Introduction to financial ratio analysis

What is a financial ratio?

Financial ratios are metrics used to gain insights into a company’s performance. They’re calculated using figures that can be found on a company’s financial statements – such as balance sheets, income statements and cash flows.

Financial ratios can be used to analyse and assess a company’s profitability, growth, leverage, rates of return, valuations and so much more.

How are financial ratios used?

Financial ratios are used to:

1. Assess a company’s performance – tracking the changes in financial ratios over time can help you to identify whether a business is growing or in decline
2. Compare a company to competitors – you can judge whether a firm is performing better or worse than others in the same industry to help assess its value

What are non-financial ratios?

Non-financial ratios tend to measure non-financial factors, such as customer satisfaction, customer retention, internal development, productivity and brand reputation.

While they aren’t directly used to assess the intrinsic value of a company, looking at the ways a company interacts with customers and staff can give you insights into how likely they are to succeed in the long term.

How many financial ratios are there?

There are a lot of financial ratios that can be used to analyse a business. Broadly speaking, there are five main types of financial ratio, these are:

1. Market value ratios – which assess value per share
2. Liquidity ratios – which assess the capacity to repay debt
3. Leverage ratios – which assess how much capital comes from debt
4. Efficiency ratios – which assess how effectively resources are used
5. Profitability ratios – which assess the income generated

Market value ratios

Market value ratios are used to evaluate the share price of a company’s stock. They’re used by traders, investors and analysts to assess a stock’s true value, and whether it is over- or under-priced.

The main market value ratios are:

1. Book-value-per-share
2. Dividend-yield ratio
3. Earnings-per-share ratio
4. Price-earnings

The book-value-per-share ratio

The book-value-per-share (BVPS) ratio measures the per-share value of a company based on the equity available to shareholders. It represents the minimum value of a company’s equity.

If BVPS is higher than the market value of the shares, the company’s stock is undervalued, and if the BVPS is lower than the current share price, the stock is overvalued. 

The book-value-per-share ratio is calculated as:

BVPS = (shareholder’s equity – preferred equity) / total common shares outstanding

The dividend-yield ratio

The dividend-yield ratio measures how much a company pays out in dividends each year relative to the market value per share. The resulting figure is the percentage of a company’s share price that is paid to shareholders.

It’s calculated as:

Dividend-yield ratio = dividend per share / share price

Earnings-per-share ratio

The earnings-per-share ratio, more commonly known as the EPS ratio, measures the amount of net income earned for each share outstanding over a certain time period. It indicates the company’s ability to produce profits for shareholders.

The EPS ratio formula is:

Earnings-per-share ratio = net earnings / total shares outstanding

 

A high EPS ratio tells us that a company’s shares are expensive compared to the profit a company earns for shareholders, while a low EPS ratio tells us the shares are undervalued. The figures are commonly compared to a company’s own EPS history to find growth trends, or against competitors.

The price-earnings ratio

The price-earnings (P/E) ratio compares a company’s share price to its earnings per share (EPS). It provides an educated guess of what earnings analysts and investors expect the company to earn in the future.

The formula is:

Price-earnings ratio = share price / earnings per share

 

A high P/E ratio indicates the company’s shares are overvalued, or that high growth is expected in the future. Low P/E ratios indicate a company’s shares are undervalued and a correction could take place. Companies that have no current earnings won’t have a P/E ratio.

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Liquidity ratios

Liquidity ratios measure a company’s ability to repay short- and long-term obligations. The most widely used liquidity financial ratios include:

1. Current ratio
2. Acid-test ratio
3. Cash ratio
4. Operating cash-flow ratio

 

The current ratio

The current ratio measures a company’s ability to pay off short-term obligations or those that are due within one year. The figure gives insight into how well a company can maximise the current assets on its balance sheet to meet its debts and other payments.

The current ratio is also called current balance, because it looks at both current assets and current liabilities. The formula looks like this:

Current ratio = current assets / current liabilities

The acid-test ratio

The acid-test ratio, or quick ratio, measures a company’s ability to pay off current liabilities with current assets – in other words, whether a company is liquid enough that its cash can pay its debts. To be included, assets must be able to be converted to cash within 90 days.

Acid-test ratio = current assets – inventories / current liabilities

 

The acid-test ratio is seen as more useful than the current ratio, as it excludes assets that are difficult to liquidate.

The cash ratio

The cash ratio measures a company’s total cash and cash equivalents to current liabilities, giving insights into how efficiently a company can repay short-term debts.

Cash ratio = cash and cash equivalents / current liabilities

 

The cash ratio is seen as an indicator of a company’s value if it were to go out of business. It tells creditors the value of current assets that could be turned into cash and how much of its liabilities this would cover.

The operating cash-flow ratio

The operating cash-flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated within the same period. The formula is:

Operating-cash-flow ratio = operating cash flow / current liabilities

 

A number greater than one indicates a company has generated more cash than is needed, and a number less than one indicates that a firm cannot cover current liabilities – and would likely need to find additional means of raising funds.

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Leverage ratios

Leverage ratios measure the total amount of capital that comes from a company’s debts. The most commonly used leverage ratios include:

1. Debt-to-equity ratio
2. Debt-service coverage ratio

 

The debt ratio

The debt ratio measures the total debt relative to the company’s total assets, usually expressed as a percentage. It shows us how much of a company’s assets are financed by its debts. The formula is:

Debt ratio = total liabilities / total assets

 

A ratio over 1 shows that a company has more debt than assets, which indicates it could be at risk of default on loans. A ratio below 1 indicates most of a company’s assets are funded by equity.

The debt-to-equity (D/E) ratio

The debt-to-equity ratio evaluates the weight of total debt and liabilities against shareholders’ equity. It shows us how a company is financing its operations, and its capacity to cover debts in the event of a downturn.

The debt-to-equity ratio formula is:

Debt to equity ratio = total liabilities / shareholder’s equity

 

Higher ratios indicate a company that would be a greater risk to shareholders, as the debts cannot be covered by equity alone. However, high debt can be a sign of a growth stock, so it’s important to look at a full balance sheet to understand how earnings are growing too.

The interest coverage ratio

The interest coverage ratio shows how easily a company can pay its interest expenses on any outstanding debt. It’s calculated using a company’s earnings before interest and taxes (EBIT), which is its operating income.

Interest coverage ratio = operating income / interest expenses

 

With the interest coverage ratio, a higher number is better, as it means they can cover payments and are more likely to survive any unforeseen circumstances. A ratio of 1.5 or lower means a company may not be able to meet its interest obligations.

There are other variations of the interest coverage ratio that use earnings before interest, taxes, depreciation and amortisation (EBITDA) or earnings before interest after taxes (EBIAT) instead of EBIT.

The debt-service coverage ratio (DSCR)

The debt-service coverage ratio (DSCR) measures a firm’s ability to pay its debt obligations using its income. The formula requires you to know the net operating income and the total debt servicing of the company.

Debt-service coverage ratio = operating income / total debt service

 

The DSCR is frequently used by lenders to assess how risky a company is before they agree to make a loan. A ratio of less than one shows a negative cash flow, so the company is unlikely to cover current debts without borrowing more capital. A ratio greater than 1 usually means the company has sufficient income.

However, figures around 1 – for example 1.1 or 1.2 – put the company at risk of default as any small change in its cash flow would take it into the risky category.

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Efficiency ratios

Efficiency ratios are used to measure how well a company uses its assets and resources to generate income. It’s a measure of non-interest expenses, and just shows how efficiently the company controls its spending. Financial efficiency ratios are also known as activity financial ratios.

Common efficiency ratios include:

1. Inventory turnover ratio
2. Accounts-receivable turnover ratio

 

The asset turnover ratio

The asset turnover ratio measures a company’s ability to generate revenue from its assets. It’s expressed as a percentage of the company’s assets and shows how many sales are generated from each dollar (or other currency denomination) of assets.

The formula is:

Asset turnover ratio = net sales / average total assets

 

A high ratio indicates the firm is using its assets efficiently. For example, a turnover of 0.5 would mean the company makes 50 cents for every dollar in assets.

The inventory turnover ratio

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period. It gives insight into sales and whether the company is generating enough capital from its inventory.

The inventory turnover ratio calculation is:

Inventory turnover ratio = cost of goods sold / average inventory

 

For example, an inventory turnover ratio of 0.5 would mean that a company has only sold half its inventory for the year.

The accounts-receivable turnover ratio

The accounts-receivable turnover ratio measures how many times a company can turn receivables into cash over a given period. It shows how well a company collects debt and extends its credit. It’s calculated using the following formula:

Receivables turnover ratio = net credit sales / average accounts receivable

 

A company with a higher account-receivable turnover ratio compared to others in its industry is likely to have a greater market share. It indicates it’s more efficient than its competitors.

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Profitability ratios

Profitability ratios measure a company’s ability to generate income relative to revenue, operating costs, balance sheet assets, and equity. They’re often compared with efficiency ratios, which – as we’ve seen – show us how well the company uses its assets internally to generate income.

Common profitability financial ratios include:

1. Gross margin ratio
2. Operating margin ratio
3. Return-on-assets ratio
4. Return-on-equity ratio

The gross margin ratio

The gross margin ratio compares the gross sales of a company to its cost of goods sold to show how much profit a company retains.

Gross margin ratio = net sales – cost of goods sold

 

The higher the gross margin, the higher the company’s profits, which can be used to pay other costs and obligations.

The operating margin ratio

The operating margin ratio measures how much profit a company makes on every dollar (or equivalent) of sales. It compares operating income to net sales to determine its efficiency in turning sales into profits.

The operating margin ratio calculation is:

Operating margin ratio = operating income / net sales

 

The resulting figure tells us how much capital a company is generating from its business, and how much capital it’s generating from other avenues – such as investment. Higher operating margins are better. However, it’s important to note that operating margin is only useful for comparing companies within the same industry.

The return-on-assets ratio

The return-on-assets ratio (ROA) measures how efficiently a company is using its assets to generate profit. Returns usually refers to profit or income, which is the value of a company’s earnings after costs, expenses and taxes have been deducted.

Return-on-assets ratio = net income / total assets

 

The resulting percentage shows us how efficiently a company manages its balance sheet. A higher ROA tells us the company is managing its income and generating profits, while a lower figure indicates there could be improvements to be made.

The return-on-equity ratio

The return-on-equity (ROE) ratio measures how efficiently a company uses its shareholder equity to generate profit.

The ROE formula is:

Return on equity ratio = net income / shareholder’s equity

 

ROE is considered a good gauge of profitability, but it should be compared against competitors in the same industry. You’ll need to compare it to other companies or a benchmark in order to understand what ROE to expect. As a rule, a good ROE should be above the industry average.

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