Financial Ratios Analysis

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Financial Ratio AnalysisDescriptionAnalysisImplicationsApplicationsExamples
1. Key Elements (KE)Financial Ratio Analysis involves the calculation and interpretation of various financial ratios, which are used to assess a company’s financial health, performance, and stability. Key ratios include liquidity, profitability, leverage, and efficiency ratios.– Calculate key financial ratios using data from a company’s financial statements. – Analyze these ratios to gain insights into the company’s financial position, operational efficiency, and profitability. – Compare ratios to industry benchmarks and historical data for context.– Provides a snapshot of the company’s financial condition. – Helps identify strengths and weaknesses in financial performance.– Evaluating a company’s financial health for investment decisions. – Assessing a company’s creditworthiness for lending purposes.Key Elements Example: Calculating the Current Ratio (liquidity), Profit Margin (profitability), Debt-to-Equity Ratio (leverage), and Inventory Turnover (efficiency).
2. Liquidity Ratios (LR)Liquidity ratios assess a company’s ability to meet its short-term obligations and financial stability. Common ratios include the Current Ratio and Quick Ratio.– Calculate liquidity ratios to determine the company’s short-term liquidity position. – A higher current ratio indicates better short-term solvency. – The quick ratio provides a stricter measure of liquidity by excluding inventory.– High liquidity ratios suggest the company can easily cover its short-term liabilities. – Low ratios may indicate liquidity problems or an inefficient use of assets.– Assessing a company’s ability to meet short-term financial obligations. – Evaluating working capital management.Liquidity Ratios Example: Current Ratio = Current Assets / Current Liabilities. Quick Ratio = (Current Assets – Inventory) / Current Liabilities.
3. Profitability Ratios (PR)Profitability ratios measure a company’s ability to generate profits relative to its revenues, assets, or equity. Key ratios include Profit Margin, Return on Assets (ROA), and Return on Equity (ROE).– Calculate profitability ratios to assess the company’s overall profitability. – Profit margin reflects the percentage of profit earned per dollar of revenue. – ROA and ROE evaluate profit generation relative to assets and equity, respectively.– High profitability ratios indicate effective management and strong financial performance. – Low ratios may signal challenges in generating profits or inefficiencies.– Assessing the company’s ability to generate profits from its operations. – Comparing profitability to industry peers.Profitability Ratios Example: Profit Margin = (Net Profit / Revenue) x 100. ROA = (Net Profit / Total Assets) x 100. ROE = (Net Profit / Shareholders’ Equity) x 100.
4. Leverage Ratios (LR)Leverage ratios measure the extent to which a company relies on debt financing. These ratios help assess the company’s financial risk and its ability to meet interest and principal payments. Common ratios include Debt-to-Equity Ratio and Interest Coverage Ratio.– Calculate leverage ratios to evaluate the company’s debt levels relative to equity. – A high debt-to-equity ratio indicates significant reliance on debt financing. – The interest coverage ratio assesses the company’s ability to service its interest payments from operating profits.– Low debt-to-equity ratios suggest lower financial risk and less reliance on debt financing. – High interest coverage ratios indicate the ability to comfortably cover interest expenses.– Assessing the company’s financial risk and debt management practices. – Evaluating borrowing capacity and creditworthiness.Leverage Ratios Example: Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity. Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expenses.
5. Efficiency Ratios (ER)Efficiency ratios, also known as activity or turnover ratios, assess how efficiently a company manages its assets and resources to generate sales and cash flow. Common ratios include Inventory Turnover and Accounts Receivable Turnover.– Calculate efficiency ratios to evaluate the company’s asset management and resource utilization. – Inventory turnover measures how quickly inventory is sold. – Accounts receivable turnover assesses the efficiency of collecting outstanding payments.– High efficiency ratios indicate effective asset utilization and management. – Low ratios may suggest inventory overstock or challenges in collecting receivables.– Analyzing the company’s operational efficiency and resource utilization. – Identifying areas for improvement in inventory or receivables management.Efficiency Ratios Example: Inventory Turnover = Cost of Goods Sold / Average Inventory. Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable.

Financial Analysis Ratios

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
The Enlightened Accountant by Gennaro Cuofano – FourWeekMBADownload

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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