Financial ratio analysis uses ratios in addition to those calculated indirectly in common-size analysis, such as gross profit margin, net profit margin, etc. It is because relationships between other financial statement items also provide useful information. Such financial ratios are categorized into the following:
- Activity: These are concerned with efficiency of asset-utilization.
- Liquidity: They provide information about a company’s ability to meet its short-term obligations.
- Solvency: They are used to assess the long-term financial position.
- Profitability: They tell us a company’s ability to generate profits.
- Valuation: They benchmark a company’s value with reference to different performance parameters.
These categories are just one of the different ways in which ratios can be classified. Some ratios are helpful in analyzing more than one aspect of a company’s financial situation.
Interpretation of ratios
The most important step in analysis of a ratio is identification of a relevant benchmark, a peer group of the company’s historical track record. The aim is to understand the underlying drivers of performance. While consistency indicates stable performance, it should be looked at skeptically (because it may indicate earning smoothing).
Financial ratios must be analyzed in the context of:
- The company’s goals and strategies.
- Industry norms and practices.
- Economic conditions and sensitivity of a company to business cycles.
Activity ratios
Activity ratios (also called asset utilization ratios or operating efficiency ratios) assess how good a company is in managing its assets. They typically contain an income statement item in the numerator and a balance sheet item from the denominator. Since efficiency impacts liquidity, these ratios are also useful in liquidity analysis.
In the following paras, COGS stands for the cost of goods sold, and D stands for the number of days in the period.
Inventory turnover and days inventory on hand
Inventory turnover ratio calculates the number of times (on average) a company is able to sell its inventories during a period. For an annual period, it is calculated as follows:
\[ Inventory\ Turnover\ Ratio =\frac{COGS}{Average\ Inventory} \]Days of inventory on hand (DOH) represents the number of days a company takes in selling its inventories. It equals the number of days in a period divided by inventory turnover for the period.
\[ DOH\ =\frac{D}{Average\ Inventory\ Turnover}=D\times\frac{Average\ Inventories}{COGS} \]For example, if monthly inventory turnover is 2, DOH is calculated by dividing 30 by 2.
A high inventory turnover ratio (and a low DOH) relative to the industry may indicate effective inventory management, or it may indicate that the company does not carry adequate inventories. This can be confirmed by looking at the company’s revenue growth in relation to the industry. A low inventory turnover (and hence, a high DOH) may indicate slow-moving inventory.
Receivable turnover and days sales outstanding
Receivables turnover tells us the number of days a company collects cash from its average credit customer during a period.
\[ Receivables\ Turnover=\frac{Revenue}{Average\ Receivables} \]Days of sales outstanding (DSO) shows the number of days in which cash is collected from an average credit customer. For an annual period, the formula is as follows:
\[ DSO\ =\frac{D}{Receivable\ Turnover}=D\ \times\frac{Average\ Receivables}{Revenue} \]A high receivable turnover (and hence, low DSO) may indicate efficient credit and collection performance or it might indicate too stringent credit requirements. An analyst needs to look at the revenue growth and aging analysis of receivables (in the notes to the financial statements) to see which is the more plausible explanation.
Payables turnover and number of days payable
Payables turnover shows how many times a company pays its accounts payable during a period.
\[ Payables\ Turnover=\frac{Purchases}{Average\ Accounts\ Payable} \]Purchases can be calculated the cost of goods sold by adjusting it for changes in inventories.
Number of days of payables is the reciprocal of payables turnover. It calculates days taken in paying accounts payable on average. For annual
\[ DPO\ =\frac{D}{Payables\ Turnover}=D\ \times\frac{Average\ Accounts\ Payable}{Purchases} \]A high payable turnover may indicate that either the company is taking advantage of discounts or it is paying vendors too early. An excessively low payables turnover may indicate that either the company is having trouble paying its creditors or that it is enjoying very lenient credit terms. This can be confirmed by looking at the company’s liquidity situation.
Asset turnover ratios
Working capital turnover measures dollar of revenue generated per dollar of average investment in working capital (i.e. current assets minus current liabilities).
\[ Working\ Capital\ Turnover=\frac{Revenue}{Average\ Working\ Capital} \]For companies whose working capital is close to zero or negative (i.e. when their current liabilities are greater than current assets), fixed asset turnover, and total asset turnover ratios are more relevant. These ratios are calculated just by replacing average working capital with average fixed assets and average total assets, respectively.
A high fixed asset turnover ratio generally indicates efficient operations and a low fixed asset turnover may be because either (a) the business is capital intensive, (b) the company has not yet achieved its full capacity, and/or (c) inefficiency. The fixed asset turnover ratio must be used with care because the value of fixed assets is affected by depreciation which is not relevant to sales revenue.
The total asset turnover ratio communicates the combined efficiency of a company’s total assets. A low total asset turnover may indicate operational inefficiency or low capital intensity of the business, and vice versa.
Liquidity ratios
Liquidity analysis focuses on a company’s ability to pay its short-term obligations. It depends on the structure of the company’s liabilities, its funding sources, and contingent liabilities.
Different industries have different liquidity needs. In general, large companies have better liquidity because of their ability to access funds from different sources. Contingent liabilities must be included in the analysis, particularly for financial sector entities, because these represent potential outflows that can impair a company’s liquidity position drastically.
Popular liquidity ratios are current ratio, quick ratio, cash ratio, defensive interval ratio, and cash conversion cycle.
Current ratio
The current ratio expresses current assets as a proportion of current liabilities. A ratio greater than 1 means that current assets are more than current liabilities. A low ratio may indicate that the company is relying on cash flows from operations to pay off current liabilities.
\[ Current\ Ratio=\frac{Current\ Assets}{Current\ Liabilities} \]The current ratio inherently assumes that inventories and accounts receivable are liquid, but when the relevant turnover ratios are low, it might indicate that it is not the case. In such a situation, it is useful to look at the quick ratio and cash ratio.
Quick ratio
Quick ratio excludes inventories and prepayments from the definition of liquid assets because they are harder to convert to cash.
\[ Quick\ Ratio=\frac{Cash + Short‐term\ Investments + Receivables}{Current\ Liabilities} \]The quick ratio is a more stringent measure of liquidity. Just like the current ratio, a higher ratio is better.
When we divide the numerator in the quick ratio (cash + short-term marketable securities + receivables) by the daily cash expenditure, it gives us the defensive interval ratio. It measures the number of days a company can survive just on its liquid assets.
Cash ratio
Cash ratio is even more stringent than the quick ratio. It compares the cash and cash equivalents and short-term financial assets with current liabilities.
\[ Cash\ Ratio=\frac{Cash + Short‐term\ Marketable\ Investments}{Current\ Liabilities} \]Even though the cash ratio is a reliable measure of liquidity, short-term marketable instruments may lose significant value in times of financial crisis.
Cash conversion cycle
The cash conversion cycle represents the time it takes a company in recouping (through receipts from customers) its outlay of cash (that it made in purchasing inventories). It is also called the net operating cycle.
\[ Cash\ Conversion\ Cycle=DOH+DSO\ -\ DPO \]A shorter cash conversion cycle is better. A longer ratio means that the company would need a higher investment in working capital.
Solvency ratios
Solvency analysis involves an assessment of the level of debt in a company’s capital structure and its ability to meet its long-term obligations. Analysis of debt is important because debt results in a fixed interest charge on a company’s income and cash flows which can have a magnifying effect, called leverage, on its return on equity.
If a company has high operating fixed costs, a change in sales has a more pronounced impact on operating income and if a company has a high interest expense (due to high debt level), a percentage change in operating income causes a larger percentage change in net income.
An analyst needs to look at the use of financial leverage by a company both in comparison with its peer group and past practices. Solvency analysis is not only useful for valuation of its debt instruments but can also provide an important signal about the management’s beliefs about the company’s outlook.
There are different variants of solvency ratios. Some are balance sheet ratios that compare total debt (sum of interest-bearing short-term and long-term debt) to total assets or equity while others compare debt to income statement items.
A higher debt-to-assets, debt-to-capital, and debt-to-equity ratios indicate higher financial leverage and risk. The debt-to-equity ratio may also be calculated using market values.
Financial leverage ratio (also called leverage ratio) measures dollars of total assets per dollar of equity. This ratio may also be calculated using ending values.
The debt to EBITDA ratio measures the sufficiency of EBITDA (which is a proxy for operating cash flow) with respect to repayment of debt. A higher ratio means that it would take a company longer to pay-off the debt.
Interest coverage ratio measures the number of times a company’s operating income (EBIT) can pay off interest payments. Similarly, the fixed charge coverage ratio measures sufficiency of operating income before lease charge (EBIT + lease payments) to make the interest and lease payments. Higher interest and fixed charge coverage ratios are better and may be used as an indicator of quality of income available for preferred dividends.
Profitability ratios
Profitability ratios measure a company’s ability to generate a return on its assets. It is an indicator of the company’s competitive position.
There are two variants of profitability ratios, those which measure return on sales, and those which measure return on investment.
Gross profit margin
Gross profit margin, operating profit margin, pretax margin and net profit margin are calculated by dividing gross profit (revenue minus COGS), operating income (which is not necessarily equal to EBIT), earnings before taxes, and net income by net revenue.
Gross profit margin is a measure of a company’s competitive advantage. A company with low competition is able to charge a higher profit and hence earn a higher gross profit margin.
Operating profit margin
Operating profit margin also includes the effect of operating expenses (other than the cost of goods sold). If operating profit margin increases more than the gross profit margin, it means that the company has been able to control operating expenses.
Pretax margin
Pretax margin is also affected by a company’s non-operating income. Hence, if the pretax margin changes faster or slower than the operating profit margin, it means changes in the company’s non-operating income/expense.
Net profit margin
The net profit margin includes the effect of all operating and non-operating activities of a company.
Return on assets (ROA)
Return on assets (ROA) measures the return earned by a company per dollar of assets. It is most often calculated by dividing net income by average total assets:
Some practitioners object to this formula because net income represents only the income available to equity shareholders but total assets are financed by both debt and equity. Hence, they add back after-tax interest expense to the numerator:
\[ ROA=\frac{Net\ Income\ +\ Interest\ Expense\ \times\ (1\ -\ Tax\ Rate)}{Average\ Total\ Assets} \]Operating ROA
Still some other analysts calculate ROA based on operating income (EBIT). This version is called operating ROA.
Return on total capital
Return on total capital measures return earned by short-term debt, long-term debt and equity collectively.
Return on equity
Return on equity works out return earned per dollar of equity. Shareholders’ equity includes common equity, minority interest, and preferred equity. One variant of ROE, called return on common equity uses only the company’s common equity in the denominator.