Financial Ratio Analysis

Key Elements of Financial Ratio AnalysisAnalysisImplicationsExamples
1. Data Collection and PreparationCollect and organize the necessary financial statements, including the income statement, balance sheet, and cash flow statement. Ensure data accuracy and consistency.– Accurate financial data is essential for reliable ratio analysis. – Ensure data is prepared in a consistent format for meaningful comparisons.– Gathering income statements and balance sheets for the past three fiscal years. – Adjusting data for non-recurring items or accounting changes.
2. Calculation of Key RatiosCalculate a range of financial ratios that provide insights into different aspects of the company’s performance, including liquidity, profitability, leverage, and efficiency.– Ratios provide quantitative measures of financial health and performance. – Different ratios serve various purposes and provide a holistic view of the company.– Calculating the current ratio (liquidity) as Current Assets / Current Liabilities. – Determining the return on equity (profitability) as Net Income / Shareholders’ Equity.
3. Analysis of RatiosAnalyze the calculated ratios to assess the company’s strengths, weaknesses, and overall financial health. Compare ratios to industry benchmarks and historical data.– Identify areas of financial strength and areas that require attention or improvement. – Benchmarking helps gauge the company’s performance relative to peers.– Assessing a high current ratio indicates strong liquidity, while a low ratio may suggest cash management issues. – Comparing the debt-to-equity ratio to industry averages to assess leverage.
4. Trend AnalysisExamine how ratios have changed over time to identify trends and assess the company’s ability to maintain or improve its financial performance.– Detect long-term trends in financial health and efficiency. – Identify whether the company’s financial position is strengthening or weakening.– Analyzing the trend of increasing profit margins over the past five years. – Observing a declining debt-to-assets ratio, indicating improved solvency.
5. Industry and Peer ComparisonCompare the company’s ratios to industry benchmarks and similar peers to gain insights into its competitive position and relative performance.– Determine how the company stacks up against industry leaders and competitors. – Identify areas where the company outperforms or lags behind its peers.– Comparing the company’s return on assets (ROA) to the industry average to assess relative efficiency. – Benchmarking the company’s price-to-earnings (P/E) ratio against competitors.
6. Interpretation and Decision-MakingInterpret the findings from the ratio analysis to make informed financial decisions, set goals, and develop strategies for improvement or growth.– Utilize ratio insights to make data-driven decisions regarding financial health, investment, and resource allocation. – Align financial strategies with business goals.– Deciding to invest in a company with strong profitability and liquidity ratios. – Developing a strategy to reduce operating expenses based on low profit margins.
RatioTypeDescriptionWhen to UseExampleFormula
Price-to-Earnings (P/E) RatioValuationMeasures a company’s current share price relative to its earnings per share (EPS).Assess valuation and growth prospects.A P/E ratio of 15 means investors pay $15 for every $1 of earnings.P/E = Price per Share / Earnings per Share
Price-to-Sales (P/S) RatioValuationCompares a company’s market capitalization to its total sales revenue.Evaluate valuation when earnings are not meaningful.A P/S ratio of 1 indicates the company’s market cap is equal to its annual revenue.P/S = Market Cap / Total Revenue
Price-to-Book (P/B) RatioValuationCompares a company’s market price per share to its book value per share.Assess valuation relative to tangible assets.A P/B ratio of 2 suggests the stock is trading at twice its book value.P/B = Price per Share / Book Value per Share
Price/Earnings to Growth (PEG) RatioValuation/GrowthCombines the P/E ratio with the expected earnings growth rate to assess valuation with growth prospects.Evaluate valuation relative to expected growth.A PEG ratio of 0.75 indicates potential undervaluation considering growth.PEG = P/E Ratio / Earnings Growth Rate
Dividend YieldDividendMeasures the annual dividend income relative to the stock’s price.Evaluate income potential from dividend stocks.A 3% dividend yield means $3 in annual dividends for every $100 invested.Dividend Yield = Annual Dividend per Share / Price per Share
Dividend Payout RatioDividendShows the proportion of earnings paid out as dividends.Assess sustainability of dividend payments.A 50% payout ratio means half of earnings are distributed as dividends.Payout Ratio = Dividends / Earnings
Debt-to-Equity RatioSolvencyMeasures the proportion of a company’s debt to its equity.Evaluate the financial risk and leverage.A debt-to-equity ratio of 0.5 suggests moderate leverage.Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Current RatioLiquidityCompares a company’s current assets to its current liabilities.Assess short-term liquidity and solvency.A current ratio of 2 indicates good liquidity with twice as many assets as liabilities.Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-Test Ratio)LiquiditySimilar to the current ratio but excludes inventory from current assets.Assess immediate liquidity without relying on inventory.A quick ratio of 1 means current liabilities can be fully covered by liquid assets.Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Return on Equity (ROE)ProfitabilityMeasures a company’s profitability relative to shareholders’ equity.Assess how efficiently equity is used to generate profits.An ROE of 15% indicates a company generated a 15% return on shareholders’ equity.ROE = Net Income / Shareholders’ Equity
Return on Assets (ROA)ProfitabilityMeasures a company’s profitability relative to its total assets.Assess how efficiently assets are used to generate profits.An ROA of 10% means a company earned a 10% return on total assets.ROA = Net Income / Total Assets
Gross MarginProfitabilityMeasures the percentage of revenue that remains after subtracting the cost of goods sold (COGS).Assess a company’s ability to control production costs.A gross margin of 30% indicates a 70% profit on COGS.Gross Margin = (Revenue – COGS) / Revenue
Operating MarginProfitabilityMeasures the percentage of revenue that remains after operating expenses are deducted.Assess a company’s operational efficiency.An operating margin of 15% means 15% of revenue remains as profit after operating expenses.Operating Margin = Operating Income / Revenue
Net Profit MarginProfitabilityMeasures the percentage of revenue that remains as profit after all expenses, including taxes and interest.Assess overall profitability.A net profit margin of 8% means 8% of revenue is profit after all expenses.Net Profit Margin = Net Income / Revenue
Earnings Before Interest and Taxes (EBIT) MarginProfitabilityMeasures the percentage of revenue that remains before interest and taxes are deducted.Assess operating performance without considering financing decisions.An EBIT margin of 20% indicates strong operational performance.EBIT Margin = EBIT / Revenue
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) MarginProfitabilityMeasures the percentage of revenue that remains before interest, taxes, depreciation, and amortization are deducted.Assess operating performance with a focus on cash flow.An EBITDA margin of 25% indicates efficient operation.EBITDA Margin = EBITDA / Revenue
Free Cash Flow (FCF) MarginCash FlowMeasures the percentage of revenue that remains as free cash flow after all operating and capital expenses.Evaluate a company’s ability to generate cash.An FCF margin of 10% means 10% of revenue is available as free cash flow.FCF Margin = FCF / Revenue
Price-to-Cash Flow (P/CF) RatioValuationCompares a company’s market price per share to its cash flow per share.Assess valuation based on cash flow.A P/CF ratio of 8 suggests investors pay $8 for every $1 of cash flow.P/CF = Price per Share / Cash Flow per Share
Inventory Turnover RatioEfficiencyMeasures how quickly a company sells and replaces its inventory.Assess inventory management efficiency.An inventory turnover ratio of 5 suggests inventory is sold and replaced 5 times a year.Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Accounts Receivable Turnover RatioEfficiencyMeasures how quickly a company collects payments from its customers.Assess accounts receivable collection efficiency.An AR turnover ratio of 6 suggests accounts receivable turn over 6 times a year.Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Total Asset Turnover RatioEfficiencyMeasures how efficiently a company uses its assets to generate revenue.Evaluate asset utilization and efficiency.A total asset turnover ratio of 0.8 suggests assets generate 80% of revenue annually.Total Asset Turnover Ratio = Revenue / Total Assets
Operating Cash Flow to Sales RatioCash FlowMeasures the percentage of sales revenue that is converted into operating cash flow.Assess the conversion of sales into cash.An operating cash flow to sales ratio of 15% means 15% of sales become cash flow.Operating Cash Flow to Sales Ratio = Operating Cash Flow / Revenue
Operating Income MarginProfitabilityMeasures the percentage of revenue that remains as operating income before interest and taxes.Assess profitability from core operations.An operating income margin of 12% suggests strong operational profitability.Operating Income Margin = Operating Income / Revenue
Debt RatioSolvencyCompares a company’s total debt to its total assets.Assess the proportion of assets financed by debt.A debt ratio of 0.4 indicates 40% of assets are financed by debt.Debt Ratio = Total Debt / Total Assets
Quick Assets RatioLiquidityCompares a company’s quick assets (cash, marketable securities, and receivables) to its current liabilities.Assess immediate liquidity without relying on inventory.A quick assets ratio of 1.2 indicates strong liquidity.Quick Assets Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Earnings Per Share (EPS)ProfitabilityRepresents the portion of a company’s profit allocated to each outstanding share of common stock.Assess profitability on a per-share basis.EPS of $2 means $2 of profit for each outstanding share.EPS = Net Income / Number of Shares Outstanding
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)ProfitabilityMeasures a company’s operating earnings before non-operating expenses.Assess operating profitability.EBITDA of $500,000 indicates strong operating earnings.EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization
Earnings Before Interest and Taxes (EBIT)ProfitabilityRepresents a company’s operating profit before interest and taxes.Assess core operational profitability.EBIT of $1 million indicates strong operating profit.EBIT = Earnings Before Interest and Taxes
Operating Cash Flow (OCF)Cash FlowMeasures the cash generated or used by a company’s core operating activities.Evaluate cash flow from operations.OCF of $800,000 indicates positive cash flow from operations.OCF = Operating Cash Flow
Free Cash Flow (FCF)Cash FlowRepresents the cash generated or used by a company after capital expenditures.Assess cash available for investors or debt reduction.FCF of $400,000 indicates cash available for dividends or debt reduction.FCF = Free Cash Flow
Return on Investment (ROI)ProfitabilityMeasures the return on an investment relative to its cost.Evaluate the efficiency of an investment.An ROI of 20% indicates a 20% return on an investment.ROI = (Gain from Investment – Cost of Investment) / Cost of Investment
Return on Capital Employed (ROCE)ProfitabilityMeasures the return generated from the capital employed in a business.Assess the efficiency of capital utilization.ROCE of 15% indicates a 15% return on capital employed.ROCE = Earnings Before Interest and Taxes (EBIT) / Capital Employed
Operating CycleEfficiencyMeasures the time it takes for a company to convert inventory to cash.Assess the efficiency of inventory and receivables management.An operating cycle of 45 days suggests efficient working capital management.Operating Cycle = Average Days of Inventory + Average Days of Receivables
Cash Conversion Cycle (CCC)EfficiencyMeasures the time it takes for a company to convert inventory and receivables into cash, considering payables.Assess cash flow efficiency and liquidity management.A CCC of 30 days indicates quick conversion of assets into cash.CCC = Operating Cycle – Average Days of Payables
Net Working CapitalLiquidityRepresents the difference between a company’s current assets and current liabilities.Assess liquidity and short-term solvency.Net working capital of $500,000 indicates good short-term liquidity.Net Working Capital = Current Assets – Current Liabilities
Quick Liquidity RatioLiquidityCompares a company’s quick assets (cash, marketable securities, and receivables) to its current liabilities.Assess immediate liquidity without relying on inventory.A quick liquidity ratio of 1.5 indicates strong immediate liquidity.Quick Liquidity Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Times Interest Earned (TIE)SolvencyMeasures a company’s ability to cover interest payments with its earnings before interest and taxes.Assess solvency and ability to meet interest obligations.A TIE ratio of 4 indicates earnings are four times the interest expenses.TIE = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Price-to-Operating Cash Flow (P/OCF) RatioValuationCompares a company’s market price per share to its operating cash flow per share.Assess valuation based on operating cash flow.A P/OCF ratio of 10 suggests investors pay $10 for every $1 of operating cash flow.P/OCF = Price per Share / Operating Cash Flow per Share
Price-to-Free Cash Flow (P/FCF) RatioValuationCompares a company’s market price per share to its free cash flow per share.Assess valuation based on free cash flow.A P/FCF ratio of 12 suggests investors pay $12 for every $1 of free cash flow.P/FCF = Price per Share / Free Cash Flow per Share
Return on Sales (ROS)ProfitabilityMeasures the percentage of revenue that remains as profit after all expenses.Assess overall profitability.An ROS of 12% means 12% of revenue is profit after all expenses.ROS = Net Income / Total Revenue

Connected Economic Concepts

Market Economy

market-economy
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.

Positive and Normative Economics

positive-and-normative-economics
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.

Inflation

how-does-inflation-affect-the-economy
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation. 

Asymmetric Information

asymmetric-information
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.

Autarky

autarky
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.

Demand-Side Economics

demand-side-economics
Demand side economics refers to a belief that economic growth and full employment are driven by the demand for products and services.

Supply-Side Economics

supply-side-economics
Supply side economics is a macroeconomic theory that posits that production or supply is the main driver of economic growth.

Creative Destruction

creative-destruction
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.

Happiness Economics

happiness-economics
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.

Oligopsony

oligopsony
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.

Animal Spirits

animal-spirits
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage.  Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.

State Capitalism

state-capitalism
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.

Boom And Bust Cycle

boom-and-bust-cycle
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.

Paradox of Thrift

paradox-of-thrift
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.

Circular Flow Model

circular-flow-model
In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.

Trade Deficit

trade-deficit
Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.

Market Types

market-types
A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.

Rational Choice Theory

rational-choice-theory
Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.

Conflict Theory

conflict-theory
Conflict theory argues that due to competition for limited resources, society is in a perpetual state of conflict.

Peer-to-Peer Economy

peer-to-peer-economy
The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.

Knowledge-Economy

knowledge-economy
The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.

Command Economy

command-economy
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.

Labor Unions

labor-unions
How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.

Bottom of The Pyramid

bottom-of-the-pyramid
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”

Glocalization

glocalization
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.

Market Fragmentation

market-fragmentation
Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.

L-Shaped Recovery

l-shaped-recovery
The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth.  The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.

Comparative Advantage

comparative-advantage
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846.  Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.

Easterlin Paradox

easterlin-paradox
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.

Economies of Scale

economies-of-scale
In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

diseconomies-of-scale
In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Economies of Scope

economies-of-scope
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.

Price Sensitivity

price-sensitivity
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

Negative Network Effects

negative-network-effects
In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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