Financial ratios are primarily used to interpret the data provided in a company’s financial accounts and other sources, to analyse the company’s performance and financial situation. The majority of the ratios can be easily calculated using the information provided in the financial statements and other publicly available information such as the share price. Financial ratios are expressed in proportional, or percentage, terms, allowing comparisons between firms of different sizes.
Financial ratios generally focus on certain areas of the company, allowing them to be divided into five categories:
- Liquidity ratios
- Operational efficiency ratios
- Financial leverage ratios
- Profitability ratios
- Dividend policy ratios
Liquidity ratios are generally used to determine a firm’s level of financial liquidity, in other words its ability to meet any short term financial obligations based on the level of assets held. As such, they are generally used by providers of finance and investors worried about the health of a company. There are three main ratios used:
The current ratio is a measure of how well the company’s current assets can cover its current liabilities:
Current Ratio = Current Assets / Current Liabilities
A high current ratio indicates that a firm is holding a large level of current assets relative to its current liabilities. This indicates that the firm is relatively solvent, in that it is likely to raise more cash in the next year from its assets than it will have to pay out in its liabilities. However, a current ratio which is too high can indicate that the firm is not being efficient in managing its current assets, such as not selling its inventory or not collecting its debts from customers. In general, a current ratio of 1 is taken as an indication that a firm is relatively solvent, however this can depend on the industry.
The quick ratio is similar to the current ratio, but it excludes the firm’s inventory. This is because inventory is generally harder to dispose of quickly, and hence is unlikely to be useful if short term debts have been called in:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
The quick ratio often is referred to as the acid test ratio, as it tests how well the firm could cover its debts in an ‘acid test’ where quick repayment of short term debts was required.
The final liquidity ratio is the cash ratio, which only includes cash and equivalent securities as current assets:
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
Marketable securities are defined as any investment which can be rapidly sold at or close to market price, such as shares or bonds. As such, the cash ratio shows how well a firm could cover its liabilities using assets that are instantly available. This is the most conservative financial ratio and is generally only used in the most risky industries.
Operational Efficiency Ratios
Operational efficiency ratios are an indicator of how efficient a firm is at managing its assets and liabilities to generate revenue. As such, they are often called asset turnover or asset management ratios. The most common ratios in this category are receivables turnover, payables turnover and inventory turnover.
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Receivables turnover shows how many times a company turns over its total trade receivables every year. In other words, it shows how quickly a firm collects its trade receivables, and hence how good it is at collecting customer debts:
Receivables Turnover = Annual Credit Sales / Trade Receivables
Where the annual credit sales can be found from the income statement or management accounts, and the trade receivables are on the balance sheet. If annual credit sales are not available, total revenue can be used as a substitute however this should be stated in the calculation.
The receivables turnover can also be shown as the average number of days the firm takes to settle its accounts with its consumers. This measure is termed the company’s debtor days, and can be calculated as follows:
Debtor days = Trade Receivables * 365 / Annual Credit Sales
The debtor days ratio is seen as a key indicator of the efficiency of a company’s customer credit option. If the debtor days ratio is too high, then a company is not collecting its debts very well, is essentially extending large interest free loans to its customers, and may have trouble calling in its trade receivables if it encounters liquidity trouble. However, if the debtor days ratio is too low, then the company may be being too aggressive with customers, and could be losing sales due to not giving customers decent payment terms. As such, the debtor days and receivables turnover ratios should always be compared to the industry averages or benchmarks.
The counterpart to receivables turnover is payables turnover. Payables turnover measures how many times a company pays off all its trade payables every year. This is a key measure of the efficiency of the finance department at paying the invoices generated by the purchasing department:
Payables Turnover = Annual Credit Purchases / Trade Payables
Again, if annual credit purchase figures are not available, cost of sales or cost of goods sold can be used instead.
Similar to the receivables turnover ratio, payables turnover can be expressed in days, using the formula for creditor days:
Creditor Days = Trade Payables * 365 / Annual Credit Purchases
With this ratio, a high creditor days figure indicates that a firm is being too slow paying its suppliers, and could receive better payment terms and lower prices if it were to negotiate faster payment. Failing to pay suppliers on time can also be seen as an indication that the firm is having liquidity trouble and is not a reliable creditor. However, if creditor days are too low, the firm may not be making best use of its working capital: by paying suppliers a little later, the company could use the cash to invest in the business and generate more profits. Again, creditor days and payables turnover figures should be compared to the industry average or benchmark.
The inventor turnover ratio is a measure of how well the firm turns over its inventory to generate sales. As such, it is represented as:
Inventory Turnover = Cost of Goods Sold / Average Inventory
Or in inventory days as:
Inventory Days = Average Inventory * 365 / Cost of Goods Sold
In this case, inventory and cost of goods sold figures are generally always available from the financial accounts.
The inventory days figure is an indication of how long the firm holds stock, on average, before selling it. A high figure indicates that the company is not very efficient at turning over its inventory, and hence is holding high levels of inventory which may cause costs to rise. A low figure for inventory days can indicate that the firm is not holding enough stock, and may experience stock shortages. However, note that some companies, such as Toyota, specifically hold low amounts of inventory as part of a just in time production system. As such, their inventory days will likely be lower than the industry average.
Financial Leverage Ratios
The third category of ratios, financial leverage ratios, examines the long term solvency of a company. As such, they are similar to the liquidity ratios, except that whilst the liquidity ratios concentrate on short term debts, the financial leverage ratios focus on levels of long term debt.
There are three main financial leverage ratios: the debt ratio, the debt to equity ratio and the interest coverage ratio:
Debt Ratio = Total Debt / Total Assets
Debt-to-Equity Ratio = Total Debt / Total Equity
Interest Coverage = Earnings Before Interest and Taxation / Interest Charges
It is important to note that both the debt ratio and the debt to equity ratio use total debt as the numerator, and not total liabilities. As such, it is important to be careful when defining which liabilities represent financial debt. In general, deferred taxation, trade payables and similar items are defined as operational liabilities, and would not be treated as debt. Loans, notes issued, bonds issued and overdrafts are some of the most common types of debt.
The debt ratio measures how much of the firm’s assets are financed by debt. A high debt ratio indicates that, should the firm have trouble paying its debts, creditors might not get all of their money back. In addition, if the market value of the firm’s assets falls for any reason, the firm’s total debt may exceed its total assets; which would cause the firm to become insolvent. As such, a company with a debt ratio close to 100% would be seen as a risky investment.
The debt to equity ratio is a similar measure, indicating how the firm’s total debt compares to the shareholders’ equity. Again, a high debt to equity ratio indicates that the firms is primarily financed by debt, and may be vulnerable to insolvency. However, a low debt to equity ratio can indicate that a firm is being excessively cautious, and not maximising its shareholder value by not gearing the shareholders’ funds efficiently.
The interest coverage ratio indicates the extent to which a company’s operating profit can cover any interest payments due on its debt. A low interest coverage ratio indicates that debt repayments are taking up much of the company’s profits, and the company may have taken on too much debt, or debt that is too expensive. In contrast, a high interest coverage ratio may indicate that the firm is being too cautious with its leverage, and hence is not maximising shareholder value.
Profitability ratios are intended to measure how well the firm is producing profits from its assets, revenues and equity.
The gross and net profit margins measure how well the firm is performing in terms of generating profit from its revenue. The gross profit margin is based solely on sales versus cost of goods sold, whilst the net profit margin is based on sales versus all costs, including taxation:
Gross Profit Margin = (Total Revenue - Cost of Goods Sold) / Total Revenue
Net Profit Margin = (Net Profit After Taxes) / Total Revenue
As part of shareholder value maximisation goals, it is expected that a firm will look to maximise its gross and net profit margins. A low gross profit margin indicates that a company is incurring too many direct costs in its operations, whilst a low net profit margin indicates that indirect and fixed costs are too high.
The other main profitability ratios measure the firm’s return on assets and return on equity. These both measure how well the firm is generating profits from its assets and shareholder equity:
Return on Assets = Net Income After Taxes / Total Assets
Return on Equity = Net Income After Taxes / Shareholder Equity
Again, both these ratios should be as high as possible in order to fulfil shareholder maximisation goals. However, it is important to assess them in the context of the financial leverage ratios discussed in the previous section. A company with a high return on equity but a high debt to equity ratio may have taken on excessive debt, and could be vulnerable to a downturn.
Dividend Policy Ratios
Dividend policy ratios demonstrate how much profits the firm is returning to its shareholders in terms of dividends. The main two ratios are the dividend yield ratio and the payout ratio.
Dividend Yield = Dividends Per Share / Share Price
Payout Ratio = Dividends Per Share / Earnings Per Share
The dividend yield is often used as a measure of whether a share is cheap or expensive. However, it is important to note that a high dividend yield does not imply a high rate of return. Indeed, an excessively high dividend yield could indicate that a company is struggling to find profitable investments for its profits, and hence is returning them to shareholders. This could be indicated by an increase in the payout ratio, which indicates what proportion of profits are being returned to shareholders, and hence which portion are being reinvested
Limitations of Financial Ratios
- On their own, most financial ratios are fairly meaningless. They can only be meaningfully interpreted when compared to similar ratios, including historical values for the same company, industry standards, or the ratios of competing companies.
- In addition, most ratios should be considered in the context of other ratios. For example, comparing the return on equity and the debt to equity ratio for a firm will demonstrate the firm’s level of financial risk and performance, and how these are related.
- Some ratios, such as the operational efficiency ratios, use year-end values for figures such as inventory and trade payables and receivables. These values may not be representative of the actual figures throughout the years, as seasonal variations may have affected them.
- Different accounting standards and methods can change the value of certain ratios. As such, the accounting policy of a company, and any changes in that policy, should be considered when analysing the company’s ratios.