Financial Ratio Guide

Financial Ratios Guide

This guide provides an overview of key financial ratios used to assess a company’s financial health, operational efficiency, and valuation. Each ratio is explained with its formula, interpretation, and a practical example to illustrate its application.

Financial Ratio Analysis Overview

What is Ratio Analysis?

Ratio analysis involves using quantitative measures to evaluate a company’s financial performance. These ratios help financial analysts, investors, and managers assess financial health, make investment decisions, and compare companies across industries.

Why Use Ratio Analysis?

Ratio analysis allows comparison of companies of different sizes, quantifies operational efficiency, and evaluates solvency, aiding stakeholders in understanding profitability and risk.

Types of Ratios

Financial ratios are categorized into four main types:

Liquidity Ratios: Measure a company’s ability to meet short-term obligations.
Leverage Ratios: Assess the extent of debt financing in a company’s capital structure.
Efficiency Ratios: Evaluate how effectively a company uses its assets and resources.
Profitability Ratios: Measure a company’s ability to generate profit relative to revenue, assets, or equity.
Valuation Ratios: Used to determine a company’s market value relative to its earnings or revenue.

Profitability Ratios

Profitability ratios evaluate a company’s ability to generate profit relative to revenue, assets, operating costs, or equity. They are divided into return ratios and margin ratios.

A. Return Ratios

Return on Equity (ROE)

Overview: Measures the annual return (net income) relative to shareholders’ equity, expressed as a percentage.
Formula:
$$ \text{ROE} = \frac{\text{Net Income}}{\text{Shareholders’ Equity}} $$
Interpretation: A higher ROE indicates better profitability for shareholders. Comparing ROE to industry averages highlights competitive advantages.
Example: A company has a net income of $5 million and shareholders’ equity of $25 million.
$$ \text{ROE} = \frac{5,000,000}{25,000,000} = 0.2 \text{ or } 20\% $$
This means the company generates a 20% return on equity, which should be compared to industry peers.

Return on Assets (ROA)

Overview: Measures profitability relative to total assets, indicating how efficiently assets are used to generate profit.
Formula:
$$ \text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}} $$
Interpretation: A higher ROA suggests efficient asset utilization. ROA varies by industry, with capital-intensive industries typically having lower ROA.
Example: A company has a net income of $4 million and total assets of $40 million.
$$ \text{ROA} = \frac{4,000,000}{40,000,000} = 0.1 \text{ or } 10\% $$
This indicates the company earns 10 cents per dollar of assets.

Return on Capital Employed (ROCE)

Overview: Measures how efficiently a company uses its capital to generate profits.
Formula:
$$ \text{ROCE} = \frac{\text{EBIT}}{\text{Total Assets} – \text{Current Liabilities}} $$
Interpretation: A higher ROCE indicates efficient capital use. It should be used alongside other profitability ratios.
Example: A company has EBIT of $6 million, total assets of $50 million, and current liabilities of $10 million.
$$ \text{ROCE} = \frac{6,000,000}{50,000,000 – 10,000,000} = \frac{6,000,000}{40,000,000} = 0.15 \text{ or } 15\% $$
This shows a 15% return on capital employed.

B. Margin Ratios

Gross Margin Ratio

Overview: Compares gross profit to revenue, showing the percentage of revenue retained after cost of goods sold (COGS).
Formula:
$$ \text{Gross Margin Ratio} = \frac{\text{Total Revenue} – \text{COGS}}{\text{Total Revenue}} $$
Interpretation: A higher ratio indicates better profitability. Comparisons should be industry-specific.
Example: A company has revenue of $100 million and COGS of $60 million.
$$ \text{Gross Margin Ratio} = \frac{100,000,000 – 60,000,000}{100,000,000} = \frac{40,000,000}{100,000,000} = 0.4 \text{ or } 40\% $$
This means 40% of revenue is retained as gross profit.

Operating Profit Margin

Overview: Measures the percentage of profit from operations before taxes and interest.
Formula:
$$ \text{Operating Profit Margin} = \frac{\text{EBIT}}{\text{Total Revenue}} $$
Interpretation: A higher margin indicates efficient expense management. Useful in leveraged buyout analysis.
Example: A company has EBIT of $15 million and revenue of $100 million.
$$ \text{Operating Profit Margin} = \frac{15,000,000}{100,000,000} = 0.15 \text{ or } 15\% $$
This shows 15 cents of operating profit per dollar of revenue.

Net Profit Margin

Overview: Calculates the percentage of net profit relative to total revenue.
Formula:
$$ \text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Total Revenue}} $$
Interpretation: A higher margin indicates better overall profitability. Varies by industry.
Example: A company has net income of $10 million and revenue of $100 million.
$$ \text{Net Profit Margin} = \frac{10,000,000}{100,000,000} = 0.1 \text{ or } 10\% $$
This means 10 cents of net profit per dollar of revenue.

Leverage Ratios

Leverage ratios indicate the level of debt in a company’s capital structure and assess solvency.

Debt-to-Equity Ratio

Overview: Compares total debt to shareholders’ equity, showing the balance between debt and equity financing.
Formula:
$$ \text{Debt-to-Equity Ratio} = \frac{\text{Short-Term Debt} + \text{Long-Term Debt} + \text{Other Fixed Payments}}{\text{Shareholders’ Equity}} $$
Interpretation: A higher ratio indicates a leveraged firm, which may be riskier but beneficial for stable cash flow companies.
Example: A company has total debt of $50 million and equity of $120 million.
$$ \text{Debt-to-Equity Ratio} = \frac{50,000,000}{120,000,000} = 0.42 $$
This means 42 cents of debt per dollar of equity.

Equity Ratio

Overview: Measures the proportion of shareholders’ equity relative to total assets.
Formula:
$$ \text{Equity Ratio} = \frac{\text{Shareholders’ Equity}}{\text{Total Assets}} $$
Interpretation: A higher ratio indicates greater shareholder claim on assets. Expressed as a percentage.
Example: A company has equity of $15 million and total assets of $50 million.
$$ \text{Equity Ratio} = \frac{15,000,000}{50,000,000} = 0.3 \text{ or } 30\% $$
This shows 30% of assets are financed by equity.

Debt Ratio

Overview: Indicates the percentage of assets financed by debt.
Formula:
$$ \text{Debt Ratio} = \frac{\text{Short-Term Debt} + \text{Long-Term Debt}}{\text{Total Assets}} $$
Interpretation: A higher ratio indicates greater leverage and risk. A ratio above 1 suggests more liabilities than assets.
Example: A company has total debt of $30 million and total assets of $50 million.
$$ \text{Debt Ratio} = \frac{30,000,000}{50,000,000} = 0.6 \text{ or } 60\% $$
This means 60% of assets are financed by debt.

Efficiency Ratios

Efficiency ratios measure how effectively a company uses its assets and resources.

Accounts Receivable Turnover Ratio

Overview: Measures how many times a company collects its average accounts receivable in a period.
Formula:
$$ \text{Accounts Receivable Turnover Ratio} = \frac{\text{Net Credit Sales}}{\text{Average Accounts Receivable}} $$
Interpretation: A higher ratio indicates efficient collection. Compare to industry averages.
Example: A company has net credit sales of $46,800 (credit sales $50,000 – returns $3,200) and average accounts receivable of $4,500 (($6,000 + $3,000)/2).
$$ \text{Accounts Receivable Turnover Ratio} = \frac{46,800}{4,500} = 10.4 $$
The company collects receivables 10.4 times per year.

Accounts Receivable Days

Overview: Measures the average number of days to collect credit sales.
Formula:
$$ \text{Accounts Receivable Days} = \frac{\text{Number of Days in Period}}{\text{Accounts Receivable Turnover Ratio}} $$
Interpretation: A lower number indicates faster collection. Compare to industry averages.
Example: Using the above turnover ratio of 10.4 for a 365-day period.
$$ \text{Accounts Receivable Days} = \frac{365}{10.4} = 35.1 \text{ days} $$
It takes 35.1 days on average to collect receivables.

Asset Turnover Ratio

Overview: Measures how efficiently assets generate sales.
Formula:
$$ \text{Asset Turnover Ratio} = \frac{\text{Net Sales}}{\text{Average Total Assets}} $$
Interpretation: A higher ratio indicates efficient asset use. Industry-specific.
Example: A company has net sales of $100,000 and average total assets of $61,000 (($65,000 + $57,000)/2).
$$ \text{Asset Turnover Ratio} = \frac{100,000}{61,000} = 1.64 $$
This means $1.64 in sales per dollar of assets.

Inventory Turnover Ratio

Overview: Measures how many times a company sells its inventory in a period.
Formula:
$$ \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} $$
Interpretation: A higher ratio indicates efficient inventory management.
Example: A company has COGS of $3 million and average inventory of $305,000 (($350,000 + $260,000)/2).
$$ \text{Inventory Turnover Ratio} = \frac{3,000,000}{305,000} = 9.84 $$
The company sells its inventory 9.84 times per year.

Inventory Turnover Days

Overview: Measures the average number of days to sell inventory.
Formula:
$$ \text{Inventory Turnover Days} = \frac{\text{Number of Days in Period}}{\text{Inventory Turnover Ratio}} $$
Interpretation: A lower number indicates faster inventory turnover.
Example: Using the above turnover ratio of 9.84 for a 365-day period.
$$ \text{Inventory Turnover Days} = \frac{365}{9.84} = 37.1 \text{ days} $$
It takes 37.1 days to sell the entire inventory.

Liquidity Ratios

Liquidity ratios assess a company’s ability to meet short-term and long-term debt obligations.

A. Asset Ratios

Current Ratio

Overview: Measures the ability to pay short-term obligations with current assets.
Formula:
$$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$
Interpretation: A ratio above 1 indicates financial health, but too high suggests underutilized cash.
Example: A company has current assets of $60 million and current liabilities of $30 million.
$$ \text{Current Ratio} = \frac{60,000,000}{30,000,000} = 2 $$
The company can cover its liabilities twice with current assets.

Quick Ratio

Overview: Measures the ability to pay short-term liabilities with liquid assets (cash, marketable securities, accounts receivable).
Formula:
$$ \text{Quick Ratio} = \frac{\text{Cash} + \text{Marketable Securities} + \text{Accounts Receivable}}{\text{Current Liabilities}} $$
Interpretation: A ratio above 1 indicates strong liquidity.
Example: A company has cash of $20 million, marketable securities of $10 million, accounts receivable of $18 million, and current liabilities of $25 million.
$$ \text{Quick Ratio} = \frac{20,000,000 + 10,000,000 + 18,000,000}{25,000,000} = \frac{48,000,000}{25,000,000} = 1.92 $$
The company can cover liabilities 1.92 times with liquid assets.

Cash Ratio

Overview: Measures the ability to pay short-term liabilities with cash and cash equivalents.
Formula:
$$ \text{Cash Ratio} = \frac{\text{Cash} + \text{Cash Equivalents}}{\text{Current Liabilities}} $$
Interpretation: A ratio between 0.5 and 1 is preferred. Too high suggests underutilized cash.
Example: A company has cash of $10 million, treasury bills of $5 million, and current liabilities of $25 million.
$$ \text{Cash Ratio} = \frac{10,000,000 + 5,000,000}{25,000,000} = \frac{15,000,000}{25,000,000} = 0.6 $$
The company can cover 60% of liabilities with cash.

Defensive Interval Ratio (DIR)

Overview: Indicates how many days a company can operate without tapping long-term assets.
Formula:
$$ \text{DIR} = \frac{\text{Current Assets}}{\text{Daily Expenditures}} $$
Interpretation: A higher DIR indicates better liquidity. Compare to industry peers.
Example: A company has current assets of $55,000 ($30,000 cash, $7,000 receivables, $18,000 securities), annual operating expenses of $270,000, and depreciation of $23,000. Daily expenditures = $\frac{270,000 – 23,000}{365} = 676.7$.
$$ \text{DIR} = \frac{55,000}{676.7} = 81.28 \text{ days} $$
The company can operate for 81 days without long-term assets.

B. Earnings Ratios

Times Interest Earned (TIE) Ratio

Overview: Measures the ability to meet interest payments using EBIT.
Formula:
$$ \text{TIE Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}} $$
Interpretation: A higher ratio indicates lower default risk.
Example: A company has EBIT of $7.8 million and interest expense of $1.2 million.
$$ \text{TIE Ratio} = \frac{7,800,000}{1,200,000} = 6.5 $$
The company can cover interest 6.5 times.

C. Cash Flow Ratios

Times Interest Earned (Cash-Basis) Ratio (TIE-CB)

Overview: Measures the ability to meet interest payments using adjusted operating cash flow.
Formula:
$$ \text{TIE-CB Ratio} = \frac{\text{Adjusted Operating Cash Flow}}{\text{Interest Expense}} $$
Interpretation: A higher ratio indicates strong cash-based debt coverage.
Example: A company has cash flow from operations of $15,000, fixed costs of $6,000 (advertising $2,500, rent $3,000, utilities $500), taxes of $500, and interest of $1,000. Adjusted cash flow = $15,000 + 6,000 + 500 = 21,500$.
$$ \text{TIE-CB Ratio} = \frac{21,500}{1,000} = 21.5 $$
The company can cover interest 21.5 times with cash flow.

CAPEX to Operating Cash Ratio

Overview: Assesses the proportion of operating cash flow used for capital expenditures.
Formula:
$$ \text{CAPEX to Operating Cash Ratio} = \frac{\text{Capital Expenditures}}{\text{Cash Flow from Operations}} $$
Interpretation: A higher ratio indicates focus on growth but may signal liquidity risks if too high.
Example: A company has capital expenditures of $50,000 and cash flow from operations of $200,000.
$$ \text{CAPEX to Operating Cash Ratio} = \frac{50,000}{200,000} = 0.25 \text{ or } 25\% $$
25% of operating cash is used for capital expenditures.

Operating Cash Flow Ratio

Overview: Measures how well operating cash flow covers current liabilities.
Formula:
$$ \text{Operating Cash Flow Ratio} = \frac{\text{Cash Flow from Operations}}{\text{Current Liabilities}} $$
Interpretation: A ratio above 1 indicates strong liquidity from operations.
Example: A company has cash flow from operations of $120,000 and current liabilities of $100,000.
$$ \text{Operating Cash Flow Ratio} = \frac{120,000}{100,000} = 1.2 $$
The company can cover liabilities 1.2 times with operating cash flow.

Valuation Ratios

Valuation ratios help determine a company’s market value relative to earnings or revenue.

A. Price Ratios

Price-to-Earnings (P/E) Ratio

Overview: Compares stock price to earnings per share (EPS), indicating market expectations.
Formula:
$$ \text{P/E Ratio} = \frac{\text{Share Price}}{\text{Earnings per Share}} $$
Interpretation: A high P/E suggests growth expectations; a low P/E may indicate undervaluation.
Example: A company’s stock price is $30, and EPS is $2.
$$ \text{P/E Ratio} = \frac{30}{2} = 15 $$
Investors pay $15 per dollar of earnings.

B. Enterprise Value Ratios

EV/EBITDA Ratio

Overview: Compares enterprise value to EBITDA, used for valuation comparisons.
Formula:
$$ \text{EV/EBITDA} = \frac{\text{Enterprise Value}}{\text{EBITDA}} $$
Interpretation: A lower ratio may indicate undervaluation. Used for peer comparisons.
Example: A company has an enterprise value of $114 million (market cap $100 million + net debt $14 million) and EBITDA of $10 million.
$$ \text{EV/EBITDA} = \frac{114,000,000}{10,000,000} = 11.4 $$
The company’s value is 11.4 times its EBITDA.

EV/EBIT Ratio

Overview: Compares enterprise value to EBIT, including depreciation for capital-intensive firms.
Formula:
$$ \text{EV/EBIT} = \frac{\text{Enterprise Value}}{\text{EBIT}} $$
Interpretation: Similar to EV/EBITDA but accounts for depreciation.
Example: Using the same company with EBIT of $13 million.
$$ \text{EV/EBIT} = \frac{114,000,000}{13,000,000} = 8.77 $$
The company’s value is 8.77 times its EBIT.

EV/Revenue Ratio

Overview: Compares enterprise value to revenue, useful for companies with negative EBITDA.
Formula:
$$ \text{EV/Revenue} = \frac{\text{Enterprise Value}}{\text{Revenue}} $$
Interpretation: A lower ratio may indicate undervaluation, especially for early-stage companies.
Example: The company has revenue of $100 million.
$$ \text{EV/Revenue} = \frac{114,000,000}{100,000,000} = 1.14 $$
The company’s value is 1.14 times its revenue.

Valuation Ratios Comparison

Ratio	Pros	Cons
P/E	Widely used, easy to calculate	Affected by accounting policies
EV/EBITDA	Incorporates profitability, ignores accounting differences	Ignores depreciation, CAPEX, tax profiles
EV/EBIT	Useful for capital-intensive firms	Ignores tax profiles, accounting differences
EV/Revenue	Suitable for negative EBITDA firms	Does not address revenue quality or profitability

Pyramid of Ratios

The pyramid of ratios breaks down ROE into profitability, efficiency, and leverage components, providing a comprehensive view of financial performance. It’s useful for horizontal analysis (tracking a company over time) and benchmarking (comparing to peers). For detailed guidance, refer to CFI’s Financial Analysis Fundamentals course.