Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy. Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:

I. LIQUIDITY RATIO
Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending shortterm credit to the firm. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment a. Current Ratio/Working Capital Ratio A liquidity ratio that measures a company's ability to pay short-term obligations. The Current Ratio formula is:

A current ratio of assets to liabilities of 2:1 is usually considered to be acceptable (i.e., your current assets are twice your current liabilities). The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that

point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign. b. Quick Ratio (Acid-Test Ratio/ Quick Assets Ratio) An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.

The quick ratio is more conservative than the current ratio, a more wellknown liquidity measure, because it excludes inventory from current assets. Inventory is excluded because some companies have difficulty turning their inventory into cash. In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength. c. Cash Ratio The ratio of a company's total cash and cash equivalents to its current liabilities. The cash ratio is most commonly used as a measure of company liquidity. It can therefore determine if, and how quickly, the company can repay its short-term debt. A strong cash ratio is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party.

The cash ratio is the most stringent and conservative of the three shortterm liquidity ratios (current, quick and cash). It only looks at the most liquid short-term assets of the company, which are those that can be most

easily used to pay off current obligations. It also ignores inventory and account receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities. Very few companies will have enough cash and cash equivalents to fully cover current liabilities, which isn't necessarily a bad thing, so don't focus on this ratio being above 1:1. The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company. It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities. The reason being that it's often seen as poor asset utilization for a company to hold large amounts of cash on its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher returns.

II.

LEVERAGE RATIO (SOLVENCY RATIO)

Definition of leverage - Leverage is the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example, if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders. Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been

leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value. Definition of Leverage Ratio Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses. a. Debt/Equity Ratio' A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

b. Interest Coverage Ratio (debt service ratio / debt service coverage ratio) A ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period:

The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses. The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses. A high debt service ratio or interest coverage ratio assures the lenders a regular and periodical interest income. But the weakness of the ratio may create some problems to the financial manager in raising funds from debt sources.

III. TURNOVER RATIO

A measure of the number of times a company's inventory is replaced during a given time period.

 Turnover ratio is calculated as cost of goods sold divided by average inventory during the time period. A high turnover ratio is a sign that the company is producing and selling its goods or services very quickly. a) Inventory turnover ratio

Inventory Turnover =

Cost of Goods Sold Average Inventory

A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.

Things to remember

A low turnover is usually a bad sign because products tend to deteriorate as they sit in a warehouse. Companies selling perishable items have very high turnover.

b) Receivables turnover ratio

Receivables turnover is an indication of how quickly the firm

collects its accounts receivables

This ratio measures the number of times, on average, receivables (e.g. Accounts Receivable) are collected during the period.

 A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms of days. Remember that the Receivable turnover ratio is figured as "turnover times" and the Average collection period is in "days". Accounts receivable turnover measures the efficiency of a business in collecting its credit sales. Generally a high value of accounts receivable turnover is favorable and lower figure may indicate inefficiency in collecting outstanding sales but a normal level of receivables turnover is different for different industries. Increase in accounts receivable turnover overtime indicates improvement in credit sales collection process. c. Average Collection Period The approximate amount of time that it takes for a business to receive payments owed, in terms of receivables, from its customers and clients. The receivables turnover often is reported in terms of the number of

days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:

Average Collection Period =

365 Receivables Turnover ratio

d. Fixed assest turnover ratio

Asset turnover ratio is the ratio of a company's sales to its assets. It is an efficiency ratio which tells how successfully the company is using its assets to generate revenue. A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company's ability to generate net sales from fixed-asset investments - specifically property, plant and equipment (PP&E) - net of depreciation. A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues. There are a number of variants of the ratio like total asset turnover ratio, fixed asset turnover ratio and working capital turnover ratio. In all cases the numerator is the same i.e. net sales (both cash and credit) but denominator is average total assets, average fixed assets and average working capital respectively. Following formulas are used to calculate each of the asset turnover ratios: Net Sales Average Total Assets Net Sales Fixed Asset Turnover Ratio = Average Fixed Assets Net Sales Working Capital Turnover Ratio = Average Net Working Capital Total Asset Turnover Ratio = Analysis If a company can generate more sales with fewer assets it has a higher turnover ratio which tells it is a good company because it is using its assets efficiently. A lower turnover ratio tells that the company is not using its assets optimally.

IV. PROFITABILITY RATIO

Profitability ratios show a company's overall efficiency and performance. We can divide profitability ratios into two types: margins and returns. Ratios that show margins represent the firm's ability to translate sales dollars into profits at various stages of measurement. Ratios that show returns represent the firm's ability to measure the overall efficiency of the firm in generating returns for its shareholders. Margin Ratios-----i. Gross Profit Margin

The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently pass on the costs to its customers. The larger the gross profit margin, the better for the company. The calculation is: Gross Profit/Net Sales = ____%. ii. Operating Profit Margin

Operating profit is also known as EBIT. EBIT is earnings before interest and taxes. The operating profit margin ratio is a measure of overall operating efficiency, incorporating all of the expenses of ordinary, daily business activity. The operating profit margin looks at EBIT as a percentage of sales.

 The calculation is: EBIT/Net Sales = _____%. iii. Net Profit Margin The net profit margin shows how much of each sales dollar shows up as net income after all expenses are paid. For example, if the net profit margin is 5%, that means that 5 cents of every dollar is profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. The calculation is: Net Income/Net Sales = _____%. Returns Ratios-----i. Return on Assets (also called Return on Investment)

Return on Assets =

Net Income Total Assets

The Return on Assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm's level of investment in total assets. The higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales. Return on Equity

ii.

Return on Equity =

Net Income

Shareholder Equity
It measures the return on the money the investors have put into the company. This is the ratio potential investors look at when deciding whether or not to invest in the company. In general, the higher the percentage, the better, with some exceptions, as it shows that the company is doing a good job using the investors' money.

V.

VALUATION RATIO
a. Earnings per share (EPS) The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. Calculated as:

b. Dividend per share (DPS) The DPS ratio is very similar to the EPS: EPS shows what shareholders earned by way of profit for a period whereas DPS shows how much the shareholders were actually paid by way of dividends. Dividends paid to equity shareholders Dividends per share = Average number of issued equity shares c. Payout ratio The amount of earnings paid out in dividends to shareholders. Investors can use the payout ratio to determine what companies are doing with their earnings.

 A very low payout ratio indicates that a company is primarily focused on retaining its earnings rather than paying out dividends. The payout ratio also indicates how well earnings support the dividend payments: the lower the ratio, the more secure the dividend because smaller dividends are easier to pay out than larger dividends. d. Earnings yield The earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (which is the inverse of the P/E ratio) shows the percentage of each dollar invested in the stock that was earned by the company.

Earnings Yield =

Earnings Per Share Share Price

It is the reciprocal of the P/E ratio.

e. Dividend yield A financial ratio that shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock.

Dividend Yield =

Dividends Per Share Share Price

Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position - in other words, how much "bang for your buck" you are getting from dividends. Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend

yields. To better explain the concept, refer to this dividend yield example: If two companies both pay annual dividends of $1 per share, but ABC company's stock is trading at $20 while XYZ company's stock is trading at $40, then ABC has a dividend yield of 5% while XYZ is only yielding 2.5%. Thus, assuming all other factors are equivalent, an investor looking to supplement his or her income would likely prefer ABC's stock over that of XYZ. f. P/E ratio Price/Earnings or P/E ratio is the ratio of a company's share price to its earnings per share. It tells whether the share price of a company is fairly valued, undervalued or overvalued. Calculated as: Current Share Price Earnings per Share For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95). P/E Ratio = In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. Reciprocal of P/E ratio is called earnings yield (which is EPS/price).

DuPont Analysis
DuPont analysis is an extended analysis of a company's return on equity. It concludes that a company can earn a high return on equity if: 1. It earns a high net profit margin; 2. It uses its assets effectively to generate more sales; and/or 3. It has a high financial leverage

Formula Return on Equity = Net Profit Margin Asset Turnover Financial Leverage Net Income Return on Equity = Sales Analysis DuPont equation provides a broader picture of the return the company is earning on its equity. It tells where a company's strength lies and where there is a room for improvement. DuPont equation could be further extended by breaking up net profit margin into EBIT margin, tax burden and interest burden. This five-factor analysis provides an even deeper insight. ROE = EBIT Margin Interest Burden Tax Burden Asset Turnover Financial Leverage EBIT Return on Equity = Sales EBIT EBT EBT Net Income Total Assets Sales Total Equity Total Assets Total Assets Sales Total Equity Total Assets

Example: Three-factor Analysis Company A and B operate in the same market and are of the same size. Both earn a return of 15% on equity. The following table shows their respective net profit margin, asset turnover and financial leverage. Company A Net Profit Margin Asset Turnover Financial Leverage 10% 1 1.5 Company B 10% 1.5 1

Although both the companies have a return on equity of 15% their underlying strengths and weaknesses are quite opposite. Company B is better than company A in using its assets to generate revenues but it is unable to capitalize this advantage into higher return on equity due to its lower financial leverage. Company A can improve by using its total assets more effectively in generating sales and company B can improve by raising some debt. ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

Three-Step DuPont The three-step equation breaks up ROE into three very important components: ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier) These components include:

Operating efficiency - as measured by profit margin. Asset use efficiency - as measured by total asset turnover. Financial leverage - as measured by the equity multiplier. The Three-Step DuPont Calculation Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity) We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity:

ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

Profit/Capital Employed (Return on Capital Employed) Profit before Tax x 100 Total Assets - Current Liabilities This ratio measures whether or not a company is generating adequate profits in relation to the funds invested in it and is a key indicator of investment performance. A business could have difficulty servicing its borrowings if a low return is being earned for any length of time. In manufacturing we would expect to see figures in excess of 10% rising to over 25% at the top end. In retail lower figures would be experienced, ranging between 5% and 15%. Construction figures show an average of about 7% increasing to over 35% for the top performers.