Financial ratio

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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. [1] If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Contents

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

Federal debt to Federal revenue ratio Federal debt to Federal revenue ratio.webp
Federal debt to Federal revenue ratio

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. Liquidity ratios measure the availability of cash to pay debt. [2] Activity ratios measure how quickly a firm converts non-cash assets to cash assets. [3] Debt ratios measure the firm's ability to repay long-term debt. [4] Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return. [5] Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. [6] 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

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.

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.)

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

Gross margin, Gross profit margin or Gross Profit Rate [7] [8]
Gross Profit/Net Sales :::OR :::Net Sales - COGS/Net Sales
Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS) [8] [9]
Operating Income/Net Sales
  • Note: 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. [10] This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales [11] [12] )
Profit margin, net margin or net profit margin [13]
Net Profit/Net Sales
Return on equity (ROE) [13]
Net Income/Average Shareholders Equity
Return on assets (ROA ratio or Du Pont Ratio) [6]
Net Income/Average Total Assets
Return on assets (ROA) [14]
Net Income/Total Assets
Return on assets Du Pont (ROA Du Pont) [15]
Net Income/Net Sales ·Net Sales/Total Assets
Return on Equity Du Pont (ROE Du Pont)
Net Income/Net Sales ·Net Sales/Average Assets ·Average Assets/Average Equity
Return on net assets (RONA)
Net Income/Fixed Assets + Working Capital
Return on capital (ROC)
EBIT(1 − (Tax Rate))/Invested Capital
Risk adjusted return on capital (RAROC)
Expected Return/Economic Capital :::OR :::Expected Return/Value at Risk
Return on capital employed (ROCE)
EBIT/Capital Employed
  • Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity
Cash flow return on investment (CFROI)
Cash Flow/Market Recapitalisation
Efficiency ratio
Non-Interest expense/Revenue
Net gearing
Net debt/Equity
Basic Earnings Power Ratio [16]
EBIT/Total Assets

Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio (Working Capital Ratio) [17]
Current Assets/Current Liabilities
Acid-test ratio (Quick ratio) [17]
Current Assets (Inventories + Prepayments)/Current Liabilities
Cash ratio [17]
Cash and Marketable Securities/Current Liabilities
Operating cash flow ratio
Operating Cash Flow/Total Debts

Activity ratios (efficiency ratios)

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

Average collection period [3]
Accounts Receivable/Annual Credit Sales × 365 Days
Degree of Operating Leverage (DOL)
Percent Change in Net Operating Income/Percent Change in Sales
DSO Ratio. [18]
Accounts Receivable/Total Annual Sales × 365 Days
Average payment period [3]
Accounts Payable/Annual Credit Purchases × 365 Days
Asset turnover [19]
Net Sales/Total Assets
Stock turnover ratio [20] [21]
Cost of Goods Sold/Average Inventory
Receivables Turnover Ratio [22]
Net Credit Sales/Average Net Receivables
Inventory conversion ratio [4]
365 Days/Inventory Turnover
Inventory conversion period (essentially same thing as above)
Inventory/Cost of Goods Sold × 365 Days
Receivables conversion period
Receivables/Net Sales × 365 Days
Payables conversion period
Accounts Payables/Purchases × 365 Days
Cash Conversion Cycle
(Inventory Conversion Period) + (Receivables Conversion Period) (Payables Conversion Period)

Debt ratios (leveraging ratios)

Debt ratios quantify the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

Debt ratio [23]
Total Liabilities/Total Assets
Debt to equity ratio [24]
(Long-term Debt) + (Value of Leases)/(Average Shareholders Equity)
Long-term Debt to equity (LT Debt to Equity) [24]
(Long-term Debt)/(Average Shareholders Equity)
Times interest earned ratio (Interest Coverage Ratio) [24]
EBIT/Annual Interest Expense
OR
Net Income/Annual Interest Expense
Debt service coverage ratio
Net Operating Income/Total Debt Service

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.

Earnings per share (EPS) [25]
Net Earnings/Number of Shares
Payout ratio [25] [26]
Dividends/Earnings
OR
Dividends/EPS
Dividend cover (the inverse of Payout Ratio)
Earnings per Share/Dividend per Share
P/E ratio
Market Price per Share/Diluted EPS
Dividend yield
Dividend/Current Market Price
Cash flow ratio or Price/cash flow ratio [27]
Market Price per Share/Present Value of Cash Flow per Share
Price to book value ratio (P/B or PBV) [27]
Market Price per Share/Balance Sheet Price per Share
Price/sales ratio
Market Price per Share/Gross Sales
PEG ratio
Price per Earnings/Annual EPS Growth

Other Market Ratios

EV/EBITDA
Enterprise Value/EBITDA
EV/Sales
Enterprise Value/Net Sales
Cost/Income ratio

Sector-specific ratios

EV/capacity
EV/output

Capital budgeting ratios

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

See also

Related Research Articles

Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.

<span class="mw-page-title-main">Equity (finance)</span> Ownership of property reduced by its liabilities

In finance, equity is an ownership interest in property that may be offset by debts or other liabilities. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets owned. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.

This page is an index of accounting topics.

<span class="mw-page-title-main">Revenue</span> Total amount of income generated by the sale of goods or services

In accounting, revenue is the total amount of income generated by the sale of goods and services related to the primary operations of the business. Commercial revenue may also be referred to as sales or as turnover. Some companies receive revenue from interest, royalties, or other fees. "Revenue" may refer to income in general, or it may refer to the amount, in a monetary unit, earned during a period of time, as in "Last year, Company X had revenue of $42 million". Profits or net income generally imply total revenue minus total expenses in a given period. In accounting, revenue is a subsection of the Equity section of the balance statement, since it increases equity. It is often referred to as the "top line" due to its position at the very top of the income statement. This is to be contrasted with the "bottom line" which denotes net income.

In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be tangible book value.

<span class="mw-page-title-main">Financial accounting</span> Field of accounting

Financial accounting is a branch of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.

In financial accounting, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets. It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company's financial flexibility and is of interest to holders of the company's equity, debt, preferred stock and convertible securities, as well as potential lenders and investors.

In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt, and preferred stock, and is detailed in the company's balance sheet. The larger the debt component is in relation to the other sources of capital, the greater financial leverage the firm is said to have. Too much debt can increase the risk of the company and reduce its financial flexibility, which at some point creates concern among investors and results in a greater cost of capital. Company management is responsible for establishing a capital structure for the corporation that makes optimal use of financial leverage and holds the cost of capital as low as possible.

Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial analysis, accounting, portfolio analysis, and risk analysis.

Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

<span class="mw-page-title-main">Net income</span> Measure of the profitability of a business venture

In business and accounting, net income is an entity's income minus cost of goods sold, expenses, depreciation and amortization, interest, and taxes for an accounting period.

<span class="mw-page-title-main">DuPont analysis</span> Expression which breaks ROE (return on equity) into three parts

DuPont analysis is a tool used in financial analysis, where return on equity (ROE) is separated into its component parts.

In business, operating margin—also known as operating income margin, operating profit margin, EBIT margin and return on sales (ROS)—is the ratio of operating income to net sales, usually expressed in percent.

In finance, leverage, also known as gearing, is any technique involving borrowing funds to buy an investment.

The return on equity (ROE) is a measure of the profitability of a business in relation to its equity; where:

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

In economics, valuation using multiples, or "relative valuation", is a process that consists of:

<span class="mw-page-title-main">Financial statement analysis</span>

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, valuation, financial health, and future prospects of an organization.

The following outline is provided as an overview of and topical guide to finance:

References

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  15. Professor Cram. "Ratios of Profitability: Return on Assets Du Pont", College-Cram.com. 14 May 2008
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  25. 1 2 Groppelli, p. 446.
  26. Groppelli, p. 449.
  27. 1 2 Groppelli, p. 447.