financial-ratio-formulas

What Is a Financial Ratio? The Complete Beginner’s Guide to Financial Ratios – Part One

 

A financial ratio is a metric usually given by two values taken from a company's financial statements that compared give five main types of insights for an organization. Things such as liquidity, profitability, solvency, efficiency, and valuation are assessed via financial ratios. Those are metrics that can help internal and external management to make informed decisions about the business. 

Financial-ratio-Analysis

The aim of the ratio analysis isn't necessarily to give an answer by looking at a single metric. In many cases to have an overview of the business, it is critical to look at several metrics. Almost like in a decision tree that branches out. That is how we find answers!

Why Ratio Analysis?

Ratio Analysis allows us to answer questions such as: How profitable is the company? Will the organization be able to meet its obligations in the short and long-term? How effectively is the organization using its resources?

Of course, some of the ratios (such as the profitability ratios) if not assessed against other ratios do not mean anything. Also, if you want to know more about one company you have to analyze it in comparison with other companies which present the same characteristics, such as industry, geography, customers and so on.

For example, if you are performing an analysis on Apple Inc., you cannot compare its ratios with Coca-Cola. Instead, you should compare Apple Inc. with Samsung or Microsoft. 

Therefore, the ratio analysis is a tool that gives you the opportunity to interpret the information provided by the P&L and BS to understand how the business is operating in the marketplace.

Financial Ratio Analysis and interpretation

By looking at the primary financial statements (Balance Sheet and Income Statement), you won’t be able to find an answer unless you ask the right questions. 

Although the financial statements give you already a great deal of information about the business, there is still something missing. Financial ratios are a simple way to interpret those financial statements to extract critical insights to assess a company from the inside or the outside. 

In short, either you are a manager looking for ways to improve your business. Or you're an analyst trying to figure out insights about an organization whose financial ratios will help you out. 

assets-liabilities

Key financial ratios

There are several financial ratios to assess the health of a business.  Sone of the key ratios used by managers include the following:

  1. Current Ratio
  2. Quick Ratio
  3. Operating profit margin
  4. Net profit margin
  5. Debt to equity ratio
  6. Inventory Turnover
  7. Return on equity
  8. Earnings per Share
  9. Return on assets

As we'll see through this guide the choice of a financial ratio is also in accordance to the industry and business models we're analyzing.

Types of financial ratios

Financial ratios are great "financial heuristics" to have a quick glance at a business performance. Those financial ratios, in particular, help us assess five things:

  • Liquidity
  • Profitability
  • Solvency
  • Efficiency
  • Valuation

Each of those aspects it's essential for a business sustainable short and long-term growth.

What is liquidity?

Liquidity is the capacity of a business to find the resources needed to meet its obligations in the short-term. 

For such reason, the liquidity on the Balance Sheet is measured by the presence of Current Assets in excess of Current Liabilities or the relationship between current assets and current liabilities.

Why do we need to assess the liquidity of a business?

For several reasons; Imagine, you are establishing contact with a new supplier. There is no precedent history between you two. The supplier wants some sort of guarantee that you will be able to meet the future obligations. 

Therefore, he asks for a credit report about your organization. This report shows whether an organization has enough liquidity to sustain its operations in the short-term. 

How? Based on the main liquidity ratios of your organization a rating will be assigned. The rating is a grade the organization gets if it meets specific criteria. 

Based on that rating the supplier will decide whether to entertain business with you or not. Of course, the Rating itself is more qualitative and quantitative. 

In other words, the numbers provided by the liquidity ratios will be intersected with other metrics (such as profitability ratios and leverage ratios). 

Another example, imagine you want to open an overdraft account with a local bank. The same scenario applies since the local bank will assess your credit score before approving the overdraft. Thereby, the bank will look at your BS and see how liquid the organization is.

What are the main liquidity ratios?

Current Ratio

what-is-current-ratio

This ratio shows the relationship between the company’s current assets over its current liabilities. It measures the short-term capability of a business to repay for its obligations:

Current Assets / Current Liabilities

Example: Imagine, your organization, in Year-Two has total current assets for $100K and total current liabilities for $75K. Therefore: 100/75= 1.33 times. Your Current ratio is 1.33.

Is it good or bad? Well, it depends.

You have to compare this data with the previous year ratio. Also, it depends on the kind of industry you are operating within. Of course, a clothing store or specialty food store will have a much higher current ratio. 

Thereby the current assets will be 4 or 5 times the current liabilities, mainly due to large inventories. Other companies, such as the ones operating in the retail industry can have current ratios lower than 1, due to favorable credit condition from their suppliers. 

This allows them to operate with a low level of inventories. For example, companies such as Burger King will have a ratio as high as 1.5, while companies such as Wal-Mart as low as 0.3.

Quick Ratio (Acid or Liquid Test)

what-is-quick-ratio

On the Balance Sheet (BS) the items are listed from the most liquid (cash) to the least liquid (inventories and prepaid expenses). The first section of the BS shows the current assets subsection (part of the Assets section). 

Current Assets are those converted in cash within one accounting cycle. Therefore, while the current ratio tells us if an organization has enough resources to pay for its obligations within one year or so, the Quick ratio or acid test is a more effective way to measure liquidity in the very short-term. Indeed, the quick ratio formula is:

Liquid Assets / Current Liabilities

How do we define liquid assets? Liquid assets are defined as Current Assets – (Inventory + Pre-paid expenses). Although inventory and pre-paid expenses are current assets, they are not always turned into cash as quickly as anyone would think.

Example: Imagine that of $100K of current assets. Of which $80K are liquid assets, the remaining portion is inventory. The liability stays at $75k. 

The quick ratio will be 1.06 times or $80K/$75K. Therefore, the liabilities can be met in the very short-term through the company’s liquid assets. To assess if there was an improvement on the creditworthiness of the business we have to compare this data with the previous year. 

Although, a quick ratio of over 1, can generally be accepted, while below one is usually seen as undesirable since you will not be able to pay very short-term obligations unless part of the inventories is sold and converted into cash.

Absolute Ratio

what-is-absolute-ratio

This is the third current ratio, less commonly used compared to current and quick ratio. If the quick ratio is more stringent in comparison to the current ratio, the absolute ratio is the strictest of the three. This is given by:

Absolute Assets / Current Liabilities

Liquid assets - Accounts receivable = Absolute Assets. Generally, cash on hand and marketable securities are part of the absolute assets. The purpose of the absolute ratio is to determine the liquidity of the business in the very short-term (few days).

Using one current ratio or the other is really up to you, and it depends on the kind of analysis performed. Of course, if you want to know if an organization would be able to pay in the three-month time frame, then, the Quick Ratio may be a more appropriate measure of liquidity compared to the Current Ratio. 

In addition, I find much more reliable the Quick Ratio compared with the other two Liquidity Ratios. For two simple reasons, on the one hand, the Current Ratio is not stable enough to tell whether a company will be able to meet its obligations in the short-term since it comprises items such as Inventories and Prepaid Expenses which are hardly converted into cash. 

On the other hand, the Absolute Ratio takes into account just those items, (Cash, cash equivalents and short-term investments) which are very volatile. Indeed, I would not be surprised if you saw the Absolute Ratio swinging from one excess to the other. 

In fact, companies usually invest their cash right away in other long-term assets that will produce future benefits for the organization. Therefore, unless you are Microsoft, which saves billions in cash reserves, I would not rely on the Absolute Ratio as well.

What is profitability?

Profitability is the ability of any business to produce “earnings.” The Financial Statement, which tells us whether a company is making profits or not is the Income Statement (or Profit and Loss Statement).

What are the main profitability ratios?

In order to understand if a business is making profits we have to look at its Net Profit Line also called “bottom line” since we always find it as the last item shown on this statement.

The main profitability ratios used in financial accounting are:

  • Gross profit margin
  • Operating profit margin
  • Return on capital employed (ROCE)
  • Return on equity (ROE)

Gross Profit Margin

what-is-gross-profit-margin

This is the relationship between Goss Profit and sales, and it is expressed in percentage:

(Gross Profit (Revenue – CoGS) / Sales) x 100%

Imagine, company XYZ had $100K in Gross profit and $250K in Sales, for Year-Two, therefore:

(100/250) * 100% = 40%

It means that 60% of your income is used to cover for the cost of goods sold.  This ratio is critical, since for many organizations, in particular, manufacturing, most of the costs are associated with CoGS (Cost of Goods Sold). 

For example, if you have to produce an Ice cream, you have to buy raw materials to make it. Also, someone has to “assemble” the Ice cream before it can be sold. 

Well, the raw materials and the work needed to produce the final product are considered CoGS. In other words, those are the costs required before the Ice cream can be sold.  

Therefore, this measure can be beneficial to assess the operational profitability of the business. In short, the Gross Profit Margin tells us whether we are properly managing our inventories as well.

Operating Profit Margin

what-is-operating-profit-margin

This is a relationship between Operating Profit and Sales, and it is expressed in percentage:

(Operating Profit (Revenue – CoGS - Op. Expense) / Sales) x 100%

Imagine, in Year-Two, the Operating profit was $25K and your revenue $250K. Therefore:

(25/250) * 100% = 10%

This measure compared to the Gross Profit Margin has a wider spectrum, and it assesses the profitability of the overall operations. Indeed, the operating profit is considered one of the most important metrics within the P&L. 

Indeed, the Operating Profit can be influenced by managers’ choices. Why? Managers cannot control Taxes and Interest payments (although they can reduce the leverage). 

Therefore, the Operating Profit is the measure that truly tells us how the management is administrating the business. For such reason, it is one of the most important metrics.

Return on capital employed

what-is-return-on-capital-employed

This measure assesses whether the company is profitable enough, considering the capital invested in the business. 

Indeed, it tells for each dollar invested in the business, how much return is generated. Indeed, the ROCE is the relationship between Operating Profit, and Capital Employed, expressed in percentage terms. Let’s see below what is considered capital employed:

(Operating Profit / Capital Employed (Total Assets – Current Liabilities)) x 100%

Imagine, company XYZ operating profit for Year-Two is $100K, and the capital invested in the business (your total assets – current liabilities) is $500K. The ROCE will be 0.2 or 20% ((100/500) * 100%). 

Therefore, for every dollar invested in the business the company made 20 cents. The higher the ROCE, the better it is for its stakeholders. Consequently, an increasing ROCE overtime is a good sign.

Return on Equity

what-is-the-return-on-equity

This is the relationship between net income and shareholder equity or, the amount of revenue generated by the shareholder's investment in the organization. This is one of the most used ratios in finance. The formula for the ROE is:

              (Net Income / Shareholders Equity) x 100%

Imagine the net income of Company XYZ in Year-Two was $20K and you invested $100K. Therefore the ROE is (20/100) x 100% = 20%.  Also, an increasing ROE is a good sign. 

It means that the shareholders are getting rewarded overtime for their risky investment. This leads to more future investments by other shareholders and the appreciation of the stock. 

The ROE itself is often used without caution. In fact, the problem of this ratio lies in its denominator. Indeed, the management can control Shareholders’ Equity. 

How? For instance, the Net Income is produced through assets that the company bought. Assets can be acquired either through Equity (Capital) or Debt (Liability). 

Consequently, when companies decide to finance their assets through Debt, usually revenue accelerate at a higher speed compared to interest expenses. This leads to a higher Net Income, although a lower Shareholders’ Equity. 

That, in turn, generates an artificially high Return on Equity.  For such reason, it is important to use this ratio cautiously and in conjunction with other leverage ratios as well (such as the Debt to Equity ratio).

How, why and when to us financial ratios 

Many “analysts” and “investors” are deceived by the use of the valuation ratios. Those ratios help us to have an understanding of how Mr. Market values a business. 

On the other hand, we want to use valuation ratios in conjunction with liquidity, profitability, efficiency, and leverage. In other words, decide before to start your analysis beforehand what will be the ratios that will guide you throughout your analysis. 

For instance, if you are going to analyze a technological business, you will use different parameters compared to a manufacturing one. 

Indeed, in the former case it might be more appropriate to use liquidity ratios when assessing the financial situation of a tech company rather than efficiency ratios (a tech firm hopefully does not carry inventories); in the latter case, instead, it might be more appropriate to use the efficiency ratios when it comes to manufacturing companies. 

In fact, on one hand, tech companies operate in a more competitive environment, where changes happen swiftly (and therefore revenues plunge quickly). In such scenario holding a safe (financial) cushion, it is more appropriate. 

For such reason, the Quick Ratio is going to tell us a lot about the business. On the other hand, when analyzing a manufacturing company, the efficiency ratios may tell us much more about the business. 

Indeed, in such scenario, the way inventories, receivable and payable are managed can be crucial to give enough oxygen to the business itself. 

Therefore, in conjunction with the quick ratio, the inventory turnover, accounts receivable and accounts payable turnover will give us a more precise account of the business. 

One last important point is that Ratios help us in the understanding of the past and the current situation. Although the past and the present are essential to interpret the future, they can be deceitful as well. Therefore, when analyzing any organization, it is essential to be guided by caution.  Having highlighted this point, let’s move on to dirt our hands now. 

The Complete Beginner's Guide to Financial Ratios - Part Two

Published by

Gennaro Cuofano

Creator of FourWeekMBA.com | Head of Business Development at WordLift.io | International MBA

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