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 nonfinancial, 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 marketdata 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 (crosssectional analysis), other benchmarks, or a look at financial ratio time series can call attention to trends and outliers which require an indepth 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:
Shortterm 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 shortterm liquidity indicators are the following balancesheet based ratios:
L1. Cash Ratio =

Cash + Equivalents

(often: =

Cash + Shortterm 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 cashonly 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 nonbalancesheet 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 Accrualbased Times Interest Earned Ratio)

Interest Expense

D2. DebttoEquity Ratio =

Total Liabilities

Total Equity

D3. DebttoTotal Assets Ratio =

Total Liabilities

Total Assets

Sometimes, cashbased forms of the coverage and longterm debttoequity or longterm debttototal 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 creditgranting and creditcollecting 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


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