easily it can service debt and cover short-term liabilities. Cash ratio is the most stringent and conservative of the three liquidity ratios (current, quick and cash ratio). It only looks at the company's most liquid short-term assets cash and cash equivalents which can be most easily used to pay off current obligations. Calculation (formula) Cash ratio is calculated by dividing absolute liquid assets by current liabilities: Cash ratio = Cash and cash equivalents / Current Liabilities Both variables are shown on the balance sheet (statement of financial position). Norms and Limits Cash ratio is not as popular in financial analysis as current or quick ratios, its usefulness is limited. There is no common norm for cash ratio. In some countries a cash ratio of not less than 0.2 is considered as acceptable. But ratio that are too high may show poor asset utilization for a company holding large amounts of cash on its balance sheet. Exact Formula in the ReadyRatios Analytic Software Cash ratio = F1[CashAndCashEquivalents] / F1 Print Email

Current Ratio Liquidity ratios Definition The current ratio is balance-sheet financial performance measure of company liquidity. Print Email

The current ratio indicates a company's ability to meet short-term debt obligations. The current ratio measures whether or not a firm has enough resources to pay its debts over the next 12 months. Potential creditors use this ratio in determining whether or not to make short-term loans. The current ratio can also give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. The current ratio is also known as the working capital ratio. Calculation (formula) The current ratio is calculated by dividing current assets by current liabilities: The current ratio = Current Assets / Current Liabilities Both variables are shown on the balance sheet (statement of financial position). Norms and Limits The higher the ratio, the more liquid the company is. Commonly acceptable current ratio is 2; it's a comfortable financial position for most enterprises. Acceptable current ratios vary from industry to industry. For most industrial companies, 1.5 may be an acceptable current ratio. Low values for the current ratio (values less than 1) indicate that a firm may have difficulty meeting current obligations. However, an investor should also take note of a company's operating cash flow in order to get a better sense of its liquidity. A low current ratio can often be supported by a strong operating cash flow. If the current ratio is too high (much more than 2), then the company may not be using its current assets or its short-term financing facilities efficiently. This may also indicate problems in working capital management. All other things being equal, creditors consider a high current ratio to be better than a low current ratio, because a high current ratio means that the company is more likely to meet its liabilities which are due over the next 12 months. Exact Formula in the ReadyRatios Analytic Software Current ratio = F1[CurrentAssets]/F1[CurrentLiabilities] F1 Statement of financial position (IFRS).

Acid-Test Ratio Liquidity ratios Print Email

The term Acid-test ratio is also known as quick ratio. The most basic definition of acid-test ratio is that, it measures current (short term) liquidity and position of the company. To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company. The formula for the acid-test ratio is: Quick ratio = (Current Assets Inventory) / Current liabilities This concept is important as if the companys financial statements ( income statement, balance sheet) get through the analysis of the acid-test ratio, then the short term debts can be paid by the company. Example: Let us suppose that XYZ Company has total $2 million in its bank account and cash. The amount of accounts receivable (short term debitors of the XYZ company) is $11 million. The amount of short term investments is $4 million. The amount of Current liabilities (short term credit owed to others) is $12 million. So the Acid-Test ratio of Company X is (2million +11 million + 4 million ) / (12 mill) = 1. 33. If the value of the acid-term ratio is less than 1, then it is said that such a company is not stable and may face difficulty is paying off their debts (short term). In order to clear the short term debts they probably would need to sell some of their assets. But such an option affects the overall position of the company because if the company owns very little assets. The biggest advantage of acid-test ratio is that it helps the company in understanding the end results very feasibly. The only major issue with the acid-test ratio is its dependence of the accounts receivable and current liabilities which can cause trouble. If due to any dispute the contract with the creditor or debtors gets messed up whole of the process gets unbalanced. And also, a minor mistake in the calculation can just destroy and conclude misleading outcomes.

Balance Sheet Analysis Financial analysis Print Email

Meaning and definition of Balance Sheet Analysis Balance sheet analysis can be defined as an analysis of the assets, liabilities, and equity of a company. This analysis is conducted generally at set intervals of time, like annually or quarterly. The process of balance sheet analysis is used for deriving actual figures about the revenue, assets, and liabilities of the company. Goal of Balance Sheet Analysis The balance sheet analysis is helpful for the investors, investment bankers, share brokers, and financial institutions, for verifying the profitability of investment for a specific company. How to perform a Balance Sheet Analysis It is not a difficult task to perform a Balance Sheet Analysis. The main steps include: The primary step involves adding up liabilities and the paid up equity share capital. The sum must tally with the sum of total assets. After the process of tallying is done, contrast the total assets with total liabilities. However, this evaluation does not include the issued shares amount in the liabilities. If the total assets are exceeding the total liabilities, the financial standing and performance of the company is considered to be good. The next step involves looking at the current assets and liabilities. Sometimes, it is considered as a good sign to have more unsecured liabilities. Another important step is calculating the ROA by dividing the net income by assets. Producer companies feature a high ROA unlike the real estate and leasing companies which feature a low ROA. The fourth step involves special concern for copyrights and patents. It is important to consider the ratio between invested amount for research and the consequent returns. Next step involves calculating the debt asset ratio by dividing total liabilities by total assets. A lower liability dimension reflects a better performance by the company. Another step includes estimating the receivables turnover ratio which

signifies the relation between investment in sales and money receivable. A better financial status is reflected in high amount of money receivables. Another important ratio is the inventory turnover ratio which indicates the companys capability of producing goods with available assets. The final step includes analyzing other features of company including goodwill, credit ratings, and current projects. This analysis is helpful in evaluating the company activities in near future.