Financial Ratio Analysis

Financial Ratios

• Used for performance comparison within a company or between different companies
• Determines what the ratio measures and why the information from it is important

Ratio Categories

• Liquidity Ratios measure short-term solvency
• Long-Term Solvency Ratios evaluate long-term debt-paying ability
• Asset Utilization Ratios measure how efficiently a firm uses its assets
• Profitability Ratios measure a company’s ability to generate earnings
• Market Value Ratios use market data to evaluate a firm's performance

Liquidity Ratios

• Measure a company's ability to meet its short-term obligations
• Current Ratio = Current Assets / Current Liabilities: Indicates a company's ability to pay its short-term liabilities
• Quick Ratio = (Current Assets - Inventory) / Current Liabilities: Indicates the ability to pay short-term liabilities with its most liquid assets
• Cash Ratio = Cash / Current Liabilities: Indicates the ability to pay short-term liabilities with cash

Long-Term Solvency Ratios

• Assess a company's ability to meet its long-term obligations and financial leverage
• Total Debt Ratio = Total Debt / Total Assets: Indicates the proportion of a company's assets financed by debt
• Debt-to-Equity Ratio = Total Debt / Total Equity: Indicates the proportion of equity and debt a company uses to finance its assets
• Equity Multiplier = Total Assets / Total Equity: Shows how a company uses debt to finance its assets; a higher multiplier indicates higher financial leverage
• Times Interest Earned = EBIT / Interest: Reveals how many times a company can cover its interest charges on a pretax basis
• Cash Coverage Ratio = (EBIT + Depreciation) / Interest: Measures a company’s ability to meet its obligations with operating cash flow

Asset Utilization Ratios

• Evaluate how efficiently a company uses its assets to generate sales
• Receivables Turnover = Sales / Accounts Receivable: Measures how efficiently a firm uses its assets
• Days Sales in Receivables = 365 days / Receivables Turnover: Shows the approximate time a business takes to receive payments owed
• Inventory Turnover = Cost of Goods Sold / Inventory: Demonstrates how many times a company’s inventory is sold and replaced over a period
• Days Sales in Inventory = 365 days / Inventory Turnover: Shows how long it takes a company to turn its inventory into sales
• Accounts Payable Turnover = Cost of Goods Sold / Accounts Payable: Indicates how many times a company pays its average payable amount per period
• Total Asset Turnover = Sales / Total Assets: Shows the amount of sales or revenues generated per dollar of assets

Profitability Ratios

• Measure a company's ability to generate profits from its sales and assets
• Profit Margin = Net Income / Sales: Measures how much of every dollar of sales a company keeps in earnings
• Return on Equity (ROE) = Net Income / Total Equity: Indicates the amount of net income returned as a percentage of shareholders' equity and reveals how much profit a company generates with shareholders’ investments
• Return on Assets (ROA) = Net Income / Total Assets: Shows how profitable a company is relative to its total assets

DuPont Analysis

• Used for performance measurement
• DuPont Corporation used it in the 1920s
• Assets are measured at their gross book value, not net book value, for a higher return on equity (ROE)
• Determines that ROE is affected by operating efficiency, asset use efficiency, and financial leverage
• ROE = Profit Margin × Total Asset Turnover × Equity Multiplier
• ROE = (Net Income / Sales) × (Sales / Total Assets) × (Total Assets / Total Equity)

Market Value Ratios

• Use market data to evaluate a firm's performance, including its stock price
• Price-Earnings Ratio (P/E) = Price per Share / Earnings per Share: Shows a valuation ratio of a company’s current share price compared to its per-share earnings
• EPS = Net income / Number of shares
• Market-to-Book Ratio: Compares a company's market value to its book value
• Market-to-book = Market value per share / Book value per share
• Market - to - book = Market value per share / (Total equity / Number of shares)
• Ratio < 1, then the stock is undervalued, a ratio > 1, then the stock is overvalued