Financial ratio

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In finance, a financial ratio or accounting ratio is a ratio of two selected numerical values taken from an enterprise's financial statements. 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. Security 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.

Ratios may be expressed as a decimal value, such as 0.10, or given as an equivalent percent 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%.


[edit] Sources of data for financial ratios

Values used in calculating financial ratios are taken from the balance sheet, income statement, statement of cash flows or (sometimes) the statement of retained earnings. 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 organization.

[edit] Purpose and types of ratios

Financial ratios quantify many aspects of a business and are an integral part of 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]

Financial ratios allow for comparisons

  • between companies
  • between industries
  • between different time periods for one company
  • between a single company and its industry average

Ratios generally hold no meaning 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.

[edit] 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 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.

[edit] 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 Shareholder's 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.

[edit] Other abbreviations

[edit] Ratios

[edit] Profitability ratios

Profitability ratios measure the firm'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]
\frac{\mbox{Gross Revenue}}{\mbox{Net Sales}}
\frac{\mbox{Net Sales -- COGS}}{\mbox{Net Sales}}
Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)[9][8]
\frac{\mbox{Operating Income}}{\mbox{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] [14]
\frac{\mbox{Net Income}}{\mbox{Net Sales}}
Return on equity (ROE) [14]
\frac{\mbox{Net Income}}{\mbox{Average Shareholders Equity}}
Return on investment (ROI ratio or Du Pont ratio)[6]
\frac{\mbox{Net Income}}{\mbox{Average Owners Equity}}
Return on assets (ROA)[15]
\frac{\mbox{Net Income}}{\mbox{Total Assets}}
Return on assets Du Pont (ROA Du Pont)[16]
\left(\frac{\mbox{Net Income}}{\mbox{Net Sales}}\right)\left(\frac{\mbox{Net Sales}}{\mbox{Total Assets}}\right)
Return on Equity Du Pont (ROE Du Pont)
\left(\frac{\mbox{Net Income}}{\mbox{Net Sales}}\right)\left(\frac{\mbox{Net Sales}}{\mbox{Average Assets}}\right)\left(\frac{\mbox{Average Assets}}{\mbox{Average Equity}}\right)
Return on net assets (RONA)
\frac{\mbox{Net Income}}{\mbox{Fixed Assets + Working Capital}}
Return on capital (ROC)
\frac{\mbox{Net Operating Profit -- Adjusted Taxes}}{\mbox{Owners Equity}}
Risk adjusted return on capital (RAROC)
\frac{\mbox{Expected Return}}{\mbox{Economic Capital}}
\frac{\mbox{Expected Return}}{\mbox{Value at Risk}}
Return on capital employed (ROCE)
\frac{\mbox{Net Income}}{\mbox{Capital Employed}}
Note: this is somewhat similar to (ROI), which calculates Net Income per Owner's Equity
Cash flow return on investment (CFROI)
\frac{\mbox{Cash Flow}}{\mbox{Market Recapitalisation}}
Efficiency ratio
\frac{\mbox{Non-Interest Income}}{\mbox{Net Interest Income + Non-Interest Income}}

[edit] Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

Current ratio[17]
\frac{\mbox{Current Assets}}{\mbox{Current Liabilities}}
Acid-test ratio (Quick ratio)[17]
\frac{\mbox{Current Assets -- (Inventories + Prepayments)}}{\mbox{Current Liabilities}}
Operation cash flow ratio
\frac{\mbox{Operation Cash Flow}}{\mbox{Total Debts}}

[edit] Activity ratios

Activity ratios measure the effectiveness of the firms use of resources.

Average collection period[3]
\frac{\mbox{Accounts Receivable}}{\mbox{Annual Credit Sales ÷ 365 Days}}
Degree of Operating Leverage (DOL)
\frac{\mbox{Percent Change in Net Operating Income}}{\mbox{Percent Change in Sales}}
DSO Ratio[18]
\frac{\mbox{Accounts Receivable}}{\mbox{Total Annual Sales ÷ 365 Days}}
Average payment period[3]
\frac{\mbox{Accounts Receivable}}{\mbox{Annual Credit Purchases ÷ 365 Days}}
Asset turnover[19]
\frac{\mbox{Net Sales}}{\mbox{Total Assets}}
Inventory turnover ratio[20][21]
\frac{\mbox{COGS}}{\mbox{Average Inventory}}
Receivables Turnover Ratio[22]
\frac{\mbox{Net Credit Sales}}{\mbox{Average Net Receivables}}
Inventory conversion ratio[4]
\frac{\mbox{365 Days}}{\mbox{Inventory Turnover}}
Inventory conversion period
\left (\frac{\mbox{Inventory}}{\mbox{COGS}}\right)\mbox{365 Days}
Receivables conversion period
\left (\frac{\mbox{Receivables}}{\mbox{Net Sales}}\right)\mbox{365 Days}
Payables conversion period
\left (\frac{\mbox{Purchases}}{\mbox{Accounts Payable}}\right)\mbox{365 Days}
Cash Conversion Cycle
Inventory Conversion Period + Receivables Conversion Period - Payables Conversion Period

[edit] Debt ratios

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

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

[edit] Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

Earnings per share (EPS)[25]
\frac{\mbox{Expected Earnings}}{\mbox{Number of Shares}}
Payout ratio[25][26]
P/E ratio
\frac{\mbox{Market Price per Share}}{\mbox{Diluted EPS}}
Cash flow ratio or Price/cash flow ratio[27]
\frac{\mbox{Market Price per Share}}{\mbox{Present Value of Cash Flow per Share}}
Price to book value ratio (P/B or PBV)[27]
\frac{\mbox{Market Price per Share}}{\mbox{Balance Sheet Price per Share}}
Price/sales ratio
\frac{\mbox{Market Price per Share}}{\mbox{Gross Sales}}
PEG ratio
\frac{\mbox{Price per Earnings}}{\mbox{Annual EPS Growth}}

Other Market Ratios

\frac{\mbox{Enterprise Value}}{\mbox{EBITDA}}
\frac{\mbox{Enterprise Value}}{\mbox{Net Sales}}
Cost/Income ratio

Sector-specific ratios


[edit] 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

[edit] See also

[edit] References

  1. ^ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc.. pp. 433. ISBN 0764112759. 
  2. ^ Groppelli, p. 434.
  3. ^ a b c Groppelli, p. 436.
  4. ^ a b Groppelli, p. 439.
  5. ^ Groppelli, p. 442.
  6. ^ a b Groppelli, p. 445.
  7. ^ Williams, P. 265.
  8. ^ a b Williams, p. 1094.
  9. ^ Williams, Jan R.; Susan F. Haka, Mark S. Bettner, Joseph V. Carcello (2008). Financial & Managerial Accounting. McGraw-Hill Irwin. pp. 266. ISBN 9780072996500. 
  10. ^ Operating income definition
  11. ^ Groppelli, p. 443.
  12. ^ Bodie, Zane; Alex Kane and Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 459. ISBN 0072510773. 
  13. ^ Professor Cram. "Ratios of Profitability: Profit Margin" 14 May 2008 <>
  14. ^ a b Groppelli, p. 444.
  15. ^ Professor Cram. "Ratios of Profitability: Return on Assets" 14 May 2008 <>
  16. ^ Professor Cram. "Ratios of Profitability: Return on Assets Du Pont" 14 May 2008 <>
  17. ^ a b Groppelli, p. 435.
  18. ^ Professor Cram. "Ratios of Asset Management Study Sheet" 14 May 2008 <>
  19. ^ Bodie, p. 459.
  20. ^ Groppelli, p. 438.
  21. ^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.
  22. ^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 800.
  23. ^ Groppelli, p. 440; Williams, p. 640.
  24. ^ a b c Groppelli, p. 441.
  25. ^ a b Groppelli, p. 446.
  26. ^ Groppelli, p. 449.
  27. ^ a b Groppelli, p. 447.
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