What are Financial ratios?

A financial ratio (or accounting ratio) is a 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. Security analysts use financial ratios to compare the strengths and weaknesses in various companies.If shares in a company are traded in a financial market, 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 percent 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 for financial ratios

Values used in calculating financial ratios are taken from the balance sheet,incomeStatement, statement of cash flows or (sometimes) the statement of retained earnings. 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 organization.

Purpose and types of ratios

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. Activity ratios measure how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm’s ability to repay long-term debt. Profitability ratios measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return. 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.

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 hold no meaning 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.

Other abbreviations

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

$frac{mbox{Gross Profit}}{mbox{Net Sales}}$

$frac{mbox{Net Sales -- COGS}}{mbox{Net Sales}}$

Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)

$frac{mbox{Operating Income}}{mbox{Net Sales}}$

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. This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales)

Profit margin, net margin or net profit margin

$frac{mbox{Net Profit}}{mbox{Net Sales}}$

Return on equity (ROE)

$frac{mbox{Net Income}}{mbox{Average Shareholders Equity}}$

Return on investment (ROI ratio or Du Pont Ratio) $frac{mbox{Net Income}}{mbox{Average Total Assets}}$

Return on assets (ROA)

$frac{mbox{Net Income}}{mbox{Total Assets}}$

Return on assets Du Pont (ROA Du Pont)

$left(frac{mbox{Net Income}}{mbox{Net Sales}}right)left(frac{mbox{Net Sales}}{mbox{Total Assets}}right)$

Return on Equity Du Pont (ROE Du Pont)

$left(frac{mbox{Net Income}}{mbox{Net Sales}}right)left(frac{mbox{Net Sales}}{mbox{Average Assets}}right)left(frac{mbox{Average Assets}}{mbox{Average Equity}}right)$

Return on net assets (RONA)

$frac{mbox{Net Income}}{mbox{Fixed Assets + Working Capital}}$

Return on capital (ROC)

$frac{mbox{EBIT(1 − Tax Rate)}}{mbox{Invested Capital}}$

Risk adjusted return on capital (RAROC)

$frac{mbox{Expected Return}}{mbox{Economic Capital}}$

$frac{mbox{Expected Return}}{mbox{Value at Risk}}$

Return on capital employed (ROCE)

$frac{mbox{EBIT}}{mbox{Capital Employed}}$

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

Cash flow return on investment (CFROI)

$frac{mbox{Cash Flow}}{mbox{Market Recapitalisation}}$

Efficiency ratio

$frac{mbox{Non-Interest expense}}{mbox{Revenue}}$

Net gearing

$frac{mbox{Net debt}}{mbox{Equity}}$

Basic Earnings Power Ratio

$frac{mbox{EBIT}}{mbox{Total Assets}}$

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio)

$frac{mbox{Current Assets}}{mbox{Current Liabilities}}$

Acid-test ratio (Quick ratio)

$frac{mbox{Current Assets -- (Inventories + Prepayments)}}{mbox{Current Liabilities}}$

Cash ratio

$frac{mbox{Cash and Marketable Securities}}{mbox{Current Liabilities}}$

Operation cash flow ratio

$frac{mbox{Operating Cash Flow}}{mbox{Total Debts}}$

Activity ratios (Efficiency Ratios)

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period

$frac{mbox{Accounts Receivable}}{mbox{Annual Credit Sales ÷ 365 Days}}$

Degree of Operating Leverage (DOL)

$frac{mbox{Percent Change in Net Operating Income}}{mbox{Percent Change in Sales}}$

DSO Ratio.

$frac{mbox{Accounts Receivable}}{mbox{Total Annual Sales ÷ 365 Days}}$

Average payment period

$frac{mbox{Accounts Payable}}{mbox{Annual Credit Purchases ÷ 365 Days}}$

Asset turnover

$frac{mbox{Net Sales}}{mbox{Total Assets}}$

Stock turnover ratio

$frac{mbox{Cost of Goods Sold}}{mbox{Average Inventory}}$

Receivables Turnover Ratio

$frac{mbox{Net Credit Sales}}{mbox{Average Net Receivables}}$

Inventory conversion ratio

$frac{mbox{365 Days}}{mbox{Inventory Turnover}}$

Inventory conversion period (essentially same thing as above)

$left (frac{mbox{Inventory}}{mbox{Cost of Goods Sold}}right)mbox{365 Days}$

Receivables conversion period

$left (frac{mbox{Receivables}}{mbox{Net Sales}}right)mbox{365 Days}$

Payables conversion period

$left (frac{mbox{Accounts Payables}}{mbox{Purchases}}right)mbox{365 Days}$

Cash Conversion Cycle

Inventory Conversion Period + Receivables Conversion Period – Payables Conversion Period

Debt ratios (leveraging ratios)

Debt ratios measure the firm’s ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio

$frac{mbox{Total Liabilities}}{mbox{Total Assets}}$

Debt to equity ratio

$frac{mbox{Long-term Debt + Value of Leases}}{mbox{Average Shareholders Equity}}$

Long-term Debt to equity (LT Debt to Equity)

$frac{mbox{Long-term Debt}}{mbox{Total Assets}}$

Times interest-earned ratio / Interest Coverage Ratio

$frac{mbox{EBIT}}{mbox{Annual Interest Expense}}$

$frac{mbox{Net Income}}{mbox{Annual Interest Expense}}$

Debt service coverage ratio

$frac{mbox{Net Operating Income}}{mbox{Total Debt Service}}$

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)

$frac{mbox{Net Earnings}}{mbox{Number of Shares}}$