Financial Ratio Analysis
Financial ratio analysis is the process of calculating financial ratios, which are mathematical indicators calculated by comparing key financial information appearing in financial statements of a business, and analyzing those to find out reasons behind the business’s current financial position and its recent financial performance, and develop expectation about its future outlook.
For example, net profit margin is a financial ratio which compares a business’s net income with its net revenue to find out the dollars of profit the business earned per $100 of sales. Net profit margin ratio helps find out if a business is more profitable than its peers or for example if its profitability has increased over different periods.
Financial ratio analysis is very useful tool because it simplifies the process of financial comparison of two or more businesses. Direct comparison of financial statements is not efficient due to difference in the size of relevant businesses. Financial ratio analysis makes the financial statements comparable both among different businesses and across different periods of a single business.
There are different financial ratios to analyze different aspects of a business’ financial position, performance and cash flows. Financial ratios calculated and analyzed in a particular situation depend on the user of the financial statements. For example, a shareholder is primarily concerned about a business’s profitability and solvency; a debt-holder is concerned about its solvency, liquidity and profitability in the descending order of importance; a creditor/supplier is worried mainly about the business’ liquidity, etc.
Financial ratios can be broadly classified into liquidity ratios, solvency ratios, profitability ratios and efficiency ratios (also called activity ratios or asset utilization ratios). Other categories include cash flow ratios, market valuation ratios, coverage ratios, etc.
Liquidity ratios asses a business’s liquidity, i.e. its ability to convert its assets to cash and pay off its obligations without any significant difficulty (i.e. delay or loss of value). Liquidity ratios are particularly useful for suppliers, employees, banks, etc. Important liquidity ratios are:
Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc. Key solvency ratios are:
- Debt ratio
- Debt to equity ratio
- Debt to capital ratio
- Times interest earned ratio
- Fixed charge coverage ratio
- Equity multiplier
Profitability ratios measure the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios explain the financial position of a business, profitability ratios and efficiency ratios communicate the financial performance of a business. Important profitability ratios include:
- net profit margin
- gross profit margin
- operating profit margin
- return on assets
- return on capital employed
- return on equity
- earnings per share
Other ratios related to profitability that are used by investors to assess the stock market performance of a business include:
- price to earnings (P/E) ratio
- price to book (P/B) ratio
- Dividend payout ratio
- Dividend yield ratio
- Retention ratio
Activity ratios assess the efficiency of operations of a business. For example, these ratios attempt to find out how effectively the business is converting inventories into sales and sales into cash, or how it is utilizing its fixed assets and working capital, etc. Key activity ratios are:
- inventory turnover ratio
- days sales in inventory
- receivables turnover ratio
- days sales outstanding
- payables turnover ratio
- days payable outstanding
- fixed asset turnover ratio
- working capital turnover ratio
Cash flow ratios
Cash flow ratios are mainly used to assess the quality of earnings of a business. Since net income information is based on accrual concept, which is subject to significant management judgment, cash flows ratios (also called performance ratios) provide a more unbiased assessment. Example include cash flow per share.
Coverage ratios are supplementary to solvency and liquidity ratios and measure the risk inherent in lending to the business in long-term. They include EBIDTA coverage ratio, debt coverage ratio, interest coverage ratio (also known as times interest earned), fixed charge coverage ratio, etc.
Written by Obaidullah Jan, ACA, CFA