22/8/2021 EBSCOhost

Registro: 1
Título: Financial Ratios.
Autores: Beckham, Heather Wall1
Fuente: Financial Ratios -- Research Starters Business. 4/1/2018, p1-6. 6p.
Tipo de documento: Article
Términos temáticos: Financial ratios

Benchmarking (Management)

Financial statements

Liquidity (Economics)

Market value

Profitability

Financial performance

Stockholders

Government agencies
Palabras clave proporcionadas Benchmarking

por el autor: Financial Statement Analysis

Leverage

Liquidity

Market Value
NAICS/Códigos del sector: 911910 Other federal government public administration

912910 Other provincial and territorial public administration

913910 Other local, municipal and regional public administration

921190 Other General Government Support

522321 Central credit unions

522320 Financial Transactions Processing, Reserve, and Clearinghouse

Activities
Resumen: Financial ratios are an important tool to help understand a firm's
financial condition. Ratios can be derived from published financial
statements and used to compare performance among peers as well as
performance within a company over time. This article is devoted to
exploring financial ratios in five categories: Profitability, Activity, Liquidity,
Leverage and Market Value. [ABSTRACT FROM AUTHOR]
Copyright of Financial Ratios -- Research Starters Business is the
property of Great Neck Publishing and its content may not be copied or
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holder's express written permission. However, users may print,
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1
Afiliaciones del autor: Adjunct professor in the Economics and Business Department of
Agnes Scott College
Recuento total de palabras: 3548

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Número de acceso: 47669164

Base de datos: Research Starters - Business
Financial Ratios 
Finance >Financial Ratios
Financial ratios are an important tool to help understand a firm's financial condition. Ratios can be derived from
published financial statements and used to compare performance among peers as well as performance within
a company over time. This article is devoted to exploring financial ratios in five categories: Profitability, Activity,
Liquidity, Leverage and Market Value.

Keywords: Benchmarking; Financial Statement Analysis; Liquidity; Leverage; Market Value; Profitability

Financial Ratios

Overview
Financial ratios allow analysts to synthesize large amounts of financial and accounting information into metrics
that can be easily compared and contrasted. Examination of these ratios can help to assess the financial
health of a firm. There are numerous parties that utilize financial ratios to provide insight into company
performance. Stockholders, potential investors, managers, lenders, creditors, regulatory agencies and
competitors are each interested in different ratios.

Financial ratios are often used in benchmarking. Comparisons are made between the financial ratios of a firm
and those of its peers or an industry standard. A financial ratio can be used as a yardstick for measuring how
the firm stacks up against its competition. Internal comparisons are also commonly made. Looking at historical
financial ratios over a period of time can uncover important trends. Financial ratios are an excellent tool for
understanding if the company's performance is improving or declining. The results of the ratio analysis can
indicate a positive trend or raise red flags for areas of concern.

Each financial ratio is a simple calculation. The inputs for these calculations can be found in a firm's published
financial statements. An understanding of the accounting practices is necessary for each firm being compared.
When comparing two companies, adjustments might need to be made so that the accounting information is
represented in a similar way.

Various questions can be answered by analyzing financial ratios. Are profit margins improving or deteriorating?
How well are assets being utilized by the organization? How liquid is the organization? Is the company a good
credit risk? Does the company have the ability to meet its interest payments? How much are investors willing
to pay for each dollar of earnings? What proportion of net income was paid out in dividends?

There are twenty commonly used financial ratios that are discussed in this article. These ratios fall into five
distinct categories:

Profitability
Activity/Efficiency
Liquidity
Leverage
Market Value

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Applications
The following section of this article provides formulas for calculating each ratio and an explanation for why the
ratio is valuable.

Profitability Ratios
Profitability Ratios are a set of metrics which illustrate how well a firm is using its resources to earn income.
These ratios are helpful in assessing how successful management is at controlling costs and ultimately
generating profit for the firm.

Net Profit Margin = Net Profit after Taxes/Net Sales

Net Profits after Taxes and Net Sales numbers are found on a firm's income statement. Net Profit Margin
provides information on how much of the firm's revenue makes its way to the bottom line. Profit margins should
not be analyzed in isolation. Profit margins from two different companies cannot be simply compared to
determine which one is "better." For example, different industries can have wildly different economic models
and therefore standard profit margins will vary significantly. In addition, the net profit margin could be low due
to some investment for the future. The profit margin also does not take into account the volume of sales. If a
company's strategic approach was to be a low cost leader, then the margins might be low. However, the
company could still have attractive profits due to the velocity and volume of sales. It is best to compare the
profit margins of firms with similar competitive approaches in the same industry. This ratio is also helpful for a
company to evaluate its own historical margins over time. Upward movement over time indicates a positive
trend.

Return on Sales (or

ROS) = Net Sales — Operating Expenses/Net Sales

Net Sales and Operating Expense numbers are found on a firm's income statement. Return on Sales looks at
the profit margin from an operational perspective. It excludes the impact of financing and interest payments. As
with Net Profit Margin, be mindful of the situation of the firm and the industry when doing a comparison. Just as
was seen with Net Profit Margin, upward movement over time indicates a positive trend.

Gross Profit Margin = Net Sales — Cost of Goods Sold/Net Sales

Net Sales numbers are found on a firm's income statement. Cost of Goods Sold is usually found on the income
statement. However in some cases, this information is not available in published financial statements. Gross
Profit Margin shows the percentage of revenue left after subtracting out the expenses incurred producing the
product (e.g., materials and labor). The same caveats for comparing Net and Operating Profit Margin also
applies to Gross Profit Margin. The higher the Gross Profit Margin, the more funds available to cover overhead
costs and yield a profit.

Return on Assets

(or ROA) = Net Profit After Taxes/Average Total Assets

Net Profit after Taxes is found on a firm's income statement and Total Assets are found on the firm's balance
sheet. To calculate Average Total Assets, simply add the previous year and current year's Total Assets and
divide by 2. Return on Assets is a key profitability indicator. This ratio helps measure how effectively the
company is utilizing its assets. The higher the number, the more effective the assets being employed.
However, since the capital intensity of each industry differs so significantly, this ratio should not be used to
compare firms in different industries.

Return on Equity (or

ROE) = Net Profit After Taxes/Stockholder's Equity

Net Profit after Taxes is found on a firm's income statement and Stockholder's Equity is found on the firm's
balance sheet. To calculate Average Stockholder's Equity, simply add the previous year and current year's
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Stockholder's Equity and divide by 2. Return on Equity provides a measure for how well the stockholder's
capital contribution is being utilized and translated into profit.

Earnings per

Share (or EPS) = Net Income — Preferred Stock Dividends/

Average Number of Shares of Common Stock

Outstanding
Net Income after Preferred Stock Dividends is often found on a firm's income statement and Number of Shares
of Common Stock Outstanding is often found on the firm's balance sheet. To calculate Average Number of
Shares of Common Stock Outstanding, simply add the previous year and current year's Number of Shares of
Common Stock Outstanding and divide by 2. The Earnings per Share ratio provides the profit generated for
each share of stock. Investors like to see growth in this ratio year over year.

Activity/Efficiency Ratios
Activity Ratios provide insight into how effectively the assets of the organization are being managed. Putting
together the results of several of these metrics will show how quickly the firm can convert assets into cash.
Proficient asset utilization will lessen the need for additional capital.

Asset Turnover = Net Sales/Average Total Assets

Net Sales numbers are found on a firm's income statement and Total Assets are found on the firm's balance
sheet. To calculate Average Total Assets, simply add the previous year and current year's Total Assets and
divide by 2. This ratio measures how well the company is utilizing its assets to create revenue.

Days of Inventory = Average Inventory/Cost of Goods Sold ÷ 365

Inventory is found on the firm's balance sheet and Cost of Goods Sold is usually found on the income
statement. However in some cases, this information is not available in published financial statements. To
calculate Average Inventory, simply add the previous year and current year's Inventory and divide by 2. Days
of Inventory reveals the number of days a product is held in inventory until it is sold. This ratio helps determine
how successfully the organization is managing its inventory and it can reveal how accurate their forecasting is.
Typically, lower numbers are viewed more favorably. However, if inventories are too low then it will hamper the
firm's ability to react quickly to surges in demand.

Inventory Turnover = Cost of Goods Sold/Average Inventory

Using the same information as the Days of Inventory ratio, we can come up with and Inventory Turnover
metric. This metric reveals the number of times that inventory turns over in a year. If this number is high, it can
indicate an efficient inventory management strategy. The more inventory that is turned over, the higher the
sales and the less inventory carrying costs.

Day's Receivables

(or Average Collection Period) = Average Accounts Receivable/

Net Sales ÷ 365

Accounts Receivable is found on the firm's balance sheet and Net Sales is found on the income statement. To
calculate Average Accounts Receivable, simply add the previous year and current year's Accounts Receivable
and divide by 2. Day's Receivables reveals the approximate number of days it takes to collect payment from
customer after the sale. The duration of this collection period is extremely important because a longer
collection period can put significant strain on the firm's cash flow. In general, a low ratio is viewed positively.

Day's Payables = Average Accounts Payable/Net Sales ÷ 365

Accounts Payable is found on the firm's balance sheet and Net Sales is found on the income statement. To
calculate Average Accounts Payable, simply add the previous year and current year's Accounts Payable and

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divide by 2. Day's Payable provides a metric for how long it takes the firm to pay its suppliers and creditors.
How quickly the company pays has implications on the cash flow.

To get an idea of the cash conversion cycle for a firm, you can take Day's Receivables plus Days Inventory and
then subtract Day's Payables. The result provides insight into how long funds are tied up before they are
converted into cash. The shorter the cycle, the more liquid the company is.

Working Capital Turnover = Net Sales/Average Current Assets

— Average Current Liabilities

Net Sales are found on the firm's income statement and Current Assets and Current Liabilities are found on the
balance sheet. Current Assets less Current Liabilities is commonly referred to as Working Capital. To calculate
Average Current Assets, simply add the previous year and current year's Current Assets and divide by 2. Use
the same methodology for determining Average Current Liabilities. Working Capital Turnover measures how
effectively the company is using its working capital to generate sales. A higher turnover indicates a more
effective use of working capital funds.

Liquidity Ratios
Liquidity Ratios provide valuable information on how solvent the company is. These ratios can provide an
estimate for the amount of cash the company can quickly come up with. Analyzing these metrics will show the
effectiveness with which a firm meets its short-term obligations. Creditors and lenders can use these ratios to
assess a firm's ability to repay short-term debts.

Current Ratio = Current Assets/Current Liabilities

Current Assets and Current Liabilities are found on the firm's balance sheet. This ratio is a test of liquidity, or its
ability to pay off current liabilities with current assets. A healthy company will have a ratio of at least 1.
However, the specific benchmark for an attractive Current Ratio is dependent on the industry. Cash flow and
liquid assets vary significantly between industries.

Quick Ratio ( or

Acid Test) = Cash + Short-Term Investments +

Receivables/Current Liabilities
Cash, Short-Term Investments, Receivables and Current Liabilities are found on the firm's balance sheet. This
ratio serves a similar purpose as the Current Ratio, but takes the assets one step closer to actual cash. This
ratio only utilizes assets which can be reliably liquidated on very short notice. This ratio excludes assets such
as inventory, which might take some time to sell off or may require significant discounts in order to close a sale
quickly.

Leverage Ratios
Leverage Ratios measure the amount of financial leverage, or debt, a company is saddled with. This is an
important ratio for stockholders because they will only get paid once the debt obligations have been met. In the
case of liquidation, stockholders must wait in line. A firm that has higher debt is usually considered more risky.

Debt Ratio = Total Debt/Total Assets

Total Assets and Total Debt are found on the firm's balance sheet. This ratio reveals the extent to which capital
was borrowed in order to fund the firm's operations. The higher the Debt Ratio, the more levered the firm.
Highly levered firms are considered riskier because of the possibility of being forced into bankruptcy if the firm
has trouble meeting its interest or principle payments.

Debt to Equity Ratio = Total Debt/Total Stockholder's Equity

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Total Debt and Total Stockholder's Equity are found on the firm's balance sheet. The Debt to Equity Ratio is
another way to communicate the extent of leverage a firm is employing. It also shows the mix of Debt versus
Equity that was used to finance operations. In this ratio, healthy firms usually have a ratio less than 1.

Times Interest Earned (or

Coverage Ratio) = EBIT/Interest Expense

EBIT (Earnings before Interest and Taxes) and Interest Expenses are found on the firm's income statement.
This ratio determines whether or not a firm is able to pay its annual interest costs. The higher the ratio, the
more cushion the firm has if profits dip below expectations. Lenders want to ensure that the firm can weather
downturns and usually require a minimum Coverage Ratio of 2x to ensure creditworthiness.

Market Value Ratios

Market Value Ratios provide a mechanism for combining accounting and stock market information. Current
stockholders and future investors may use this information to make a buy, sell or hold decisions.

Price Earnings Ratio

(or PE) = Current Market Price per Share of

Stock/Earnings per Share

Current Market Price per Share is published continuously while the markets are open. Due to the intense
fluctuations of many stocks, the Market Price per Share is often calculated using an average over a specific
period of time. The formula for Earnings per Share was given in the previous section of this article that
discussed Profitability Ratios. The PE Ratio is of particular interest to investors because it measures the price
investors are willing to pay for each dollar of earnings. Higher PE ratios indicate confidence in the firm's future
and growth prospects.

Dividend Yield Ratio = Annual Dividends per Share of

Stock/Market Price per Share of Stock

Dividends paid out are found on a firm's Cash Flow statement. As seen with the PE ratio, Market Price per
Share is often calculated using an average over a specific time. This ratio measure the return investors receive
in the form of dividends. However, the dividend is only part of an investor's total return. Investors can benefit
from the dividend as well as appreciation of the stock. Therefore, a low dividend yield in itself does not
necessarily translate to a poor return for the investor.

Dividend Payout Ratio = Annual Dividends per Share of

Stock/Earnings Per Share

Dividends paid out are found on a firm's Cash Flow statement. The formula for Earnings per Share was given
in the previous section of this article which discussed Profitability Ratios. Dividend Payout Ratio indicates the
percentage of net income that was paid out to investors in the form of dividends. Both the Dividend Yield and
Dividend Payout provide an investor with insight into future dividend streams that may be paid out to common
stock holders.

Further Insight

DuPont Model
The DuPont Model was developed by F. Donaldson Brown, an employee of E.I. du Pont de Nemours &
Company, in the 1920's. This formula integrates various ratios together to provide an integrative look at
highlights from both the income statement and the balance sheet.

DuPont Model (ROE) = Net Profit Margin * Asset Turnover *Assets/Equity

Although we already covered the formula for ROE in this article, the DuPont Model is a different way of looking
at the equation. This model is one that a manager might find valuable because it requires examination into
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several key areas in one formula. This model touches on profitability (Net Profit Margin), activity/efficiency
(Asset Turnover) and leverage (Assets/Equity).

Common Size Financial Statements

Common size financial statements are often used by analysts to make comparisons. In a common size Income
Statement, all entries of the income statement will be expressed as a percentage of sales. In a common size
Balance Sheet, all entries are expressed as a percentage of total assets. Presenting the data in this way
highlights changes in the operations or capital structure. It is much easier to uncover inconsistencies when
presented in these absolute terms. It also allows for easier comparisons of different sized firms.

Issues
Financial ratios are widely used in the business environment. However, these ratios are just one tool of many
that should be utilized in a comprehensive business analysis. Financial ratios are a great starting point, but
there are many other factors that must be considered. A robust examination must take into account such
factors as a company's long term strategy and changes in the industry environment. These details will not be
uncovered using financial ratios alone.

The financial ratios discussed in this article are lagging indicators. The performance results contained in the
financial statements are based on past decisions. To truly understand the future financial health of a company
and its sustainability, the rationale behind such decisions and the long term strategies must also be
considered.

Finally, a deep understanding of the company's accounting practices is necessary for a ratio based analysis to
be accurate. Since accounting practices vary from company to company, ratios might not always compare
apples to apples. For example, the method used for accounting for inventory (LIFO or FIFO) would create
different inventory amounts. In addition, financial ratios may be subject to manipulation. Firms may choose
accounting practices that disguise certain charges or bolster revenue to make a ratio appear more favorable.

Financial ratios are most valuable when used as part multifaceted approach to analyzing a business.

Terms & Concepts

Accounts Payable: Outstanding balance of money a company owes to its creditors, suppliers and vendors for
goods and services. This is generally of a short-term nature, requiring payment in less than 12 months.

Accounts Receivable: The balance of money owed to a company for the goods and services it provided. This
is treated as a current asset on the balance sheet.

Asset: Anything having value that is owned by a company and that can be used to pay off debts. Categories of
assets can include current assets (e.g., cash, accounts receivables, inventory), fixed assets (e.g., capital
equipment, buildings) and intangible assets (e.g., goodwill, patents).

Debt: The amount of money the firm has borrowed from creditors.

Dividend: Portion of the company profits that is distributed to stockholders.

Equity: Stockholders' ownership interest in a corporation (includes both common and preferred stockholders).

Leverage: The extent to which a business is using borrowed capital in its operations.

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Liquidity: The degree to which assets can quickly and reliably be converted to cash.

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~~~~~~~~
Essay by Heather Wall Beckham, MBA

Heather Wall Beckham is the former Vice President of Strategic Planning for the Turner Division of Time
Warner. She has also served as a strategic consultant with Bain & Company, a financial analyst with Ford
Motor Company, and an adjunct professor in the Economics and Business Department of Agnes Scott College.
She holds an undergraduate degree from Duke University and an MBA from Harvard Business School.

Copyright of Financial Ratios -- Research Starters Business is the property of Great Neck Publishing and its
content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's
express written permission. However, users may print, download, or email articles for individual use.

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