Financial Ratio Analysis
Financial ratio analysis is widely used by investors and analysts to gain insight on companies’ liquidity, solvency, financial leverage, turnover, and profitability. There are also ratios that will allow us to compute for the market value of companies.
15 Key Financial Ratio Formulas
In this article, we share 15 key financial ratio formulas, how they are computed and what these computed figures indicate about a company’s health. (Related: 3 Reasons Why Bookkeeping is Essential for your Business to Thrive)
LIQUIDITY RATIOS
Current Ratio = Current Assets / Current Liabilities
The current ratio, also termed as the working capital ratio, is a popular metric used to measure a company’s ability to settle short-term obligations or liabilities that are due within one year. Generally, the higher the current ratio the better, but the rule of thumb is that a current ratio greater than 1 is already good as it indicates that the company can pay off its current obligations using its current assets.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick ratio, also known as the acid test ratio, is like the current ratio; however, we exclude inventories from the current assets to only account for the most liquid assets. The idea is that we want to assess a company’s ability to pay its current liabilities without the need to sell off its inventory on hand. With this, the higher the quick ratio the better too. Ideally, a good sign that a company can cover its short-term financial obligations is if its quick ratio is equal to or greater than 1.
Cash Ratio = Cash / Current Liabilities
The cash ratio is an even more conservative way to check for a company’s liquidity. This metric only accounts for assets which are readily convertible to cash such as cash and cash equivalents. Similarly, a cash ratio greater than 1 is a good sign and the higher it is, the better.
FINANCIAL LEVERAGE RATIOS
Debt to Equity Ratio = Total Liabilities / Total Equity
The debt to equity ratio tells us the capital structure of a company or the amount of money and retained earnings invested in an entity. A debt to equity ratio close to 0 indicates that the company did not rely much on borrowing to finance their operations. These companies are viewed as less risky compared to those with high debt to equity ratios who will also be exposed to more interest charges and possibly higher interest rates as well. Generally, a ratio ranging from 1 to 1.5 is good, but it is worth looking into the industry standards as well because there are certain industries where debt financing is more accepted.
Debt Ratio = Total Liabilities / Total Assets
The debt ratio provides us insight on how the company is financing their assets, whether they are using debt or equity to purchase their assets. It can also be viewed as the company’s capacity to pay off its liabilities using their assets. A lower debt ratio is more favorable as it implies lower debt thus gives a picture of a more stable business. Meanwhile, a high debt ratio raises concerns because a company may not be able to pay off their obligations in the future.
Interest Coverage Ratio = EBIT / Interest Expense
The interest coverage ratio is useful to understand a company’s ability to pay off their interest charges for their outstanding debt in a timely manner. The metric tells us how many times a company can settle their interest payments with their current earnings before interest and taxes. Generally, an interest coverage ratio of at least 2 is considered good. Meanwhile, an interest coverage ratio below 1 is indicatory that the company is not in good financial health.
PROFITABILITY RATIOS
Return on Equity = Net Income / Total Equity
The return on equity is a ratio used to evaluate the ability of the company to generate profits from the investments the shareholders made for the firm. This profitability ratio indicates how much profit each peso of equity can generate. Investors normally look at this ratio to understand how effectively their capital is being reinvested. Hence, the higher the return on equity the better and ideally, a desirable value will be somewhere between 10-20%.
Profit Margin = Net Income / Total Sales
The profit margin is another popular profitability ratio. It tells us the degree to which a company makes money or how much net income is made given the total sales achieved. The higher the profit margin, the more efficient the company is in converting sales into actual profit.
Return on Total Assets = Net Income / Total Assets
The return on total assets is a metric to measure how well a company is generating earnings using its total assets. The derived amount appears as a percentage and the higher the percentage, the more efficient a company is in utilizing their economic resources to generate profits.
TURNOVER RATIOS
Receivables Turnover = Sales / Receivables
A receivables turnover ratio is used to assess how well a company can collect their receivables. This ratio is indicative of the quality of customers the entity has as well as the company’s efficiency in converting their receivables to cash. Generally, the ratio can be compared against other companies who are also operating in the same industry. The computed receivables turnover can also be used internally to evaluate if the company’s collection processes have improved over time.
Days Payable Outstanding = Payables / (Purchases/365)
The days payable outstanding measures the number of days it takes for a company to pay its suppliers. Generally, the higher it is, the more telling it is about the company’s ability to delay their payments so that they will be able to use their cash elsewhere first. A higher days payable outstanding can be interpreted as the firm having good supplier relationships.
Inventory Turnover = Inventory / (Cost of Goods Sold / 365)
The inventory turnover tells us how many times inventory is repeatedly used or sold in a period. The higher the turnover, the more indicative it is of the company’s selling capabilities. However, it can also expose the company to possible inventory shortages. Meanwhile, a low inventory turnover can indicate that a company is not selling well and may be holding too much inventory.
Days Sales Outstanding = Accounts Receivable / (Sales / 365)
Days Sales Outstanding is a metric used to measure that number of days it takes for a company to collect payments after a sale has been made. In other words, you can view this as how long it takes to convert credit sales to cash. Generally, the faster the conversion period, the better it is for the company as this is indicative of their customers’ good credit standing and the company’s efficient collection activity.
MARKET VALUE RATIOS
Price per Earnings Ratio = Price per share/Earnings per share
The price per earnings ratio is a ratio widely used by analysts to value companies. It tells us how much an investor will be willing to pay today for a stock based on the earnings. In other words, it is the stock’s market value compared to the company’s earnings. Generally, the higher the price per earnings ratio, the more optimistic people are that the company will perform well in the future; hence, investors will be more willing to pay as well. Taken from another perspective, this can also be an indicator that the stock is overvalued.
Dividend Yield Ratio = Annual Dividend per share/Price per share
The dividend yield ratio shows us the percentage of dividends for every peso of share. It is commonly used to understand the ability of an investor to generate cash as a result of owning company shares. A high dividend yield ratio is indicative that investors are receiving a lot of returns from the investment they made.
Financial Ratio Analysis Summary
With this, we conclude by sharing a summary table below of all the financial ratios formula discussed. The one key takeaway here is that if you are looking to invest but are not sure which companies look promising, a good way to evaluate a company’s performance will be to look at the financial statements. From the balance sheet, income statement, and statement of cash flows, we can derive several financial ratios to serve as comparative metrics over time or between companies.
