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Introduction
Financial ratios are used to express one financial quantity in relation to another
and can assist with company and security valuations, as well as with stock
selections, and forecasting.
A variety of categories may be used to classify financial ratios. Although the names
of these categories and the ratios that are included in each category can vary
significantly, common categories that are used include: activity, liquidity, solvency,
profitability, and valuation ratios. Each category measures a different aspect of a
company’s business; however, all are useful for evaluating a company’s overall
ability to generate cash flows from operating its business.
Activity Ratios
Activity ratios aka asset utilization ratios or operating efficiency ratios measure how
efficiently a company performs its daily tasks such as managing its various assets.
They generally combine income statement information in the numerator and
balance sheet information in the denominator.
The list below provides a list and description of the most commonly used activity
ratios:
Inventory turnover
Computation: Cost of goods sold/average inventory
Interpretation: The ratio can also be used to measure the effectiveness of inventory
management. A lower DOH implies that inventory is held for a shorter time period.
Receivables turnover
Computation: Revenue/Average receivables
Interpretation: This measures the elapsed time between a sale and cash collection,
and reflects how fast a company collects cash from customers to whom it offers
credit. A low DSO indicates that a company is efficient in its credit and collection
processes.
Payables turnover
Computation: Purchases/Average trade payables
Interpretation: This measures how many times per year a company theoretically
pays off all its creditors.
Interpretation: This reflects the average number of days that a company takes to
pay its suppliers.
Interpretation: This indicates how efficiently a company generates revenue with its
working capital. A high working capital turnover ratio indicates greater efficiency.
Liquidity Ratios
Liquidity ratios measure a company’s ability to satisfy its short-term obligations. The
list below provides a list and description of the most commonly used liquidity ratios.
These ratios reflect a company’s position at a point in time and, therefore, usually
uses ending balance sheet data rather than averages.
Current ratio
Computation: Current assets/Current liabilities
Quick ratio
Computation: Cash + Short-term marketable investments + Receivables/Current
liabilities
Interpretation: A higher quick ratio indicates a higher level of liquidity or ability to
meet short-term obligations. It is a better indicator of liquidity than the current ratio
in instances where inventory is illiquid.
Cash ratio
Computation: Cash + Short-term marketable investments/Current liabilities
Interpretation: This measures how long a company can pay its daily expenditures
using only its existing liquid assets, without any additional cash inflow.
Other ratios
In addition to the above ratios, the Cash conversion cycle is an additional liquidity
measure that can be used. Computed as DOH+ DSO – Number of days of payables,
it measures the length of time that is required for a company to go from cash paid
(used in operations) to cash received (as a result of operations).
Solvency Ratios
Solvency ratios measure a company’s ability to satisfy its long-term obligations.
They provide information relating to the relative amount of debt in a company’s
capital structure and the adequacy of earnings and cash flow to cover interest
expenses and other fixed charges as they fall due.
There are two types of solvency ratios: (i) debt ratios, which focus on the balance
sheet and measure the amount of debt capital relative to equity capital, and (ii)
coverage ratios, which focus on the income statement and measure the ability of a
company to cover its debt payments. Both sets of ratios are useful in assessing a
company’s solvency and evaluating the quality of its bonds and other debt
obligations.
The list below provides a list and description of the most commonly used solvency
ratios:
Debt-to-assets ratio
Computation: Total debt/Total assets
Interpretation: This measures the percentage of a company’s total asssets that are
financed with debt. A higher ratio implies higher financial risk and weaker solvency.
Debt-to-capital ratio
Computation: Total debt/Total debt + Total shareholders’ equity
Interpretation: This measures the percentage of a company’s capital(debt +equity)
that is represented by debt. A higher ratio implies higher financial risk and weaker
solvency.
Debt-to-equity ratio
Computation: Total debt/Total shareholders’ equity
Interpretation: This measures the amount of debt capital relative to equity capital. A
higher ratio implies higher financial risk and weaker solvency.
Interpretation: This measures the amount of total assets that is supported for each
one money unit of equity. The higher the ratio, the more leveraged the company in
its use of debt and other liabilities to finance assets.
Interpretation: This measures the number of times that a company’s EBIT could
cover its interest payments. A higher ratio indicates stronger solvency.
PROFITABILITY RATIOS
Profitability ratios measure a company’s ability to generate profits from its
resources (assets). There are two types of profitability ratios: (i) Return-on-sales
profitability ratios, which express various subtotals on the income statement as a
percentage of revenue, and(ii) Return-on-investment profitability ratios, which
measure income relative to the assets, equity, or total capital employed by a
company.
The list below provides a list and description of the most commonly used solvency
ratios:
Pretax margin
Computation: EBT (earnings before tax but after interest)/Revenue
Interpretation: This reflects the effect on profitability of leverage and other non-
operating income and expenses.
Operating ROA
Computation: Operating income/Average total assets
Interpretation: This measures the return (prior to deducting interest on debt capital)
that is earned by a company on its assets.
Interpretation: This measures the profits that a company earns on all of the capital
that it employs.
Interpretation: This measures the return earned by a company on its equity capital,
including minority equity, preferred equity, and common equity.
Interpretation: This measures the return earned by a company only on its common
equity.
Valuation Ratios
Valuation ratios measure the quantity of an asset or flow that is associated with the
ownership of a specified claim.
The list below provides a list and description of the most commonly used valuation
ratios:
Interpretation: This tells how much an investor in common stock pays per dollar of
earnings.
Interpretation: This measures a company’s market value relative to its cash flow.
Interpretation: This compares a stock’s market value to its book value and is often
used as an indicator of market judgment about the relationship between a
company’s required rate of return and its actual rate of return. A higher ratio implies
that investors expect management to create more value from a given set of assets,
all else equal.
Question 1
Using the following information on company ABC, what is company ABC’s net profit
margin?
Revenue: 5,276,987
A. 10.95%
B. 66.97%
C. 56.02%
Solution
Question 2
Which of the following categories of ratios could be used to evaluate a company’s
ability to pay back a bank loan?
A. Liquidity ratios
B. Solvency ratios
C. Profitability ratios
Solution