Financial Ratio Analysis

  1. INTRODUCTION

Financial ratios are the foundation of fundamental analysis.  Ratios allow an investor to view certain financial figures in relation to other financial figures.  Ratios are important because few financial statement items have meaning in isolation.  By placing financial statement items within a deeper analytical context, investors can make more informed decisions about the company’s financial position and operating performance.

  1. RATIOS FOR ANALYZING BUSINESS ACTIVITY

The ratios presented in this section will assist an investor in determining how well a company is employing its assets.

2.1.  Operating Activity Ratios

2.1.1.  Inventory Turnover and Average Number of Days Inventory on Hand (DOH)

Inventory Turnover = Cost of goods sold ÷ Average inventory

This ratio shows investors how many times, on average, inventory is sold and replaced during an accounting period.  A higher-than-average ratio, as compared against industry norms, could indicate efficient inventory management.  Conversely, a high ratio could also indicate that the company is carrying insufficient quantities of inventory, which could impair future sales.  Investors should pay attention to the trend in the ratio.  A significant decrease in this ratio suggests inventory is slow to sell.

Number of Days Inventory on Hand = Number of days in period ÷ Inventory turnover

This ratio indicates the average number of days the company holds inventory before it is sold.  Generally, the longer inventory is held, the greater the risk of impairment.

2.1.2.  Receivables Turnover and Average Number of Days Sales Outstanding (DSO)

Receivables Turnover = Net credit sales ÷ average accounts receivables

This ratio assists investors in assessing the quality and liquidity of a firm’s trade receivables.  The ratio indicates the number of times the firm’s outstanding trade receivables have been collected during the accounting period.  A comparatively high turnover ratio could indicate collection efficiency, or it could mean the firm is too conservative in granting credit terms, thus potentially losing sales.  The turnover ratio indicates the age of the receivables, so a comparatively low turnover ratio could be a sign of poor earnings quality, as ultimate collection of the receivables is doubtful.

Average Number of Days Sales Outstanding = Number of days in period ÷ Receivables turnover

This ratio indicates the average number of days for the firm to collect its trade receivables.  Generally, the longer trade receivables are outstanding, the more difficult it will be for the firm to collect.  Thus, an increase in this ratio can indicate poor earnings quality.

 2.1.3.  Payables Turnover and Average Number of Days Payables Outstanding (DPO)

Payables Turnover = Inventory purchases ÷ Average trade payables

This ratio measures the average number of times a company pays its suppliers in a period.  A comparatively high ratio may indicate the company is taking advantage of its supplier’s early-pay discounts.  However, a comparatively high ratio could also indicate inefficient cash management, as the company is not fully utilizing supplier’s credit terms.

Investors should give attention to an abnormally low payables turnover ratio, as this could indicate the company is struggling to pay its bills.  The investor should further investigate the company’s ability to pay its bills by conducting a liquidity and cash flow analysis for the company, utilizing other tools discussed later in this article.

Average Number of Days Payables Outstanding = Number of days in period ÷ Payables turnover

This ratio indicates the average time a company takes to pay its suppliers.  The higher the number of days, the greater the company is using its supplier’s credit terms as operating capital.

2.1.4.  Working Capital Turnover

Working Capital turnover = Revenue ÷ Average working capital

Working capital is the difference between a company’s current assets and current liabilities.  This ratio indicates the amount of revenue a company generates per dollar of working capital.  The higher the ratio, the more efficient the company is managing its working capital.  To improve the usefulness of this ratio, the investor should exclude nonoperating assets and liabilities from the calculation of working capital.

2.2.  Investment Activity Ratios

2.2.1.  Fixed Assets Turnover

Fixed Assets Turnover = Revenue ÷ Average net fixed assets

This ratio measures the amount of sales the company generates per dollar of fixed assets.   Generally, a higher ratio indicates more efficient use of fixed assets in generating revenue.  Investors, however, should be aware of two issues with this ratio. First, newer and less depreciated assets will lead to a lower ratio than older, more depreciated assets.  Second, investment patterns are usually unequal, thus leading to some volatility in the trend.

2.2.2.  Total Asset Turnover

Total Asset Turnover = Revenue ÷ Average total assets

This ratio measures the amount of sales the company generates per dollar of total assets.  Thus, this ratio is sensitive to both the level of current assets and the level of long-term (fixed) assets.

  1. RATIOS FOR ANALYZING LIQUIDITY

Liquidity refers to a company’s ability to pay short-term (current) credit obligations.  The ratios presented in this section will assist investors in analyzing a company’s liquidity.

3.1.  Current Ratio

Current ratio = Current assets ÷ Current liabilities

The current ratio indicates the amount of current assets a company has available to “cover” each dollar of current liabilities.  Investors should be aware of the inclusion of inventory and prepaid expenses in current assets.  For an ongoing enterprise, inventory should not be considered a liquid asset, since the company must maintain a minimum level of inventory to operate.  Also, inventory is unlikely to be sold quickly without substantial impairment.  Prepaid expenses have no liquidation value, but are considered an asset only in the sense that they preserve the outlay of funds.

3.2.  Quick Ratio

Quick ratio = (cash + marketable securities + receivables) ÷ Current liabilities

The quick ratio excludes inventory and prepaid expenses from current assets, and is thus a more conservative measure of liquidity than the current ratio.

3.3.  Cash Ratio

Cash Ratio = (Cash + Marketable securities) ÷ Current liabilities

By utilizing the company’s most liquid assets, the cash ratio is the most conservative measure of liquidity.

3.4.  Defensive Interval Ratio

Defensive Interval Ratio = (Cash + Marketable securities + Receivables) ÷ Daily cash expenditures

This ratio indicates the amount of time that a company can fund its expenditures with existing resources without any cash inflows.  A similar concept known as the “burn rate” is used in the analysis of start-up and distressed firms.

3.5.  Cash Conversion Cycle

Cash Conversion Cycle = Days Inventory on Hand + Number of Days Sales Outstanding – Number of Days Payables Outstanding

The cash conversion cycle measures the average number of days between the cash outlay for materials and the cash receipt from selling finished product.  The longer the cash conversion cycle, the more a company must rely on external sources of working capital.

  1. RATIOS FOR ANALYZING SOLVENCY

Solvency refers to a company’s ability to service long-term debt obligations.  The first four ratios in the section aid investors in analyzing a company’s capital structure, i.e., the proportion of a company’s financing that is debt relative to shareholder’s equity.  The next two ratios indicate a company’s ability to service interest and other financing payments out of current earnings.

4.1.  Debt-to-Assets Ratio

Debt-to-Assets = Total debt ÷ Total assets

This ratio indicates the proportion of total assets financed with debt.  The higher this ratio, the more debt a company has relative to total assets.

 4.2.  Debt-to-Capital Ratio

Debt-to-capital = Total debt ÷ (total debt + total shareholder’s equity)

This ratio indicates the amount of debt a company has per dollar of total capital.  The greater the ratio, the more leveraged the company’s capital structure.

4.3.  Debt-to-Equity Ratio

Debt-to-Equity = Total debt ÷ Total shareholder’s equity

This ratio indicates the amount of debt a company has per dollar of equity.  The greater the ratio, the more leveraged the company’s capital structure.

 4.4.  Financial Leverage Ratio

Financial Leverage Ratio = Average total assets ÷ Average total equity

This ratio measures the amount of assets the firm owns for each dollar of equity capital.  The higher the ratio, the more the company uses debt to finance assets.

4.5.  Interest Coverage Ratio

Interest Coverage = Earnings Before Interest and Taxes (EBIT) ÷ Interest Expense

This ratio indicates the amount of pretax, pre-interest operating earnings available for each dollar of interest expense.  The ratio is also referred as the Times Interest Earned ratio, and can be interpreted as the number of times that operating earnings can cover interest expense.  A higher ratio indicates a more conservatively-financed company.

4.6.  Fixed Charge Coverage

Fixed Charge Coverage Ratio = (EBIT + Fixed charges) ÷ Total fixed charges

This ratio is a more conservative measure of a firm’s solvency in that it indicates the earnings available to cover all contractually obligated financing payments.  Particularly, this measure includes rent payments as a financing cost.  A higher ratio indicates a more conservative use of fixed charges in the company’s financial structure.

  1. RATIOS FOR ANALYZING PROFITABILITY

The ratios in this section assist investors in analyzing two facets of profitability.  The first is the amount of profit in relation to sales.  The second is the profit in relation to the assets and capital that “supports” the firm’s operations.  Profit is more meaningful to investors when it is analyzed in relation to the resources employed in generating the profit.

5.1.  Gross Margin

Gross Profit Margin = Gross profit ÷ Revenue

Gross profit is defined as revenue minus cost of goods sold.  This measure indicates the amount of each revenue dollar that is available to pay the firm’s operating expenses.

5.2.  Operating Margin

Operating Margin = Operating income ÷ Revenue

Operating income is the earnings from the company’s core operations, excluding the effects of investments, financing, and taxes.  The measure indicates the amount of each revenue dollar available after the firm pays operating expenses.  Operating margin reflects the firm’s cost structure and pricing strategy.

5.3.  Pretax Margin

Pretax Margin = Earnings Before Taxes (EBT) ÷ Revenue

The pretax margin measures the amount of each sales dollar subject to taxation.  The measure includes the effects of interest expense.

5.4.  Net Profit Margin

Net Profit Margin = Net Income (after-tax) ÷ Revenue

This ratio indicates the amount of each revenue dollar that is available after all expenses, including interest and taxes, have been paid.  This ratio is most useful to investors when it excludes nonrecurring items.

5.5.  Return on Assets

Return on Assets = Operating Income (EBIT) ÷ Average total assets

This ratio measures the amount of income the company generates per dollar of assets.  By using EBIT in the numerator, the calculation eliminates the impact of leverage (since a company’s assets are financed with both equity and debt).  Using EBIT in the numerator also allows investors to compare this measure with firms with different capital structures.

5.6.  Return on Total Capital

Return on Total Capital = Operating Income (EBIT) ÷ (Total debt + Shareholder’s equity)

This ratio measures the profits a company earns relative to all the firm’s capital employed in its operations.  The measure is interpreted as the amount of operating income generated per dollar of total capital.

5.7.  Return on Common Equity

Return on Common Equity = (Net income – Preferred dividends) ÷ Average common equity

This ratio measures the income relative to the company’s common equity.  This measure is impacted by both the company’s operating income and its use of financial leverage.

  1. FURTHER ANALYSIS OF PROFITABILITY RATIOS

A useful tool for further analysis of ROE is the DuPont formula[i].  The DuPont formula states ROE as follows:

ROE = (net income ÷ average total assets) x (average total assets ÷ average shareholder’s equity)

This formula thus states ROE as a product of (a) the firm’s ability to earn returns on assets, and (b) the firm’s use of financial leverage.  The investor can see that a company has several “levers” which it can pull to increase returns on assets and equity.  Namely, the company can improve ROE by improving its return on assets and/or by increasing its leverage.

Since returns on assets can be separated into net profit margin and asset turnover, the DuPont equation can be further expanded into three-components:

ROE = (net income ÷ revenue) x (revenue ÷ average total assets) x (average total assets ÷ average shareholder’s equity)

This expanded presentation of ROE shows that ROE is the product of a firm’s net profit margin, operating efficiency, and financial leverage.

  1. RATIOS USED IN EQUITY ANALYSIS

Investors can use the ratios presented in this section to supplement a more comprehensive stock valuation.   Investors should compare these ratios against those of similar companies and the overall stock market.

7.1.  Price-to-Earnings (P/E) Ratio

The P/E ratio is the most widely reported equity valuation ratio.  This ratio shows the amount investors are paying for each dollar of earnings.  The ratio is calculated by dividing the stock price by earnings per share (EPS).  An important consideration is whether to use past earnings or projected earnings in the denominator.  Also, investors should consider the sustainability of earnings when calculating this ratio.  A P/E ratio which is below that of competitors and the overall stock market could indicate that a stock is mispriced.

The inverse of the P/E ratio is the earnings yield.  The earnings yield shows the level of earnings relative to each dollar of stock price.  A low P/E ratio will indicate a high earnings yield, and a high P/E ratio will indicate a low earnings yield.  Conservative investors will only pay a price for a stock in which the earnings yield is adequately higher than what can be realized on a low-risk bond.

7.2.  Price-to-Cash Flow (P/CF) Ratio

The P/CF ratio is similar to the P/E ratio, but uses operating cash flow instead of earnings.  The ratio is calculated by dividing the stock price by operating cash flow per share.  The P/CF ratio indicates the amount investors are paying for each dollar of cash flow.  The inverse of the P/CF ratio is the cash flow yield.

7.3.  Price-to-Sales (P/S) Ratio

The P/S ratio became popular in the late 90’s, when many technology startups had yet to earn profits.  This ratio is calculated by dividing the stock’s price by revenue per share.

7.4.  Price-to-Book Value (P/BV) Ratio

The P/BV ratio indicates the price per dollar of shareholder’s equity.  This ratio is calculated by dividing the stock’s price by shareholder’s equity per share.  A variation of this ratio is the price-to-tangible book value ratio, which eliminates goodwill and other intangible assets from the calculation of book value.

 

Sources

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.  Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International Financial   Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

White, Gerald I., Ashwinpaul C. Sondhi, and Dov Fried.  The Analysis and Use of Financial Statements, 3rd ed.  Hoboken:  Wiley, 2003.

[i] This formula originated at E. I. du Pont de Nemours and Company.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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