Financial ratio

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies.^[1] If shares in a company are publicly listed, the market price of the shares is used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percentage value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of changes in equity. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organisation.

Purpose and types

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt.^[2] Activity ratios measure how quickly a firm converts non-cash assets to cash assets.^[3] Debt ratios measure the firm's ability to repay long-term debt.^[4] Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.^[5] Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.^[6] These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company's shares.

Financial ratios allow for comparisons

between companies
between industries
between different time periods for one company
between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may elect to not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce their financial statements, or they may use the generally accepted accounting principles of their home country.

There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.

Types of Ratio Comparisons

An important of ration analysis is interpreting ratio values. A meaningful basis for comparison is needed to answer questions such as "Is it too high or too low?" or "Is it good or bad?". Two types of ratio comparisons can be made, cross-sectional and time-series.^[7]

Cross-Sectional Analysis

Cross-sectional analysis compares the financial ratios of different companies at the same point in time. It allows companies to benchmark from other competitors by comparing their ratio values to similar companies in the industry.

Time-Series Analysis

Time-series analysis evaluates a company's performance over time. It compares its current performance against past or historical performance. This can help assess the company's progress by looking into developing trends or year-to-year changes.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the Internet. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below).

Companies that are primarily involved in providing services with labour do not generally report "Sales" based on hours. These companies tend to report "revenue" based on the monetary value of income that the services provide.

Note that Shareholders' Equity and Owner's Equity are not the same thing, Shareholder's Equity represents the total number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's book value. It is important to make this distinction when calculating ratios.

Abbreviations

(Note: These are not ratios, but values in currency.)

COGS = Cost of goods sold, or cost of sales.
EBIT = Earnings before interest and taxes
EBITDA = Earnings before interest, taxes, depreciation, and amortization
EPS = Earnings per share

Ratios

Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return

Gross margin, Gross profit margin or Gross Profit Rate^[8]^[9]

⁠Gross ProfitNet Sales⁠ :::OR :::⁠Net Sales - COGSNet Sales⁠

Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)^[9]^[10]

⁠Operating IncomeNet Sales⁠

Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit.^[11] This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales^[12]^[13])

Profit margin, net margin or net profit margin^[14]

⁠Net ProfitNet Sales⁠

Return on equity (ROE)^[14]

⁠Net IncomeAverage Shareholders Equity⁠

Return on assets (ROA ratio or Du Pont Ratio)^[6]

⁠Net IncomeAverage Total Assets⁠

Return on assets (ROA)^[15]

⁠Net IncomeTotal Assets⁠

Return on assets Du Pont (ROA Du Pont)^[16]

⁠Net IncomeNet Sales⁠ · ⁠Net SalesTotal Assets⁠

Return on Equity Du Pont (ROE Du Pont)

⁠Net IncomeNet Sales⁠ · ⁠Net SalesAverage Assets⁠ · ⁠Average AssetsAverage Equity⁠

Return on net assets (RONA)

⁠Net IncomeFixed Assets + Working Capital⁠

Return on capital (ROC)

⁠EBIT(1 − (Tax Rate))Invested Capital⁠

Risk adjusted return on capital (RAROC)

⁠Expected ReturnEconomic Capital⁠ :::OR :::⁠Expected ReturnValue at Risk⁠

Return on capital employed (ROCE)

⁠EBITCapital Employed⁠

Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity

Cash flow return on investment (CFROI)

⁠Cash FlowMarket Recapitalisation⁠

Efficiency ratio

⁠Non-Interest expenseRevenue⁠

Net gearing

⁠Net debtEquity⁠

Basic Earnings Power Ratio^[17]

⁠EBITTotal Assets⁠

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio)^[18]

⁠Current AssetsCurrent Liabilities⁠

Acid-test ratio (Quick ratio)^[18]

⁠Current Assets − (Inventories + Prepayments)Current Liabilities⁠

Cash ratio^[18]

⁠Cash and Marketable SecuritiesCurrent Liabilities⁠

Operating cash flow ratio

⁠Operating Cash FlowTotal Debts⁠

Net working capital to sales ratio ^[19]

This ratio asseses a business's actual liquidity position against its need for liquidity, represented by its sales:^[19]

⁠Current Assets - Current LiabilitiesSales⁠

Activity ratios (efficiency ratios)

Activity ratios measure the effectiveness of the firm's use of resources.

Average collection period^[3]

⁠Accounts ReceivableAnnual Credit Sales⁠ × 365 Days

Degree of Operating Leverage (DOL)

⁠Percent Change in Net Operating IncomePercent Change in Sales⁠

DSO Ratio.^[20]

⁠Accounts ReceivableTotal Annual Sales⁠ × 365 Days

Average payment period^[3]

⁠Accounts PayableAnnual Credit Purchases⁠ × 365 Days

Asset turnover^[21]

⁠Net SalesTotal Assets⁠

Stock turnover ratio^[22]^[23]

⁠Cost of Goods SoldAverage Inventory⁠

Receivables Turnover Ratio^[24]

⁠Net Credit SalesAverage Net Receivables⁠

Inventory conversion ratio^[4]

⁠365 DaysInventory Turnover⁠

Inventory conversion period (essentially same thing as above)

⁠InventoryCost of Goods Sold⁠ × 365 Days

Receivables conversion period

⁠ReceivablesNet Sales⁠ × 365 Days

Payables conversion period

⁠Accounts PayablesPurchases⁠ × 365 Days

Cash Conversion Cycle

(Inventory Conversion Period) + (Receivables Conversion Period) − (Payables Conversion Period)

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure the level of borrowed funds used by the firm to finance its activities.

Debt ratio^[25]

⁠Total Debts or LiabilitiesTotal Assets⁠

Long-term debt to assets ratio ^[26]

⁠Long-term debtTotal assets⁠

Debt to equity ratio^[27]

⁠(Long-term Debt) + (Value of Leases)(Average Shareholders Equity)⁠

Long-term Debt to equity (LT Debt to Equity)^[27]

⁠(Long-term Debt)(Average Shareholders Equity)⁠

Times interest earned ratio (Interest Coverage Ratio)^[27]

⁠EBITAnnual Interest Expense⁠

OR

⁠Net IncomeAnnual Interest Expense⁠

Debt service coverage ratio

⁠Net Operating IncomeTotal Debt Service⁠

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company's shares.

Earnings per share (EPS)^[28]

⁠Net EarningsNumber of Shares⁠

Payout ratio^[28]^[29]

⁠DividendsEarnings⁠

OR

⁠DividendsEPS⁠

Dividend cover (the inverse of Payout Ratio)

⁠Earnings per ShareDividend per Share⁠

P/E ratio

⁠Market Price per ShareDiluted EPS⁠

Dividend yield

⁠DividendCurrent Market Price⁠

Cash flow ratio or Price/cash flow ratio^[30]

⁠Market Price per SharePresent Value of Cash Flow per Share⁠

Price to book value ratio (P/B or PBV)^[30]

⁠Market Price per ShareBalance Sheet Price per Share⁠

Price/sales ratio

⁠Market Price per ShareGross Sales⁠

PEG ratio

⁠Price per EarningsAnnual EPS Growth⁠

Other Market Ratios

EV/EBITDA

⁠Enterprise ValueEBITDA⁠

EV/Sales

⁠Enterprise ValueNet Sales⁠

Cost/Income ratio

Sector-specific ratios

EV/capacity

EV/output

Capital budgeting ratios

In addition to assisting management and owners in diagnosing the financial health of their company, ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion.

Many formal methods are used in capital budgeting, including the techniques such as

References

^ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433. ISBN 0-7641-1275-9.
^ Groppelli, p. 434.
^ ^a ^b ^c Groppelli, p. 436.
^ ^a ^b Groppelli, p. 439.
^ Groppelli, p. 442.
^ ^a ^b Groppelli, p. 445.
^ Gitman & Zutter (2013). Principles of Managerial Finance (13th ed.). Pearson Education Limited. pp. 119–121. ISBN 978-0-273-77986-5.
^ Williams, P. 265.
^ ^a ^b Williams, p. 1094.
^ Williams, Jan R.; Susan F. Haka; Mark S. Bettner; Joseph V. Carcello (2008). Financial & Managerial Accounting. McGraw-Hill Irwin. p. 266. ISBN 978-0-07-299650-0.
^ "Operating income definition". Archived from the original on 26 April 2014. Retrieved 7 September 2008.
^ Groppelli, p. 443.
^ Bodie, Zane; Alex Kane; Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. p. 459. ISBN 0-07-251077-3.
^ ^a ^b Groppelli, p. 444.
^ Professor Cram. "Ratios of Profitability: Return on Assets" College-Cram.com. 14 May 2008
^ Professor Cram. "Ratios of Profitability: Return on Assets Du Pont", College-Cram.com. 14 May 2008
^ Weston, J. (1990). Essentials of Managerial Finance. Hinsdale: Dryden Press. p. 295. ISBN 0-03-030733-3.
^ ^a ^b ^c Groppelli, p. 435.
^ ^a ^b Drake, P. P., Financial ratio analysis, p. 6, published on 15 December 2012
^ Houston, Joel F.; Brigham, Eugene F. (2009). Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub. p. 90. ISBN 978-0-324-59771-4.
^ Bodie, p. 459.
^ Groppelli, p. 438.
^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.
^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 800.
^ Groppelli, p. 440; Williams, p. 640.
^ Drake, P. P., Financial ratio analysis, p. 9, published on 15 December 2012
^ ^a ^b ^c Groppelli, p. 441.
^ ^a ^b Groppelli, p. 446.
^ Groppelli, p. 449.
^ ^a ^b Groppelli, p. 447.

External links

Stock Valuation Metrics

[1] Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433. ISBN 0-7641-1275-9.

[2] Groppelli, p. 434.

[Groppelli,_p._436-3] Groppelli, p. 436.

[Groppelli,_p._439-4] Groppelli, p. 439.

[5] Groppelli, p. 442.

[Groppelli,_p._445-6] Groppelli, p. 445.

[7] Gitman & Zutter (2013). Principles of Managerial Finance (13th ed.). Pearson Education Limited. pp. 119–121. ISBN 978-0-273-77986-5.

[8] Williams, P. 265.

[Williams,_p._1094-9] Williams, p. 1094.

[10] Williams, Jan R.; Susan F. Haka; Mark S. Bettner; Joseph V. Carcello (2008). Financial & Managerial Accounting. McGraw-Hill Irwin. p. 266. ISBN 978-0-07-299650-0.

[11] "Operating income definition". Archived from the original on 26 April 2014. Retrieved 7 September 2008.

[12] Groppelli, p. 443.

[13] Bodie, Zane; Alex Kane; Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. p. 459. ISBN 0-07-251077-3.

[Groppelli,_p._444-14] Groppelli, p. 444.

[15] Professor Cram. "Ratios of Profitability: Return on Assets" College-Cram.com. 14 May 2008

[16] Professor Cram. "Ratios of Profitability: Return on Assets Du Pont", College-Cram.com. 14 May 2008

[17] Weston, J. (1990). Essentials of Managerial Finance. Hinsdale: Dryden Press. p. 295. ISBN 0-03-030733-3.

[Groppelli,_p._435-18] Groppelli, p. 435.

[drake-19] Drake, P. P., Financial ratio analysis, p. 6, published on 15 December 2012

[20] Houston, Joel F.; Brigham, Eugene F. (2009). Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub. p. 90. ISBN 978-0-324-59771-4.

[21] Bodie, p. 459.

[22] Groppelli, p. 438.

[23] Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.

[24] Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 800.

[25] Groppelli, p. 440; Williams, p. 640.

[26] Drake, P. P., Financial ratio analysis, p. 9, published on 15 December 2012

[Groppelli,_p._441-27] Groppelli, p. 441.

[Groppelli,_p._446-28] Groppelli, p. 446.

[29] Groppelli, p. 449.

[Groppelli,_p._447-30] Groppelli, p. 447.

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