Financial Ratios

In Bus501 and Bus502 we have been learning about financial ratios. There are five categories of financial ratios that tell a story about the companies financial position, management of assets, use of debt to finance assets, profitability and returns, and market value. Keep in mind that users of financial statements look at different ratios depending on their purpose. Each ratio by itself means something, but investors will look at all the ratios to use as one piece of their decision making process. Creditors may only be interested in a companies liquidity for short-term financing, and shareholders likely want to know what is my rate of return and dividend payout. Also, ratios are usually measured against that company's industry standard. In the absence of an industry standard one would compare the ratios against several companies within the same industry.

The first group of ratios is the liquidity ratios which are the current asset, quick, and cash ratio. The current and quick ratios are two of the most commonly referred to with the quick ratio measuring how many dollars of current assets per dollar of current liabilities. The quick ratio subtracts inventory from current assets since inventory isn't readily convertible to cash. The most liquid asset is cash and so a cash ratio of 1:1 says that the company can pay off all their current liabilities with just cash.

The next set of ratios tell the story about how a company manages their assets which would be inventory, accounts receivable, and total assets. All three of these assets are measured against sales. The inventory ratio tells how fast they are turning over their inventory. A company with a low turnover ratio in comparison may indicate stagnant inventory which may have to be written down. The accounts receivable ratio measures how quickly the company collects from their customers. It is measured by taking accounts receivable and dividing it by the average daily sales. A high receivables turnover ratio in comparison would likely indicate that the company was ineffective in managing the collection of accounts receivable. The ineffective management of accounts receivable and inventory would lead to higher working capital and the need for increasing short-term debt. The total asset turnover ratio measures the effectiveness of asset utilization in generating sales. The ratio measures the amount of sales generated for each dollar of assets.

Another area that a company is evaluated on is long-term debt. Long-term debt is a necessary source of funds to finance the purchase of long-term assets which will be used to generate sales and profit. There needs to be a balance between debt and equity. A company that is highly leveraged which means they are principally using debt to finance their assets is susceptible to the negative impact of high interest costs especially so when the company goes through a recession or cyclical downturn. The long-term debt ratio measures how many dollars of debt for each dollar of assets. This ratio should not be over one and should probably be around 50%.

The next set of ratios measure a company's profitability. Profit margin, return on assets, and return on equity are three of the more common ratios used to measure a company's profitability. Return on assets (ROA) measures the percent of profit for each dollar of assets. Corporations are often interested in this statistic which is referred to as RONA (Return on net assets)which is slightly different than ROA. Companies that are considering an acquisition or major capital expenditure will calculate a payback or return on investment that must meet the companies required rate of return before they will consider the investment. Shareholders will additionally want to look at profit margin and return on equity. Profit margin is especially meaningful because it tells what percent of sales is net income which is used to calculate earnings per share. A quarterly upward trend in profit margin is a strong indicator that a company is improving their gross margin and controlling their SG&A expenses. Return on equity tells an investor what their rate of return is on their investment. ROE measures the rate of return generated by the shareholders' net worth which is assets minus liabilities.

The last set of ratios is market value ratios. These ratios often tell how a company is perceived by investors. Several profitability ratios would be Price Earnings (PE), PEG (Price Earnings Growth), and cash flow. The PE ratio measures how many dollars of the market price for each dollar of earnings an investor is willing to pay. Corporations forecasting strong growth in revenue and earnings will demand a higher earnings per share price than a mature company with stable earnings but low growth. The PEG measures the ratio of the price (trading price) an investor is willing to pay for each dollar of earnings for each percent of sales growth. A high PEG ratio can be a good indicator for companies perceived to be growing quickly. A low PEG ratio of one or below could indicate that investors have overlooked the value of the company or they aren't very positive about the company's future growth prospects.

This was a good exercise for me to see how much I have learned about financial ratios, and hopefully it was helpful to those who read this.