Financial Ratios and Major Categories
What are the Financial or Accounting Ratios?
Financial or accounting ratios measure the profitability, efficiency, and solvency of a corporate entity. Financial ratios can show how efficiently or poorly a company is managed by its directors. Additionally, these ratios can be used as the basis for comparing the 'fair value' of different companies or entire industries.
- Financial ratios focus on several accounting figures such as revenue, net income, debt, and equity
- When analyzing a particular company, the denominator of a financial ratio can be an individual share price or the company's market capitalization
- Market capitalization is calculated by multiplying the share price by the total number of shares outstanding
- When analyzing general industries, the denominator of a financial ratio can be the aggregate market capitalization of a particular industry {By adding up the individual market caps of all corporations in the market}
Four (4) Major Categories of Financial Ratios
(1) Balance Sheet Ratios –Measuring Financial Stability (Liquidity and Solvency)
Balance sheet ratios deal with the financial stability of a corporation over time and are considered very important for equity investors. These are some important Balance Sheet Ratios:
i) Debt-Equity Ratio
The Debt-Equity Ratio indicates the debt exposure of a company by comparing the company’s liabilities (debt) to what the shareholders have invested in the past in the form of capital (equity).
■ Debt-Equity Ratio = Total Liabilities / Total Equity
These ratios are important too:
■ Debt Ratio = Total Liabilities / Total Assets
■ Equity Ratio = Total Equity / Total Assets
ii) Current Ratio
The Current Ratio shows the ability of a company to meet its obligations deriving from its liabilities. The higher the Current Ratio, the higher the ability of the company to pay off its current and future liabilities.
■ Current Ratio = Current Assets / Current Liabilities
iii) Quick Ratio
The quick ratio indicates a company’s liquidity position and its ability to meet short-term obligations.
■ Qucik Ratio = ( Cash + Cash Equivalents ) / Current Liabilities
iv) Accounts Receivable Turnover
The Accounts Receivable Turnover indicates the ability of a company to collect money. This is an important ratio as some companies may implement inefficient sales policies to attract new clients. Sales matter only if you get paid.
■ Accounts Receivable Turnover = Net Sales / Average Accounts Receivable
v) Times Interest Earned
The Times Interest Earned ratio indicates the ability of a company to meet its interest payment obligations.
■ Times Interest Earned = Earnings Before Interest & Taxes / Interest Expense
(2) Operating Ratios -Measuring Performance
Operating ratios are used to evaluate how a company performs in any given financial period.
i) Gross Margin
The gross margin indicates the gross profit in each sales dollar.
■ Gross Margin = (Revenue - Cost of Goods Sold) / Revenue
ii) Operating Profit Margin
The operating profit margin focuses on the company’s operating efficiency or else its ability to make profits after paying its production costs, but before paying interest or tax. It can be calculated based on EBIDTA.
■ Operating Margin = Operating Earnings / Revenue
■ EBITDA is the company’s total earnings before interest paid, depreciation, tax paid, and amortization
iii) Net Profit Margin
Net profit margin indicates the company’s general ability to generate earnings for its shareholders. Net profit margin measures the proportion of operating profit over sales. If the net profit margin remains strong after investing borrowed funds, the company's growth can be seen as stable and sustainable.
■ Net profit margin = Profit After Tax / (Revenue X 100)
(3) Efficiency Ratios –Measuring Efficiency
Efficiency ratios indicate how effectively a company is using its resources.
i) Total asset turnover ratio
Total Asset Turnover Ratio measures how efficiently the assets of the company are utilized. In other words, are the corporate assets utilized efficiently enough to create sales?
■ Total Asset Turnover Ratio = Annual Revenue / Total Assets
ii) Return on Equity
Return on Equity measures the return of the capital invested in a company by its shareholders. It can indicate the efficiency of the management.
■ Return on Equity = Profit After Tax / Shareholders’ Equity
ii) Return on Assets
Return on Assets indicates the overall profitability of assets and it can be seen as a tool to evaluate the long-term efficiency of the company's management.
■ Return on Assets = Profit After Tax / Total Assets
(4) Valuation Ratios –Measuring Effectiveness
Valuation Ratios measure how the stock market evaluates a company based on its financial strength and performance.
i) P/E Ratio
The P/E ratio is the most commonly used profitability ratio worldwide. It can be seen as a simple and reliable ratio with the disadvantage that looks backward. As it is a lagging profitability indicator, P/E can mislead investors as past earnings may not be repeated in the future. The P/E can be calculated either by dividing Price per Share by Earnings per Share or by dividing the total Market Value by the Total Earnings.
■ P/E = Price per Share / Earnings per Share, or alternatively
Alternatively:
■ P/E = Market Cap / Total Earnings
ii) P/E/G Ratio
The P/E/G Ratio is a variation of the P/E which combines price over earnings and the company's past growth rates. Therefore, if a company is growing fast, it will be better priced based on P/E/G than on a simple P/E. This ratio is very useful to evaluate technology stocks and companies that invest hugely in Research and Development (R&D).
■ P/E = (Price per Share / Earnings per Share) / Earnings Growth
Alternatively:
■ P/E = (Market Cap / Total Earnings) / Earnings Growth
iii) Dividend Yield
Dividend Yield indicates the annual cash return per share and it is considered a very important stock investing figure.
■ Dividend Yield = Annual Cash per Share / Share Price
iv) Price to Book Value (P/BV)
Price to Book Value or else P/BV compares the company's book value per share to its price. P/BV is an important ratio when pricing financial companies such as banks and investment firms and is almost irrelevant when pricing technology stocks.
■ P/BV = Share Price / Equity Per Share
Alternatively:
■ P/BV = Market Capitalization / Total Equity
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