Financial Ratio Analysis

Quick Summary
1. Liquidity ratios include the current ratio, quick ratio, cash ratio, and the defensive interval ratio.
2. Activity ratios include inventory turnover, receivables turnover, payables turnover, working capital turnover, fixed asset turnover, total asset turnover, and the cash conversion cycle.
3. Solvency ratios include debt-to-assets, debt-to-equity, financial leverage, and interest coverage.
4. Profitability ratios include gross profit margin, operating profit margin, EBITDA margin, net profit margin, return on assets, return on equity, and return on capital.
5. Market ratios include price-to-earnings, price-to-cash flow, price-to-sales, price-to-book, basic EPS, diluted EPS, cash flow per share, EBITDA per share, and dividends per share.

Introduction
While a universally accepted classification of ratios does not exist, five commonly accepted categories are liquidity, activity, solvency, profitability, and valuation. Industry-specific metrics for banks, retail companies, hotels, etc. can extend a ratio analysis even further. The most accurate picture of a company’s overall position and performance comes from examining a variety of financial ratios. Information gleaned from one ratio is often helpful in addressing concerns raised by another.

Ratios are only meaningful when they are compared over time and relative to other companies. Since ratios can vary widely from one sector to the next it is important to choose peers that operate in the same industry and are of relatively similar size. Analyzing ratios over time gives analysts a much clearer picture of any variances and emerging trends. It is common to include a company five-year average and industry average when presenting ratios in a research report.

Since some ratios include items from both the income statement and balance sheet it is best to use averages for the latter. Average balance sheet figures can be calculated by adding the value of the prior period to the value of the current period and dividing the sum by two. Additional adjustments should be made for items that distort comparability across time and peers. These include operating leases, LIFO reserves, and non-recurring items.

1. Liquidity Ratios
Liquidity ratios measure a company’s ability to satisfy its short-term debt obligations. Higher values mean a company has a larger margin of safety to cover its short-term obligations. Lower liquidity is viewed as a leading indicator of cash flow problems and a precursor to financial distress. Letters of credit or financial guarantees should additionally be considered when assessing a firm’s overall liquidity position.

Current Ratio

The current ratio is used to determine a firm’s ability to pay off its short-term obligations with relatively liquid assets. Current assets include cash, cash equivalents, marketable securities, receivables, and inventory. Current liabilities include payables, short-term debt, current portion of long-term debt, deferred revenue, and accrued expenses.

Firms are considered more liquid the higher their current ratio. An overly high current ratio however may suggest that the company is not managing its current assets efficiently. Ratios of at least 2.0 are generally considered acceptable, though acceptability varies by industry. A current ratio below 1.0 is usually a sign that the company is not in good financial health. Lower current ratios are acceptable for firms with more predictable cash flows.

As an indicator of liquidity, the current ratio is conceptually flawed since not all of a company’s current assets can readily be liquidated and converted into cash. It is therefore important to understand the types of current assets that the company holds. This perspective can be seen through more conservative liquidity ratios.

The balance sheet consequence for companies that use LIFO is a lower ending inventory (when prices are increasing). This results in a lower current ratio. To exclude the effect of this inventory valuation method on the current ratio an adjustment can be made by adding the LIFO reserve amount to current assets in the numerator.

Quick Ratio

The quick ratio (also referred to as the “acid test”) is similar to the current ratio except more stringent in that it excludes inventory from current assets. This is because inventory is generally the least liquid current asset as it cannot be quickly sold and typically becomes an account receivable before being converted into cash. On the other hand, if inventory is liquid then the current ratio is a preferred measure of liquidity. Ratios of 1.0 or greater are generally cited as acceptable.

Cash Ratio

The cash ratio represents the portion of a firm’s assets held in the most liquid short-term assets that can most easily be used to pay off current obligations in a crisis situation. More specifically, it excludes inventory and receivables as there are no guarantees that these two accounts can quickly be converted to cash. It is not uncommon for companies to have current liabilities in excess of cash and cash equivalents (i.e. a ratio less than 1.0). From a shareholder’s viewpoint, a high ratio may indicate an inefficient use of assets. While creditors rely on the cash ratio to assess margins of safety, it is seldom used by analysts in the fundamental analysis of a company.

Defensive Interval Ratio

The defensive interval ratio (DIR) measures how many days a company can pay its daily expenditures from its existing liquid assets. Daily cash expenditures are calculated by summing all expenditures on the income statement, excluding non-cash expenses and taxes, and dividing by 365. The defensive interval ratio is often seen as a better measure of liquidity because it compares assets to expenses rather than liabilities.

2. Activity Ratios
Measures of overall liquidity are often inadequate at assessing the composition of a firm’s current assets and current liabilities. It is therefore important to look at the activity of specific current accounts to understand a company’s “true” liquidity. Activity ratios (also known as operating efficiency ratios) measure how efficiently a firm manages its different assets and liabilities on a day-to-day basis. Analysts should then attempt to understand why the ratios have improved or deteriorated to facilitate judgement about future performance.

Inventory Turnover

Inventory turnover is a measure of the activity (or liquidity) of a firm’s inventory. It shows how efficiently a company is managing its inventory relative to sales. The ratio expresses how many times per year a company theoretically sells out its entire inventory.

A high ratio generally suggests strong sales. If accompanied by slower revenue growth, however, a higher inventory turnover could indicate inadequate inventory levels. A low inventory turnover rate is an indicator of poor sales and excess inventory. One usual suspect is obsolescence problems.

Analysts should carefully investigate inventory disclosures to spot any trends in the distribution of raw materials, work-in-progress and finished goods. Significant increases (decreases) in raw materials and/or work-in-progress may indicate that management expects increases (decreases) in demand. When finished goods outpace sales, this could signal increased storage costs, potential write-downs, and less cash available for other purposes.

Companies using LIFO will generally appear to manage their inventory better than equivalent companies using other cost flow assumptions. Inventory turnover can be adjusted to correct for this by subtracting the change in LIFO reserve from the numerator and adding the full LIFO reserve amount to the denominator. Inventory write-downs also positively affect inventory turnover. In some cases it might make sense to add back recent write-down amounts to the denominator. (This same logic applies to other liquidity, activity, and solvency ratios).

Inventory turnover can easily be converted into days inventory outstanding (DIO). This is accomplished by taking the number of days in a period (usually 365) and dividing by the inventory turnover. The resultant value refers to the theoretical number of days it takes to sell the entire inventory.

Receivables Turnover

The accounts receivable turnover is used to evaluate a firm’s effectiveness in extending credit and collecting debts on that credit. It is however only meaningful in relation to a firm’s credit terms.  Analysts should be sure to consult the receivables ageing schedule to better understand the underlying reasons for changes in the receivables turnover.

A high receivables turnover ratio reflects a short time lapse between sales and the collection of cash. This generally indicates that the company is efficient at collecting receivables and has a high proportion of quality customers that pay off their debts quickly. It may also suggest that the company is too conservative regarding its extension of credit and is losing sales to competitors as a result.

A low ratio often means that the company has poor collecting processes, a bad credit policy, or customers with financial difficulty. It could also be the result of a disruption in getting the right goods to customers and the customers in turn refusing to pay. The longer it takes a firm to collect on its credit sales, the longer its money is unavailable for other purposes.

The accounts receivable turnover can be translated to days sales outstanding (DSO) by taking the inverse of the turnover and multiplying it by 365. This measures the average number of days that it takes the firm to collect on its credit sales. This number should be less than or equal to the firm’s stated credit terms.

Payables Turnover

Accounts payable turnover measures the rate at which a firm pays off its suppliers. Purchases (i.e. the numerator) are generally calculated as COGS from the current period plus the change in inventory from the prior period. A high payables turnover can indicate a firm is exploiting early payment discounts or is not making full use of credit terms. Low turnover rates may suggest the firm is having difficulty making payments or is taking advantage of lenient supplier terms. It is therefore important to look at other liquidity ratios to gain a more holistic understanding. The ratio can be converted to days payable outstanding (DPO), which shows how many days a company takes to pay its suppliers.

(No adjustments are required for firm’s using the LIFO method. The theoretically precise calculation is given as COGS – ΔLIFO reserve + ΔInventory + ΔLIFO reserve. The changes in the LIFO reserve net out and the equation reduces to the conventional form of COGS + ΔInventory).

Working Capital Turnover

Working capital turnover is a measure of how efficiently a firm is using its working capital (current assets – current liabilities) to generate revenue. Higher ratios indicate greater efficiency.

Fixed Asset Turnover

The fixed asset turnover ratio reflects the amount of sales a company is able to generate from fixed-asset investments. These primarily include property, plant and equipment (PP&E), net of depreciation. This ratio is therefore of particular importance to the fundamental analysis of capital-intense industries.

A high (low) ratio generally indicates that a company has been more (less) effective in using its fixed assets to generate revenues. Due to the lumpy nature of investments in fixed assets, ratios are not generally steady across time. Ratios are also affected by whether assets are newer and have higher carrying values or older and thus more depreciated. It is therefore meaningful to look at the average age of fixed assets, which can be approximated as accumulated depreciation divided by the current depreciation expense. The average remaining useful life of assets can also be estimated by dividing net PP&E by depreciation. (Be aware that relative age calculations can only be used when assets are accounted for under the straight-line depreciation method).

Total Asset Turnover

The total asset turnover measures how financially efficient a firm is in using its assets to generate sales. More specifically, it tells how many times a year a company theoretically turns over its assets. The higher (lower) a firm’s total asset turnover, the more (less) efficient its assets have been deployed to generate revenue. The ratio serves as a key component to the DuPont analysis (here).

Adjustments for operating leases and LIFO inventory accounting can be made by adding the capitalized lease amount and the LIFO reserve to the denominator. Since inventory write-downs and asset impairments positively impact the asset turnover ratio, these charges can be added back to the denominator as well. Adjusting the ratio for investments in associates requires backing out the associate ownership percentage from the assets of the parent.

Cash Conversion Cycle

The cash conversion cycle (otherwise known as the net operating cycle) is calculated as days inventory outstanding (DIO) plus days sales outstanding (DSO) minus days payable outstanding (DSO). This metric looks at the time needed, in days, for a company to go from cash paid for inventory to cash received from receivables. It therefore represents the amount of time cash is tied up in working capital. And tied up cash must be financed through debt or equity.

Shorter (longer) cycles indicate that capital is tied up for less (more) time in the business process. The cycle also shows how efficiently management employs its short-term assets and liabilities to generate cash. This is particularly important for retailers and similar businesses since their operations heavily rely on buying inventories and selling them to customers.

3. Solvency Ratios
Solvency ratios (also referred to as debt or leverage ratios) refer to a company’s ability to fulfil long-term debt obligations. The degree of indebtedness is measured by comparing the amount of debt relative to other significant balance sheet amounts. Equity analysts are concerned with long-term debts because creditors’ claims must be satisfied before earnings can be distributed to shareholders. Greater financial leverage has a magnifying effect on returns. While higher levels of debt increase borrowing costs and the risk of default, ratios too high above industry norms may result in unnecessarily low risk and return. Companies with steady cash flows and lower business risk are better positioned to take on more leverage. A company’s use of debt can also signal management’s beliefs about the company’s future.

Debt-to-Assets

The debt-to-assets ratio (also referred to simply as the debt ratio) measures the proportion of a company’s assets that are financed through borrowing. Total debt is the sum of long-term and short-term debt. Higher ratios indicate greater indebtedness and more financial risk. Firms that finance PP&E through operating leases have lower debt-to-asset ratios since such assets are not recorded on the balance sheet. This can be adjusted for by adding the capitalized lease amount to the numerator and denominator of the ratio. Firms using LIFO inventory accounting should also have their reserve amount added to total assets.

Debt-to-Equity

The debt-to-equity ratio provides another perspective on a company’s financial leverage. In this case, debt is compared to shareholders’ equity as opposed to assets. Like the debt ratio, a lower ratio indicates that the company is using less leverage. Adjustments can be made for operating leases by adding the capitalized amount to the numerator. The equity-financed portion of the LIFO reserve can also be added to the denominator.

Financial Leverage

The financial leverage ratio measures the degree to which a company uses debt and other liabilities to finance assets. It serves as a key component in the DuPont analysis. Higher ratios indicate greater financial leverage. Operating leases and LIFO reserves can be captured by making the adjustments outlined above.

Interest Coverage

The interest coverage ratio (also referred to as times interest earned) measures the number of times a company’s EBIT could cover paying the interest it owes. It therefore represents a firm’s margin of safety in handling its contractual interest payments. Higher ratios indicate that the firm is better able to fulfill its interest obligations, though too little borrowing has the potential of negatively affecting a company’s profitability. Lower interest coverage ratios suggest that debt expense is a burden to the company. Analysts are particularly concerned with the stability of interest coverage ratios when looking at a firm. Declining ratios can signal that a company may be unable to pay its debts in the future.

A value of 3.0 (and preferably closer to 5.0) is often suggested as a reasonable margin while a ratio approaching 2.5 is generally considered a warning sign. Interest coverage ratios of 1.5 are thought by lenders to represent a bare minimum acceptable ratio, as the company’s default risk is too high. To gain a more accurate picture of a company’s interest coverage, the pro forma interest expense on capitalized operating leases should be added to the denominator. The operating lease expense (i.e. rental cost) should be added back to EBIT and the pro forma depreciation expense subtracted to maintain consistency.

4. Profitability Ratios
Profitability ratios reflect a company’s competitive position in the market. They are used by analysts to evaluate the underlying drivers of profitability. Profitability ratios take the form of either returns on sales (gross margin, operating margin, EBITDA margin, and net margin) or returns on investment (ROA, ROC, and ROE). Though not included here, separate posts cover the analysis of ROC (here) and ROE (here). It is more useful to look at profitability ratios by segment than on a consolidated basis for conglomerates. It is also important to be on the lookout for non-recurring items, which can distort ratios and therefore should be excluded. These include restructurings, gains on sales, discontinued operations, lawsuit settlements, and so on.

Gross Profit Margin

The gross profit margin (or gross margin) measures the proportion of sales remaining after the firm has paid for its cost of goods sold. Gross margin values should be relatively stable for a company unless product pricing or product costs have changed drastically. Higher gross profit margins are generally achieved through cost leadership or product differentiation. Cost leaders attain a lower relative cost of merchandise through manufacturing efficiency or power over suppliers. Improvements in gross margins as sales increase provide further evidence of economies of scale. Product differentiation, on the other hand, is accomplished by selling high quality products with superior branding (e.g. strong marketing) and/or exclusive technology (e.g. strong R&D arms).

Operating Profit Margin

The operating profit margin (or operating margin) measures the proportion of sales remaining after the firm has paid all of its operating expenditures. These typically account for all costs and expenses other than interest and taxes. Economies of scale tend to be positively correlated with higher operating margins as revenue increases. To further analyze how scale economies are being realized, divide each operating cost (e.g. COGS, SG&A, etc.) by revenue. Be aware that the volatility of operating margins is magnified by significant fixed costs. Operating margins increasing faster than gross margins can indicate improvements in controlling overhead costs.

EBITDA Margin

The EBITDA margin is often used by analysts as an alternative to the operating margin because it provides a better measure of cash-based operating income by excluding depreciation and amortization.

Net Profit Margin

The net profit margin (or net margin) measures the proportion of revenue remaining after the firm has paid all of its expenses. It is a key component to the DuPont analysis. The revenue included in the net margin is different from the revenue used in the gross margin since the former includes financial products. Strong operating profitability combined with weak net profitability may suggest a problem with non-operating items, such as interest expense.

In addition to adjusting net margin ratios for non-recurring items it is usually worth backing out the income from minority interests in other companies (recorded using the equity method). This requires subtracting the proportional share of net income of the associate from the net income of the parent. Without this adjustment, net margin ratios can be overstated since income from an associate is captured in the parent’s net income but not in sales.

Return on Assets

Return on assets (ROA) measures how effectively the company’s management is deploying its assets to generate earnings. A very high (low) ROA usually indicates efficient (inefficient) management. Analysts should be alert for any unusual expenses that might distort this ratio. Equipment rented under an operating lease should be capitalized on a pro forma basis and included in the denominator.

5. Market Ratios
Market ratios measure certain accounting values relative to the firm’s market value (e.g. price) or a specified claim (e.g. a share of ownership). These ratios give insight, on a relative basis, how investors in the marketplace are assessing the firm’s past and expected future performance.

  • Valuation Ratios:
    • Price/Earnings
    • Price/Cash Flow
    • Price/Sales
    • Price/Book
  • Per-share Quantities:
    • Basic EPS
    • Diluted EPS
    • Cash Flow per Share
    • EBITDA per Share
    • Dividends per Share
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