2.

Types of Financial Ratios

Ratio analysis is a tool that was developed to perform quantitative
analysis on numbers found on financial statements. Ratios help link
different financial statements together and offer figures that are comparable
between companies and across industries and sectors.

Ratio analysis is one of the most widely used fundamental analysis

techniques. Generally speaking, these ratios can be grouped into five
different categories. In the following chapters, we will discuss each ratio in
detail:

 Liquidity Ratios measure a company’s ability to pay off its short-

term debt obligations
 Profitability Ratios show a company’s ability to generate profits
from its operations
 Solvency Ratios quantify the firm’s ability to repay long-term debt
 Efficiency Ratios measure the effectiveness of the firm’s use of
resources
 Market Ratios estimate the attractiveness of a potential or existing
investment
Financial ratios are not useful unless they are benchmarked against
something else, for example past performance or another organization in
the same business area. Whilst you can compare the ratios of
organizations in different industries, this is usually of limited value because
of differences in market conditions, capital requirements, and
competition. However, comparing ratios for potential suppliers, partners,
acquisitions, or competitors can provide you with useful data to help with
decision making.

Key financial ratios allow for useful comparisons between:

 Organizations in the same industry sector

 Different time periods for the same organization
 An organization and its industry average

Current Ratio
The Current Ratio measures a firm’s ability to pay off its short-term
liabilities with its current assets. The current ratio is an important measure
of liquidity because short-term liabilities are due within the next year.

This means that a company has a limited amount of time in order to raise
the funds to pay for these liabilities. Current assets like cash, cash
equivalents, and marketable securities can easily be converted into cash in
the short term. This means that companies with larger amounts of current
assets will more easily be able to pay off current liabilities when they
become due without having to sell off long-term, revenue-generating
assets.

The current ratio is calculated by dividing current assets by current

liabilities:

The current ratio helps investors and creditors understand the liquidity of a
company and how easily that company will be able to pay off its current
liabilities. This ratio expresses a firm’s current debt in terms of current
assets. So a current ratio of 4 would mean that the company has 4 times
more current assets than current liabilities.

A higher current ratio is always more favorable than a lower current ratio
because it shows the company can more easily make current debt
payments.

Example:

Alberto’s Pizzeria is applying for loans to build a large terrace. Alberto’s

bank asks for the balance sheet so they can analysis the pizzeria’s current
debt levels. According to Alberto’s balance sheet, the pizzeria reported
$100,000 of current liabilities and only $25,000 of current assets. Alberto’s
current ratio would be calculated like this:

$25,000 / $100,000 = 0.25

As you can see, the pizzeria only has enough current assets to pay off 25
percent of its current liabilities. This shows that Alberto’s Pizzeria is highly
leveraged and highly risky. Banks would prefer a current ratio of at least 1
or 2, so that all the current liabilities would be covered by the current
assets. Since the pizzeria’s ratio is so low, it is unlikely that it will get
approved for the loan.

Quick Ratio
The Quick Ratio or Acid Test Ratio measures the ability of a company to
pay its current liabilities when they come due with only quick assets. Quick
assets are current assets that can be converted to cash within 90 days or in
the short-term. Cash, cash equivalents, short-term investments or
marketable securities, and current accounts receivable are
considered quick assets.

The acid test of finance shows how well a company can quickly convert its
assets into cash in order to pay off its current liabilities. It also shows the
level of quick assets to current liabilities.
The quick ratio is calculated by dividing quick assets (cash, cash
equivalents, short-term investments, and current receivables) by current
liabilities:

Higher quick ratios are more favorable for companies because it shows
there are more quick assets than current liabilities. A company with a quick
ratio of 1 indicates that quick assets equal current assets. This also shows
that the company could pay off its current liabilities without selling any long-
term assets. An acid ratio of 2 shows that the company has twice as many
quick assets than current liabilities.

Obviously, as the ratio increases so does the liquidity of the company.

More assets will be easily converted into cash if need be. This is a good
sign for investors, but an even better sign to creditors because creditors
want to know they will be paid back on time.

Example:

Let’s assume Jim’s Clothing Store is applying for a loan to remodel the
storefront. The bank asks Jim for a detailed balance sheet, so it can
compute the quick ratio. Jim’s balance sheet included cash of $10,000,
accounts receivable of $5,000, stock investments of $1,000, and current
liabilities of $15,000.

The bank can compute Jim’s quick ratio like this:

($10,000 + $5,000 + $1,000) / $15,000 = 1.07

As you can see Jim’s quick ratio is 1.07. This means that Jim can pay off all
of his current liabilities with quick assets and still have some quick assets
left over.

Profit Margin
The Profit Margin Ratio, also called the Return on Sales Ratio, compares
the earnings reported by a business to its sales. It is a key indicator of the
financial health of an organization.

Creditors and investors use this ratio to measure how well a company can
convert sales into net income. Investors want to make sure profits are high
enough to distribute dividends while creditors want to make sure the
company has enough profits to pay back its loans. An extremely low-profit
margin formula would indicate the expenses are too high and the
management needs to budget and cut expenses.

The profit margin ratio formula can be calculated by dividing net income by
net sales:

The profit margin ratio directly measures what percentage of sales is made
up of net income. In other words, it measures how much profits are
produced at a certain level of sales.

This ratio also indirectly measures how well a company manages its
expenses relative to its net sales. That is why companies strive to achieve
higher ratios. They can do this by either generating more revenues why
keeping expenses constant or keep revenues constant and lower
expenses. Since most of the time generating additional revenues is much
more difficult than cutting expenses, managers generally tend to reduce
spending budgets to improve their profit ratio.

Example:

Peter’s Fishing Shop is an outdoor fishing store that selling lures and other
fishing gear to the public. Last year Peter had the best year in sales he has
ever had since she opened the business 10 years ago. Last year Peter’s
net sales were $1,000,000 and his net income was $100,000.

Here is Peter’s Profit Margin Ratio:

 $100,000 / $1,000,000 = 10%

As you can see, Peter only converted 10 percent of his sales into profits.
Contrast that with this year’s numbers of $800,000 of net sales and
$200,000 of net income:

$200,000 / $800,000 = 25%

This year Peter may have made fewer sales, but he cut expenses and was
able to convert more of these sales into profits with a ratio of 25 percent.

Return on Assets (ROA)

The Return on Assets Ratio (ROA) compares the net earnings of a
business to its total assets. In other words, the Return on Assets Ratio
measures how well a company can manage its assets to produce profits
during a period.

Since company assets’ sole purpose is to generate revenues and produce

profits, this ratio helps both management and investors see how well the
company can convert its investments in assets into profits. In short, this
ratio measures how profitable a company’s assets are.

The return on assets ratio formula is calculated by dividing net income by

average total assets:

The return on assets ratio measures how effectively a company can earn a
return on its investment in assets. In other words, ROA shows how
efficiently a company can convert the money used to purchase assets into
net income or profits.

A positive ROA ratio usually indicates an upward profit trend as well. ROA
is most useful for comparing companies in the same industry as different
industries use assets differently. For instance, construction companies use
large, expensive equipment while software companies use computers and
servers.

Example:

Charlie’s Construction Company is a growing construction business that

has contracts to build storefronts in downtown Chicago. Charlie’s balance
sheet shows total assets of $800,000. During the current year, Charlie’s
company had a net income of $200,000. Charlie’s return on assets ratio
looks like this:

$200,000 / $800,000 = 0.25 = 25%

As you can see, Charlie’s ratio is 25 percent. This means that for every
dollar in assets, Charlie’s company earned 25 cents in profit. The number
will vary widely across different industries, however ROAs over 5% are
generally considered good. Investors would have to compare Charlie’s
return with other construction companies in his industry to get a true
understanding of how well Charlie is managing his assets.

Return on Equity (ROE)

The Return on Equity Ratio (ROE) measures the ability of a firm to
generate profits from its shareholders’ investments in the company. In other
words, the return on equity ratio shows how much profit each dollar of
common stockholders’ equity generates.

This is an important measurement for potential investors because they

want to see how efficiently a company will use its money to generate net
income. ROE is also an indicator of how well management is at using
equity financing to fund operations and grow the company.

To calculate the return on equity, simply divide net income by shareholder’s

equity. The formula is:
ROE is a profitability ratio from the investor’s point of view—not the
company. In other words, this ratio calculates how much money is made
based on the investors’ investment in the company, not the company’s
investment in assets or something else.

That being said, investors want to see a high return on equity ratio because
this indicates that the company is using its investors’ funds effectively.
Higher ratios are almost always better than lower ratios but have to be
compared to other companies’ ratios in the industry. Since every industry
has different levels of investors and income, ROE can’t be used to compare
companies outside of their industries very effectively.

Many investors also choose to calculate the return on equity at the

beginning of a period and the end of a period to see the change in return.
This helps track a company’s progress and ability to maintain a positive
earnings trend.

Example:

Toms Tool Company is a retail store that sells tools to construction

companies across the country. Tom reported net income of $100,000.
Tom also had $50,000 common shares outstanding during the year.
Tom would calculate her return on common equity like this:

$100,000 / $50,000 = 2

As you can see, Tom’s ROE is 2. This means that every dollar of common
shareholder’s equity earned about $2 this year. In other words,
shareholders saw a 200 percent return on their investment. Tom’s ratio is
most likely considered high for his industry. An average of 5 to 10 years of
ROE ratios will give investors a better picture of the growth of this
company.

Return on Investment (ROI)

Return on investment (ROI) calculates the profits of an investment as a
percentage of the original cost. In other words, it measures how much
money was made on the investment as a percentage of the purchase price.
It shows investors how efficiently each dollar invested in a project is at
producing a profit.
The ROI calculation is one of the most common investment ratios because
it’s simple and extremely versatile. Managers can use it to compare
performance rates on capital equipment purchases while investors can
calculate what stock purchases performed better.

The return on investment formula is calculated by subtracting the cost from

the total income and dividing it by the total cost:

Generally, any positive ROI is considered a good return. This means that
the total cost of the investment was recouped in addition to some profits left
over. A negative return on investment means that the revenues weren’t
even enough to cover the total costs. That being said, higher return rates
are always better than lower return rates.

Example:

Let’s look at Richard’s Brokerage House for example. Richard is a

stockbroker who specializes in penny stocks. Richard made a somewhat
risky investment in a liquid metals stock last year when he purchased 8,000
shares at $1 per share. Today, a year later, the fair market value per share
is $3.50. Richard sells the share and uses an ROI calculator to measure his
performance.

($28,000 – $8,000) / $8,000 = 2.5

As you can see, Richard’s return on investment is 2.5. This means that
Richard made $2.50 for every dollar that he invested in the liquid metals
company. This investment was extremely efficient because it increased by
250%.

Debt Ratio
The Debt Ratio measures the proportion of assets paid for with debt. One
can use the ratio to reach conclusions about the solvency of a business. A
high ratio implies that the bulk of company financing is coming from debt;
this is a risky financial structure since the borrower is at risk of not being
able to pay for the associated interest expense or paying back the principal.
A low debt ratio reflects a conservative financing strategy of using only
equity to pay for assets.

The debt ratio is calculated as total liabilities divided by total assets. The
formula is:

Lenders and creditors use the debt ratio to estimate the amount of lending
risk they will incur by extending credit to an organization. They are more
likely to lend when the debt ratio is closer to 0% than when the ratio is
closer to 100% (or more).

Example:

Jim’s Guitar Shop is thinking about building an addition onto the back of its
existing building for more storage. Jim consults with his banker about
applying for a new loan. The bank asks for Jim’s balance to examine his
overall debt levels. The banker discovers that Jim has total assets of
$100,000 and total liabilities of $25,000. Jim’s debt ratio would be
calculated like this:

$25,000 / $100,000 = 0.25

As you can see, Jim only has a debt ratio of 0.25. In other words, Jim has 4
times as many assets as he has liabilities. This is a relatively low ratio and
implies that Jim will be able to pay back his loan. Jim shouldn’t have a
problem getting approved for his loan.

Debt to Equity Ratio

The Debt to Equity Ratio compares a company’s total liabilities to total
equity. It shows the percentage of company financing that comes from
creditors and investors. A higher debt to equity ratio indicates that more
creditor financing (bank loans) is used than investor financing
(shareholders).

The debt to equity ratio is calculated by dividing total liabilities by total

equity:

Each industry has a different debt to equity ratio benchmarks, as some

industries tend to use more debt financing than others. A debt ratio of 0.5
means that there are half as many liabilities than there is equity. In other
words, the assets of the company are funded 2-to-1 by investors to
creditors. A debt to equity ratio of 1 would mean that investors and
creditors have an equal stake in the business assets.

A lower debt to equity ratio usually implies a more financially stable

business. Companies with a higher debt to equity ratio are considered
riskier to creditors and investors than companies with a lower ratio. Unlike
equity financing, a debt must be repaid to the lender. Since debt financing
also requires debt servicing or regular interest payments, debt can be a far
more expensive form of financing than equity financing. Companies
leveraging large amounts of debt might not be able to make the payments.

Example:

Assume a company has $300,000 of bank lines of credit. The shareholders

of the company have invested $1.2 million. Here is how you calculate the
debt to equity ratio:

$300,000 / $1,200,000 = 0.25

Creditors view a higher debt to equity ratio as risky because it shows that
the investors haven’t funded the operations as much as creditors have.
This could mean that investors don’t want to fund business operations
because the company isn’t performing well.

Asset Turnover Ratio

The Asset Turnover Ratio compares the sales of a business to the book
value of its assets. In other words, this ratio shows how efficiently a
company can use its assets to generate sales. A high turnover level
indicates that an entity uses a minimal amount of working capital and fixed
assets in its daily operations.

The asset turnover ratio gives investors and creditors an idea of how a
company is managed and uses its assets to produce products and sales.

To calculate the asset turnover ratio, divide sales by total average assets:

This ratio measures how efficiently a firm uses its assets to generate sales,
so a higher ratio is always more favorable. Higher turnover ratios mean the
company is using its assets more efficiently. Lower ratios mean that the
company isn’t using its assets efficiently and most likely have management
or production problems.

For instance, a ratio of 1 means that the net sales of a company equal the
average total assets for the year. In other words, the company is
generating 1 dollar of sales for every dollar invested in assets.

Like with most ratios, the asset turnover ratio is based on industry
standards. Some industries use assets more efficiently than others. To get
a true sense of how well a company’s assets are being used, it must be
compared to other companies in its industry.

Example:

Sally’s Tech Company is a tech start-up company that manufactures a new

tablet computer. Sally is currently looking for new investors and has a
meeting with an angel investor. The investor wants to know how well Sally
uses her assets to produce sales, so he asks for her financial statements.
The financial statements reports sales of $20,000 and total average assets
of $80,000.

The total asset turnover ratio is calculated like this:

 $20,000 / $80,000 = 0.25

As you can see, Sally’s ratio is only 0.25. This means that for every dollar
in assets, Sally only generates 25 cents. In other words, Sally’s start-up in
not very efficient with its use of assets.

Inventory Turnover Ratio

The Inventory Turnover Ratio shows how effectively inventory is
managed by comparing the cost of goods sold with the average inventory
for a period. This measures how many times the average inventory is
“turned” or sold during a period. In other words, it measures how many
times a company sold its total average inventory dollar amount during the
year. A company with $1,000 of average inventory and sales of $10,000
effectively sold its 10 times over.

To calculate inventory turnover, divide the ending inventory figure into the
annualized cost of sales:

When there is a low rate of inventory turnover, this implies that a business
may have a flawed purchasing system that bought too many goods, or that
stocks were increased in anticipation of sales that did not occur. In both
cases, there is a high risk of inventory aging, in which case it becomes
obsolete and has little residual value.

When there is a high rate of inventory turnover, this implies that the
purchasing function is tightly managed. However, it may mean that a
business does not have the cash reserves to maintain normal inventory
levels, and so is turning away prospective sales. The latter scenario is most
likely when the amount of debt is unusually high and there are few cash
reserves.

Example:
Donny’s Furniture Company sells industrial furniture for office buildings.
During the current year, Donny reported cost of goods sold on its income
statement of $1,000,000. Donny’s inventory was $4,000,000. Donny’s
turnover is calculated like this:

$1,000,000 / $4,000,000 = 0.25

As you can see, Donny’s turnover is 0.25. This means that Donny only sold
a quarter of its inventory during the year. It also implies that it would take
Donny approximately 4 years to sell his entire inventory or complete one
turn. In other words, Danny does not have very good inventory control.

Earnings per Share (EPS)

The Earnings per Share Ratio (EPS Ratio) measures the amount of a
company’s net income that is theoretically available for payment to the
holders of its common stock. A company with a high earnings per share
ratio is capable of generating a significant dividend for investors, or it may
plow the funds back into its business for more growth; in either case, a high
ratio indicates a potentially worthwhile investment, depending on the
market price of the stock.

To calculate the ratio, subtract any dividend payments due to the holders of
preferred stock from net income, and divide by the average number of
common shares outstanding during the measurement period. The
calculation is:

It is very worthwhile to track a company’s earnings per share ratio on a

trend line. If the trend is positive, then the company is either generating an
increasing amount of earnings or buying back its stock. Conversely, a
declining trend can signal to investors that a company is in trouble, which
can lead to a decline in the stock price.

Example:
ABC Company has a net income of $1,000,000 and also must pay out
$200,000 in preferred dividends. It has both bought back and sold its own
stock during the measurement period; the weighted average number of
common shares outstanding during the period was 400,000 shares. ABC’s
earnings per share ratio is:

($1,000,000 – $200,000) / 400,000 = $2.00 per share

As you can see, the EPS for the year is $2. This means that if ABC
Company distributed every dollar of income to its shareholders, each share
would receive 2 dollars.

Price to Earnings Ratio

The Price to Earnings Ratio (P/E Ratio) calculates the market value of a
stock relative to its earnings by comparing the market price per share by
the earnings per share. In other words, the price-earnings ratio shows what
the market is willing to pay for a stock based on its current earnings.

The P/E Ratio helps investors analyze how much they should pay for a
stock based on its current earnings. Companies with higher future earnings
are usually expected to issue higher dividends or have appreciating stock
in the future.

The price-earnings ratio formula is calculated by dividing the market value

price per share by the earnings per share:

A company with a high P/E ratio usually indicated positive future

performance and investors are willing to pay more for this company’s
shares. A company with a lower ratio, on the other hand, is usually an
indication of poor current and future performance.

Example:
The Island Corporation stock is currently trading at $50 a share and its
earnings per share for the year is 5 dollars. Island’s P/E ratio would be
calculated like this:

$50 / $5 = 10

As you can see, the Island’s ratio is 10. This means that investors are
willing to pay 10 dollars for every dollar of earnings.

Dividend Yield
The Dividend Yield Ratio shows the number of dividends that a company
pays to its investors in comparison to the market price of its stock. Thus,
the dividend yield ratio is the return on investment to an investor if the
investor were to have bought the stock at the market price on the
measurement date.

To calculate the ratio, divide the annual dividends paid per share of stock
by the market price of the stock at the end of the measurement period. The
basic calculation is:

Investors use the dividend yield formula to compute the cash flow they are
getting from their investment in stocks. In other words, investors want to
know how much dividends they are getting for every dollar that the stock is
worth.

A company with a high dividend yield pays its investors a large dividend
compared to the fair market value of the stock. This means the investors
are getting highly compensated for their investments compared with lower
dividend-yielding stocks.

Example:

Stacy’s Bakery is an upscale bakery that sells cupcakes and baked goods
in Beverly Hills. Stacy’s is listed on a smaller stock exchange and the
current market price per share is $15. As of last year, Stacy paid $15,000 in
dividends with 1,000 shares outstanding. Stacy’s yield is computed like
this:

$15 / $15 = 1

As you can see, Stacy’s yield is one dollar. This means that Stacy’s
investors receive 1 dollar in dividends for every dollar they have invested in
the company. In other words, the investors are getting a 100 percent return
on their investment every year Stacy maintains this dividend level.