Financial Ratios

Profitability Ratios

Profitability ratios associate the amount of income earned with the resources used to generate it.

Return on Assets relates net income to the investment in all the financial resources at the command of management. It is most useful as a measure of effective resource utilisation - without regard to how those resources were obtained or financed. Analysts and investors often compare the ROA of one company to the ROA of its peer group of key competitors to assess the effectiveness of top management.

ROA = Net Income / Total Assets

Return on Equity relates net income to the amount invested by shareholders. It is a measure of how efficiently the share-holders' stake in the business has been used. ROE is calculated as follows:

ROE = Net Income / Shareholders Equity.

Return on Investment is often used in business discussions that involve profitability. Unfortunately there is no standard definition of ROI, since investment may be construed from many perspectives. Investment might represent the assets committed to a particular activity, the shareholders equity involved, or invested assets minus any liabilities generated by a company taking on a project. So, when someone uses the term "return on investment" always get a clarification. Ask "how are you calculating investment?"

The earnings before interest and taxes margin (EBIT margin) more generally known as the operating margin, is used by many analysts to gauge the profitability of a company's operating activities. The operating margin removes from the equation the interest expenses and taxes over which current management may have no control, thus giving a clearer indicator of management performance. To calculate the operating margin, use this formula:

Operating Margin = EBIT / Net Sales

Corporations generally have many owners, not all of whom own an equal number of shares. For this reason it is common to express earnings on a per share basis. The calculation of earning per share, or EPS, can be complicated if there is more than one class of ownership, each with different claims against the income and assets of the firm. The earnings per share ratio must be presented in published reports, often in several variations, such as primary or fully diluted EPS.

Fully Diluted EPS = (Net Income - Preferred Stock Dividends)/(Number of common shares + Equivalents)

The profit margin - sometimes called the return on sales, or ROS - indicates a rate of return on sales. It tells us what percentage of every dollar of sales makes it to the bottom line. The profit margin is calculated as follows:

Profit Margin = Net Income / Net Sales

Activity Ratios

Activity ratios provide an indication of how well an organisation utilises its assets.

Inventory turnover is another ratio that concerns many managers. Determining the number of times that inventory is sold and replaced during the year provides some measure of it liquidity and the ability of the company to convert inventories to cash quickly is that were to become necessary.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Days receivables outstanding (sometimes called the collection period) tells us the average time it takes to collect on sales made by the company.

Days Receivables Outstanding = Accounts Receivable / Average Days Sales

Solvency Ratios

When an organisation is unable to meet its financial obligations it is said to be insolvent. Because insolvency leads to organisational distress, solvency ratios are closely scrutinised. By measuring a company's ability to meet financial obligations as they become due, solvency ratios give an indication of its liquidity. The current ratio and acid test ratio are commonly used for this measurement.

The current ratio formula is

Current Ratio = Current Assets / Current Liabilities

The size of the current ratio that a healthy company needs to maintain depends on the relationship between inflows of cash and the demands for cash payments. A company that has a continuous and reliable inflow of cash (e.g. a utilities company) or other liquid assets may be able to meet currently maturing obligations easily despite a small current ratio (say 1.10 - which means that the company has $1.10 in current assets for every $1 of current liabilities). On the other hand, a manufacturing firm with long product development and manufacturing cycles may need to maintain a larger current ratio.

To confirm the absolute liquidity of an organisation, an analysts can modify the current ratio by eliminating from current assets all that cannot be liquidated on very short notice. Inventory is left out of this calculation.

Acid Test Ratio = Quick Assets / Current Liabilities

The debt ratio is widely used in financial analysis because it reveals the effect of financial leverage.

Debt Ratio = Total Debt / Total Assets

Debt to Equity Ratio = Total Liabilities / Owners Equity

Fully funded debt - that is, all the debt that carries an interest rate charge, is probably the best measure of debt.

Creditors also use the times interest earned ratio to estimate how safe it is to lend money to individual businesses. Almost every firm has continuing commitments that must be met by future cash flows if the company is to remain solvent. Interest payments are one of those commitments. The ratio that measures the ability of a company to meet its interest payments is time interest earned. The formula for this ratio is:

Times Interest Earned Ratio = Earnings before Interest and Taxes / Interest Expense

The number of times that interest payments are covered by pre-tax earnings, or EBIT, indicates the degree to which income could fall without causing insolvency.

Financial statements expressed in percentage form facilitate the comparison