Financial Ratios

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by Clemens Werkmeister


Financial ratios as a managerial tool

Ratios or indicators aim to provide concise information about a company or its business. They are used in different ways as a managerial tool, in planning and control, or performance measurement, and in communication with different stakeholders (suppliers, banks, investors, among others). This results in a broad variety of indicators, financial and non-financial, raw (absolute) values or actual ratios (see the overview here). Given their availability, high standardization, and external auditing, ratios based on financial statements (financial ratios) are very common. Compared to market-data based security returns, they offer a different approach with additional information for investors.

Financial analysts often use rules of dumb („Golden rules“) for „good“ financial ratios. But since large differences between industries or strategies can be observed, usually the rules of dumb are not applied to all companies in the same way. Sometimes, extreme financial ratios are even the core of the competitive advantage of a company. However, a comparison of financial ratios to industry averages (cross-sectional analysis), other benchmarks, or a look at financial ratio time series can call attention to trends and outliers which require an in-depth analysis and explanation by management.

Two different approaches to build and use financial ratios are used:

  • A vertical analysis sets the balance sheet accounts in relation to the total assets and the income statement items in relation to net sales. Changes in these ratios mean that there are other trends which do not depend only on the growth or decrease of net sales and total assets.
  • A horizontal analysis comapares each balance sheet account or income statement item to a base year. It is possible to identify different growth rates and trends.

The following overview shows important financial ratios:

Short-term Liquidity Ratios

  • compare current assets or parts of them to current liabilities
  • as recognized and reported in the balance sheet
  • in order to gauge the likelihood that companies meet their current financial obligations.

The most common short-term liquidity indicators are the following balance-sheet based ratios:

L1. Cash Ratio = Cash + Equivalents (often: = Cash + Short-term Investments )
Current Liabilities Current Liabilities
L2. Quick Ratio = Cash + Equivalents + Accounts Receivable
Current Liabilities
L3. Current Ratio = Current Assets
Current Liabilities

The first ratio is a cash-only ratio, whereas the quick ratio and the current ratio depend on the ability of the company to collect receivables and to sell inventories, respectively. The use of these ratios depends on the company's cash management strategy. In general, the cash ratio is most conservative.
Two different approaches are worth mentioning:

  • The operating cash ratio considers for non-balance-sheet financial obligations (e.g. wages, interest payments, leasing and rental payments), as long as they are part of the cash flows from operating activities.
L4. Operating Cash Ratio = Cash Flows from Operating Activities
Current Liabilities
  • The working capital or net working capital as a raw indicator of liquidity in absolute terms:
L5. (Net) Working Capital = Current Assets - Current Liabilities


Debt Ratios

  • inform about the capital structure (the mix of debt and equity financing) and the financial leverage and risk associated with it;
  • compare a company's financial resources from operations to its interest obligations (based on income (accruals) or based on cash);
  • in order to indicate the ability of a company to meet its debt obligations.
D1. Interest Coverage Ratio = Operating Income (or Accrual-based Times Interest Earned Ratio)
Interest Expense
D2. Debt-to-Equity Ratio = Total Liabilities
Total Equity
D3. Debt-to-Total Assets Ratio = Total Liabilities
Total Assets

Sometimes, cash-based forms of the coverage and long-term debt-to-equity or long-term debt-to-total assets ratios are used.


Asset Efficiency or Operating Ratios

  • measure the use of specific or total assets through a company
  • as length of time required for assets to be used or replaced.

Operating ratios assume that the higher the turnover ratios the more efficient the assets are used. They intend to provide information about specific management capabilities, e.g.

  • the credit policy and its credit-granting and credit-collecting activities
  • the inventory policy and the ability to forecast the needs of customers.

The denominator usually is formed as average of two subsequent balance accounts.

O1. Accounts Receivable Turnover = Net Credit Sales or Net Sales
Account Receivables
O2. Inventory Turnover = Cost of Goods Sold
Inventory
O3. Asset Turnover = Net Sales
Total Assets


Profitability or Return Ratios

  • relate income to sales or assets
  • inform about the results achieved with sales or assets
  • inform about the results achieved with shareholders' equity.

As far as balance sheet accounts form the denominator, again an average of two points in time is often used.

P1. Operating Margin Percentage = Operating Income
Net Sales
P2. Return on Sales = Net Income
Net Sales
P3. Return on Assets = Net Income + Interest Expense
Total Assets
P4. Return on Equity = Net Income
Total Equity

A specific form of a profitability ratio is used in DuPont Analysis when the relate profitability is related to other ratios as critical success factors (profitability drivers).

P5. Return on Equity = Net Income × Net Sales × Total Assets
Net Sales Total Assets Total Equity


Stockholder Ratios

  • relate income to sales or assets
  • inform about the payout strategy
  • include market share price in the analysis.
S1. Earnings per Share (EPS) = Net Income
Number of Shares Outstanding
S2. Return on (Common) Equity = Net Income
(Common) Equity
S3. Dividend Yield = Dividends per (Common) Share
Market Price per Share
S4. Dividend Payout Ratio = Dividends Paid
Net Income
S5. Total Payout Ratio = Dividends + Stock Repurchases
Net Income


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see:
Kennzahlen
Accounting exercises
Financial Formulas
Troßmann/Baumeister/Werkmeister: Management-Fallstudien im Controlling. 2. Aufl., München 2008, Kapitel 3 (Kennzahlen)
Rich et al.: Cornerstones of Financial and Managerial Accounting. South-Western Cengage 2012.