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Financial Analysis Ratios

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Tjan Tiong Gie
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54 views10 pages

Financial Analysis Ratios

Uploaded by

Tjan Tiong Gie
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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What are financial ratios?

Financial ratios are basic calculations using quantitative data from a


company’s financial statements. They are used to get insights and
important information on the company’s performance, profitability,
and financial health.
Common financial ratios come from a company’s balance sheet,
income statement, and cash flow statement.
Businesses use financial ratios to determine liquidity, debt
concentration, growth, profitability, and market value.

Why are financial ratios so important?


Financial ratios are sometimes referred to as accounting ratios or
finance ratios. These ratios are important for assessing how a
company generates revenue and profits using business expenses and
assets in a given period. Internal and external stakeholders use
financial ratios for competitor analysis, market valuation,
benchmarking, and performance management.
Financial Ratios inside a business
Financial planning and analysis professionals calculate financial ratios
for the following reasons for internal reasons.
● To measure return on capital investments
● To calculate profit margins
● To assess a company’s efficiency and how costs are allocated
● To determine how much debt is used to finance operations
● To identify trends in profitability
● To manage working capital and short-term funding requirements
● To identify operating bottlenecks and assess inventory
management systems
● To measure a company’s ability to settle debt and liabilities
5 Essential Financial Ratios for Every Business
The common financial ratios every business should track are 1)
liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability
ratios and 5) market value ratios.

1) Liquidity ratios

Quick ratio (Acid-test ratio): (Current Assets – Inventories –


Prepaid Expenses) / Current Liabilities.

Cash ratio: Cash and cash equivalents / Current Liabilities


The cash ratio measures a business’s ability to use cash and cash
equivalent to pay off short-term liabilities. This ratio shows how
quickly a company can settle current obligations.

2) Leverage ratios

Debt ratio: Total Debt / Total Assets


The debt ratio measures the proportion of debt a company has to its
total assets. A high debt ratio indicates that a company is highly
leveraged.
Debt to equity ratio: Total Debt / Total Equity
The debt-to-equity ratio measures a company’s debt liability
compared to shareholders’ equity. This ratio is important for
investors because debt obligations often have a higher priority if a
company goes bankrupt.

Interest coverage ratio: EBIT / Interest expenses


Companies generally pay interest on corporate debt. The interest
coverage ratio shows if a company’s revenue after operating
expenses can cover interest liabilities.

3) Efficiency ratios

Asset turnover ratio: Net sales / Average total assets

Inventory turnover: Cost of goods sold / Average value of


inventory

Days sales in inventory ratio: Value of Inventory / Cost of goods sold


x (no. of days in the period)
Holding inventory for too long may not be efficient. The day sales in
inventory ratio calculates how long a business holds inventories
before they are converted to finished products or sold to customers.

Payables turnover ratio: Cost of Goods sold (or net credit


purchases) / Average Accounts Payable

The payables turnover ratio calculates how quickly a business pays its
suppliers and creditors.

Days payables outstanding (DPO): (Average Accounts Payable /


Cost of Goods Sold) x Number of Days in Accounting Period (or year)

This ratio shows how many days it takes a company to pay off
suppliers and vendors. A lower days payables outstanding implies
that a business is letting go of cash too quickly and may not be taking
advantage of longer credit terms. On the other hand, when the DPO
is too high, it means a company delays paying its suppliers, which can
lead to disputes.

Receivables turnover ratio: Net credit sales / Average accounts


receivable

Accounts receivables are credit sales made to customers. It is


important that companies can readily convert account receivables to
cash. Slow paying customers reduce a business’s ability to generate
cash from their accounts receivable.
The receivables turnover ratio helps companies measure how quickly
they turn customers’ invoices into cash. A high receivables turnover
ratio shows that a company quickly generates cash from accounts
receivables.

4) Profitability ratios
A business’s profit is calculated as net sales less expenses.
Profitability ratios measure how a company generates profits using
available resources over a given period. Higher ratio results are often
more favorable, but these ratios provide much more information
when compared to results of similar companies, the company’s own
historical performance, or the industry average. Some of the most
common profitability ratios are:

Gross margin: Gross profit / Net sales

The gross margin ratio measures how much profit a business makes
after the cost of goods and services compared to net sales.
Comparing companies can be illustrative – such as finding that Home
Depot has a 33.6% gross profit margin versus Walmart’s 25.1%.

Operating margin: Operating income / Net sales


The operating margin measures how much profit a company
generates from net sales after accounting for the cost of goods sold
and operating expenses.

Return on assets (ROA): Net income / Total assets

Return on equity (ROE): Net income / Total equity

5) Market Value ratios

Earnings per share ratio (EPS): (Net Income – Preferred Dividends) /


End-of-Period Common Shares Outstanding

The earnings per share ratio, also known as EPS, shows how much
profit is attributable to each company share.

Price earnings ratio (P/E): Share price / Earnings per share

The PE ratio is a key investor ratio that measures how valuable a


company is relative to its book value earnings per share.

Book value per share ratio: (Total Equity – Preferred Equity) / Total
shares outstanding
Dividend yield ratio: Dividend per share / Share price

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