Learn Financial Ratios A to Z

Financial ratio analysis is also referred to as ratio analysis. There are many ways through which together or alone can be used to assist the investors assess the financial stability of an organization. One of the most common is the use of financial ratio analysis. It basically includes 5 types of financial ratio, which are discussed later.

Users of financial statements understand that financial ration analysis plays a crucial role in helping them understand the various items reported in the financial statements.

It utilizes ration and relationships between various statements of accounts as basic tool to compare financial, operational and investing performance of a company over time, against each other.

Investors and users of financial information often need to measure the financial health and performance of an organization. This is done for purposes of evaluating business success; compare current, past performance, current organization performance against similar organizations and industry standards. A desirable business organization is the one which is stable, because financially stable businesses ensure the ability to generate income for its investors and retain/increase in value.

Ration analysis is essentially concerned with calculation of relationship that after successful identification and interpretation will provide information about the operations and current state of affairs of the enterprise, or business.

Some of the users of financial ratio analysis include managers within the firm, creditors, potential shareholders, analysts among others.

If shares of a given company are to be traded n a financial market, the market price of shares is used in a given financial ratio.

Purposes and considerations of financial ratio analysis

Ratio analysis is highly important as a profit tool in the financial analysis that helps analysts interpret the results that improve the liquidity, profitability, reordering financial structure, interest coverage and leverage.

Though ratio analyses reports are often on past performance, they can be used as predictive tools, and provide users with indications of areas of potential problems.

As said earlier, ration analysis is manly used to compare company’s figure in a given period of time, a method at times referred to as Trend analysis. It helps you identify good and bad trends and adjust the business practices accordingly. You also get the picture of how stuck your business is against other businesses, both in and out of the industry.

Nevertheless, when comparing the rates from one financial time to the other or between a company and the other, several considerations must be taken into account;

If you are making comparative analysis of the financial statement of a company for a given time period, make an allowance for any changes in the account policies that may arise during that time span.

When comparing your business wit others in the industry, allow for material differences n the accounting policies between your business and the industry norms.

When comparing financial ratios from various companies or fiscal periods, inquire on the type of accounting policies used, as different methods of accounting can result in a wide variation of results.

Determine if the ratios were calculated before or after adjustments made on the income statement or the balance sheet, such as inventory, non-recurring items or proforma adjustments. In most cases, the adjustments can be significantly affecting the outcome of the ratio analysis.

Carefully review any department from the industry norms

Types of ratios

  • Liquidity ratio
  • Profitability ratio
  • Efficiency ratio
  • Leverage ratio

Liquidity ratio

These are rations that relate to the company’s short time survival. They are helpful for the short term creditors, suppliers, bankers and most important to the financial managers who need to meet the obligations to credit suppliers, as well as government agencies.

Complete liquidity ratio can assist in uncovering weaknesses in the financial positioning of the business. The common liquidity ratios are;

  • Current ratio
  • Current cash debt coverage ratio
  • Quick (acid) test

Current ratio

This is the type of ratio which compares the current assets of a company to the current liabilities. It also measures the ability of the company to cover its short term obligation.

Current ratio = Current assets/Current liabilities

The test of solvency balances the current assets and liabilities. The ratio discloses the changes in balance sheet which the net working capital may not.

Quick ratio

Is also referred to as ‘acid test’. It is a ratio that specifies whether the current assets can be quickly converted into cash that would be enough to cover for current liabilities.

Quick ratio=market securities + net account receivables/Current liabilities

Before current ratio 2:1 was introduced, a firm that had additional quick assets available to its creditors was believed to have a sound financial condition.

NB: The quick ratio (acid test) assumes that all assets have equal liquidity. Receivables are one step closer to the liquidity than inventory. Nevertheless, sale is not complete till when the money is in hand.

Profitability ratios

In this section, the financial analyses focus on measures of financial performance and corporate profitability. These ratios give users good understanding of how well a business utilizes its resources in generating shareholders and profit value.

The long term profitability for any company is vital for survivability of the company ad the benefits received by the stakeholders

Gross profit margin

This is a measure of gross profit earned n sales. It considers the cost of goods sold from the firm, but doesn’t consider other costs associated

Gross profit = sales-cost of sales / Sales

The ratio also identifies whether average markup on the goods normally cover the expenses, and hence determine whether there is any profit realization.

Profit margin on sales

Measures the company’s efficiency in conversation of sale into net income

Return on assets

The ratio indicates how profitable a company is in relation to its total assets. The ROA ratio illustrates how the management is employing company’s total assets in order to make revenues. The higher the returns, the more efficient the management is using its asset base.

ROA (Return on Assets) = Net income / Average total assets

Return on equity (ROE)

This ratio indicates hoe profitable a company is, compared to the net income of average shareholders equity.

ROE = Net income / Average shareholders equity

Earnings per share

Earnings per share are a profitability ration measuring the earning of a company allocated on each standing share of a common stock.

Earning per share = Net income to common stakeholders / Weighted average shares outstanding

Price per earnings ratio

This is a measure of quality of the company’s earning. I.e. how much investor is required to pay per dollar earning?

Efficiency ratios

There are no two companies that operate in the same way. The use of efficiency ratios helps in identifying companies that efficiently manage their finances. It also measures how quick inventory moves and what kind of sales the assets generate, as discussed briefly below;

Asset turn over ratio

The ratio indicates the amount of assets sold

Turn over ratio = Net sales / Average total assets

High turn over is generally good. Nevertheless, it May also indicate that the company has insufficient merchandise and is loosing its sales.

Day sales outstanding (DSO)

This ration shows how float a company must finance itself and how effective it is in collecting money. DSO ratio also shows how effective the company’s credit policies are.  The tighter the credit policies, the lower the DSO ratio. DSO may also reduce sales

Day sales outstanding = Accounts receivables / (Net sales / 365)

Investment turnover ratio               

Shows how a company utilizes its assets. It also shows how investment and machinery of a company pays themselves.

If a company has older equipment that works in a slow pace, but pays itself 3 times annually, while a newer equipment pays itself twice for the same period, the business owner has to evaluate on whether the payoff is worth more investment.

Investment turnover ratio = Net sales /Total assets

Leverage ratio

Here, the ratio calculates proportionate contribution of business owners and creditors, at times a point of contribution between the two groups.

Creditors prefer owners participating to secure the margin of safety, while management enjoys a bigger share for risk shifting and multiplying debt return on equity.

Equity ratio = Common stakeholders equity / Total capital employed

The ratio of common stockholder’s equity to total capital of a business shows how much of total capitalization comes from the business owners.

NB: though leverage ration can magnify earnings, it can also exaggerate losses.

Practical Case of Financial Ratio Based on Motorola Company

Motorola is one of the leading manufacturers of semi conductor, electronic products and electronic solutions. The company is divided into segments that provide financial results publicly. The company’s products include personal 2 way radios, wireless handsets and other associated accessories.

Personal communication segment only accounted for 37.8% for the 2002 sales of the company, making the segment one of the largest in Motorola Company.

The GTS (Global Telecommunication Segment) manufacturers and markets the infrastructure for systems purchased by the TSP (Telecommunication Service Providers). The products include telephone switches, electronic exchanges and base controller stations for diverse wireless connection standards. The GTS accounted for 15.8% of the Company’s sales in 2002.

Te BCS (Broadband Communication Segment) manufacturers and markets different products in support of the telephony industry, cable and broadcast TV’s and delivery of higher speed data terminal systems. The BCS held 7.3% of Motorola sales In 2002.

The CGIS (Commercial Government and Industrial Segment) manufacturers and markets integrated communication system for government, commercial and industry applications, typically operates 2-way wireless network for data and voice transmissions, such as those used in public safety authorities. The segment accounted for 13% of 202 sales.

The SPS (Semi conductor Product Segment) manufacturers and market semiconductors, and microprocessors for use in various consumer electronic devices. The segment held 16.8% of 2002 sales.

IESS (Integrated Electronic Systems Segment) deals with manufacturing and marketing automotive electronic systems, energy storage products to support portable devices and single board computer systems. It accounted for 7.6% of the Company sales in 2002.

The total sales and profitability of Motorola has varied over time. For example, sales were at peak at $37 Billion in 2000. It however dropped to less than $27Billion in 2002. Thee was a net loss for the year 2001-2002.

Nevertheless, despite the incurred losses and variability of income reported, the company continued paying dividend steadily at 0.16$ per share.

Financial Ratio Analysis for Motorola

The financial analysis for the Company in the semi-conductor industry segment subject represents 87% of the total sales of 100 Billion in 2002. The firm’s equipment segment represents 91% of industry’s sales of $ 277 Billion.

 

Motorola

Semi-conductor industry

Telecommunication equipment Industry

Current ratio 1.77 2.44 1.52
Quick ratio 1.47 2.08 1.23
Average collection period 61 days 50 Days 73 Days
Inventory turnover 6.25 6.01 5.66
Fixed asset turnover 4.37 1.58 6.24
Total asset turnover 0.86 0.61 0.90
Debt ratio 0.64 0.34 0.65
Debt to equity ratio 1.77 0.52 1.82
Time interest earned NA NA NA
Gross profit margin 32.76% 37.49% 29.52%
Net profit margin -9.31% -3.00% -1.24%
Return on investment -7.98% -1.82% -1.11%
Return on equity -22.11% -2.78% -3.14%
Assets of equity 2.77 1.52 2.82

The semi-conductor industry has a slightly less liquidity than the average firm sin the same industry, with current ratio and quick ratio being lower than industry average.

The average collection for 61 days is lower than industry’s average of 50days. This indicates that the Company needs to evaluate its credit policies.

Both total assets turnover and fixed assets turn over are above semi-conductors leverage, which indicates that the company is using its assets more leveraged as compared to firms in the industry.

The higher leverage partly explains the company’s poor financial performance relative to semi-conductor industry because of the leverage committed by Motorola to the interests’ payment which must be paid regardless of the market conditions.

The ratios also indicate that the Company has high sales cost than average firm in semi-conductor industry. However, the situation is different when analyzing the Company relative to telecommunication equipment industry, considering that majority of Motorola’s business is on this industry rather than in semi-conductor industry.

This becomes the interesting and more relevant revelation. Motorola has better liquidity position, relative to telecommunication equipment industry, with quick ratio and current ratio being higher than the industry average.

The company collects receivables quicker than average firms in this industry. Motorola also may need to evaluate the credit policies that would have negatively impacted the Company. Motorola uses its assets slightly less efficiently than the average firms in telecommunications equipment industry, and its fixed asset turn over significantly less than industry average at 4.37 compared to 6.24 of the industry average.

Motorola has high margin (gross profit) in telecommunications equipment industry with 32.8% compared to 29.5%, though it has lower net margin.