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Financial ratio

Numerical value to determine the financial condition of a company

Summary

Numerical value to determine the financial condition of a company

A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are publicly listed, the market price of the shares is used in certain financial ratios.

Ratios can be expressed as a decimal value, such as 0.10, or given as an equivalent percentage value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Sources of data

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of changes in equity. These comprise the firm's "accounting statements" or financial statements. The statements' data is based on the accounting method and accounting standards used by the organisation.

Purpose and types

Financial ratios quantify many aspects of a business and are an integral part of the financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures.
Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.
Liquidity ratios measure the availability of cash to pay debt.
Efficiency (activity) ratios measure how quickly a firm converts non-cash assets to cash assets.
Debt ratios measure the firm's ability to repay long-term debt.
Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company's shares.

Financial ratios allow for comparisons

between companies
between industries
between different time periods for one company
between a single company and its industry average

Ratios generally are not useful unless they are benchmarked against something else, like past performance or another company. Thus, the ratios of firms in different industries, which face different risks, capital requirements, and competition are usually hard to compare.

Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may elect to not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce their financial statements, or they may use the generally accepted accounting principles of their home country.

There is no international standard for calculating the summary data presented in all financial statements, and the terminology is not always consistent between companies, industries, countries and time periods.

Types of Ratio Comparisons

An important feature of ratio analysis is interpreting ratio values. A meaningful basis for comparison is needed to answer questions such as "Is it too high or too low?" or "Is it good or bad?". Two types of ratio comparisons can be made, cross-sectional and time-series.

Cross-Sectional Analysis

Cross-sectional analysis compares the financial ratios of different companies at the same point in time. It allows companies to benchmark from other competitors by comparing their ratio values to similar companies in the industry.

Time-Series Analysis

Time-series analysis evaluates a company's performance over time. It compares its current performance against past or historical performance. This can help assess the company's progress by looking into developing trends or year-to-year changes.

Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the Internet. Sales reported by a firm are usually net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice. Net income is always the amount after taxes, depreciation, amortization, and interest, unless otherwise stated. Otherwise, the amount would be EBIT, or EBITDA (see below).

Companies that are primarily involved in providing services with labour do not generally report "Sales" based on hours. These companies tend to report "revenue" based on the monetary value of income that the services provide.

Note that Shareholders' Equity and Owner's Equity are not the same thing, Shareholder's Equity represents the total number of shares in the company multiplied by each share's book value; Owner's Equity represents the total number of shares that an individual shareholder owns (usually the owner with controlling interest), multiplied by each share's book value. It is important to make this distinction when calculating ratios.

Abbreviations

(*Note: * These are not ratios, but values in currency.)

COGS = Cost of goods sold, or cost of sales.
EBIT = Earnings before interest and taxes
EBITDA = Earnings before interest, taxes, depreciation, and amortization
EPS = Earnings per share

Ratios

Profitability ratios

Profitability ratios measure the company's use of its assets and control of its expenses to generate an acceptable rate of return.

Name	Ratio	Notes
Gross margin, Gross profit margin or Gross Profit Rate	or
last=Williams	first=Jan R.	author2=Susan F. Haka	author3=Mark S. Bettner	author4=Joseph V. Carcello	title=Financial & Managerial Accounting	publisher=McGraw-Hill Irwin	year=2008	pages= 266	isbn=978-0-07-299650-0}}	Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit. This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales)
Profit margin, net margin or net profit margin
Return on equity (ROE)
Return on assets (ROA ratio or Du Pont Ratio)
Return on assets (ROA)
Return on assets Du Pont (ROA Du Pont)
Return on Equity Du Pont (ROE Du Pont)
Return on net assets (RONA)
Return on capital (ROC)
Risk adjusted return on capital (RAROC)
Return on capital employed (ROCE)		This is similar to (ROI), which calculates Net Income per Owner's Equity
Cash flow return on investment (CFROI)
Efficiency ratio
Basic Earnings Power (BEP)		Similar to return on assets (ROA), but uses EBIT instead of net income

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Name	Ratio	Notes
Current ratio (Working Capital Ratio)
Acid-test ratio (Quick ratio)
Cash ratio
Operating cash flow ratio
Net working capital to sales ratio		This ratio assesses a business's actual liquidity position against its need for liquidity, represented by its sales.
Working Capital Turnover Ratio		Similar to the Net working capital to sales ratio

Efficiency ratios

Efficiency ratios measure the effectiveness of the firm's use of resources.

Name	Ratio	Notes
Average collection period	365 Days
Degree of Operating Leverage (DOL)
DSO Ratio.	365 Days
Average payment period	365 Days
Asset turnover
Stock turnover ratio
Receivables Turnover Ratio
Inventory conversion ratio
Inventory conversion period	365 Days	Essentially same thing as above
Receivables conversion period	365 Days
Payables conversion period	365 Days
Cash Conversion Cycle	(Inventory Conversion Period) + (Receivables Conversion Period) - (Payables Conversion Period)

Debt ratios

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure the level of borrowed funds used by the firm to finance its activities.

Name	Ratio	Notes
Debt ratio
Long-term debt to assets ratio
Debt to equity ratio (gearing ratio)
Long-term Debt to equity (LT Debt to Equity)
Times interest earned ratio (Interest Coverage Ratio)	, or equivalently
Debt service coverage ratio
Cash-flow-to-debt ratio

Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. These are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company's shares.

Name	Ratio	Notes
Earnings per share (EPS)
Payout ratio
Dividend cover (the inverse of Payout Ratio)
P/E ratio
Dividend yield
Cash flow ratio or Price/cash flow ratio
Price to book value ratio (P/B or PBV)
Price/sales ratio
PEG ratio

Other ratios

Name	Ratio	Notes
EV/EBITDA
EV/Sales
Cost/Income ratio
EV/capacity
EV/output

Capital budgeting ratios

Main article: Capital budgeting

In addition to assisting management and owners in diagnosing the financial health of their company, ratios can also help managers make decisions about investments or projects that the company is considering to take, such as acquisitions, or expansion.

Many formal methods are used in capital budgeting, including the techniques such as

Net present value
Profitability index
Internal rate of return
Modified internal rate of return
Equivalent annuity

References

Groppelli, Angelico A.. (2000). "Finance, 4th ed". Barron's Educational Series, Inc..
Groppelli, p. 442.
Groppelli, p. 434.
Groppelli, p. 436.
Groppelli, p. 439.
Groppelli, p. 445.
Gitman & Zutter. (2013). "Principles of Managerial Finance". Pearson Education Limited.
Williams, P. 265.
Williams, p. 1094.
Williams, Jan R.. (2008). "Financial & Managerial Accounting". McGraw-Hill Irwin.
"Operating income definition".
Groppelli, p. 443.
Bodie, Zane. (2004). "Essentials of Investments, 5th ed". McGraw-Hill Irwin.
Groppelli, p. 444.
[http://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets/ Professor Cram. "Ratios of Profitability: Return on Assets"] College-Cram.com. 14 May 2008
[http://www.college-cram.com/study/finance/ratios-of-profitability/return-on-assets-du-pont/ Professor Cram. "Ratios of Profitability: Return on Assets Du Pont"], College-Cram.com. 14 May 2008
Weston, J.. (1990). "Essentials of Managerial Finance". Dryden Press.
Groppelli, p. 435.
Drake, P. P., ''Financial ratio analysis'', p. 6, published on 15 December 2012
(2009). "Fundamentals of Financial Management". South-Western College Pub.
Bodie, p. 459.
Groppelli, p. 438.
Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). ''Accounting Principles'' (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.
Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). ''Accounting Principles'' (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 800.
Groppelli, p. 440; Williams, p. 640.
Drake, P. P., Financial ratio analysis, p. 9, published on 15 December 2012
Groppelli, p. 441.
Groppelli, p. 446.
Groppelli, p. 449.
Groppelli, p. 447.

Wikipedia Source

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