Finacial Ratios

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ACADEMIC TOPIC OVERVIEWS
Financial Ratios
Finance >Financial Ratios
easily compared and contrasted. Examination of these ratios can

Table of Contents
help to assess the financial health of a firm. There are numerous
parties that utilize financial ratios to provide insight into com-
Abstract pany performance. Stockholders, potential investors, managers,
Overview lenders, creditors, regulatory agencies and competitors are each
interested in different ratios.
Applications
Profitability Ratios Financial ratios are often used in benchmarking. Comparisons
are made between the financial ratios of a firm and those of its
Activity/Efficiency Ratios peers or an industry standard. A financial ratio can be used as
Liquidity Ratios a yardstick for measuring how the firm stacks up against its
competition. Internal comparisons are also commonly made.
Leverage Ratios Looking at historical financial ratios over a period of time can
Market Value Ratios uncover important trends. Financial ratios are an excellent tool
for understanding if the company's performance is improving or
Further Insight declining. The results of the ratio analysis can indicate a positive
trend or raise red flags for areas of concern.
DuPont Model
Common Size Financial Statements Each financial ratio is a simple calculation. The inputs for these
calculations can be found in a firm's published financial state-
Issues ments. An understanding of the accounting practices is necessary
Terms & Concepts for each firm being compared. When comparing two companies,
adjustments might need to be made so that the accounting infor-
Bibliography mation is represented in a similar way.
Suggested Reading
Various questions can be answered by analyzing financial ratios.
Are profit margins improving or deteriorating? How well are
assets being utilized by the organization? How liquid is the orga-
nization? Is the company a good credit risk? Does the company
Abstract have the ability to meet its interest payments? How much are
investors willing to pay for each dollar of earnings? What pro-
Financial ratios are an important tool to help understand a firm's portion of net income was paid out in dividends?
financial condition. Ratios can be derived from published finan-
cial statements and used to compare performance among peers There are twenty commonly used financial ratios that are dis-
as well as performance within a company over time. This article cussed in this article. These ratios fall into five distinct categories:
is devoted to exploring financial ratios in five categories: Profit-
ability, Activity, Liquidity, Leverage and Market Value.
• Profitability
• Activity/Efficiency
Overview • Liquidity
• Leverage
Financial ratios allow analysts to synthesize large amounts of
financial and accounting information into metrics that can be • Market Value
EBSCO Research Starters® • Copyright © 2014 EBSCO Information Services, Inc. • All Rights Reserved
Financial Ratios
Applications for comparing Net and Operating Profit Margin also applies to
Gross Profit Margin. The higher the Gross Profit Margin, the
The following section of this article provides formulas for calcu- more funds available to cover overhead costs and yield a profit.
lating each ratio and an explanation for why the ratio is valuable.
Net Profit After Taxes
Profitability Ratios __________________________
Return on Assets (or ROA) =
Profitability Ratios are a set of metrics which illustrate how well Average Total Assets
a firm is using its resources to earn income. These ratios are help-
ful in assessing how successful management is at controlling Net Profit after Taxes is found on a firm's income statement and
costs and ultimately generating profit for the firm. Total Assets are found on the firm's balance sheet. To calculate
Average Total Assets, simply add the previous year and current
Net Profit after Taxes year's Total Assets and divide by 2. Return on Assets is a key
_____________________
Net Profit Margin = profitability indicator. This ratio helps measure how effectively
Net Sales the company is utilizing its assets. The higher the number, the
more effective the assets being employed. However, since the
Net Profits after Taxes and Net Sales numbers are found on a capital intensity of each industry differs so significantly, this
firm's income statement. Net Profit Margin provides informa- ratio should not be used to compare firms in different industries.
tion on how much of the firm's revenue makes its way to the
bottom line. Profit margins should not be analyzed in isolation. Net Profit After Taxes
__________________________
Profit margins from two different companies cannot be simply Return on Equity (or ROE) =
compared to determine which one is "better." For example, dif- Stockholder’s Equity
ferent industries can have wildly different economic models and
therefore standard profit margins will vary significantly. In addi- Net Profit after Taxes is found on a firm's income statement and
tion, the net profit margin could be low due to some investment Stockholder's Equity is found on the firm's balance sheet. To cal-
for the future. The profit margin also does not take into account culate Average Stockholder's Equity, simply add the previous year
the volume of sales. If a company's strategic approach was to and current year's Stockholder's Equity and divide by 2. Return on
be a low cost leader, then the margins might be low. However, Equity provides a measure for how well the stockholder's capital
the company could still have attractive profits due to the veloc- contribution is being utilized and translated into profit.
ity and volume of sales. It is best to compare the profit margins
of firms with similar competitive approaches in the same indus- Net Income −
try. This ratio is also helpful for a company to evaluate its own Preferred Stock Dividends
_______________________
historical margins over time. Upward movement over time indi- Earnings per Share (or EPS) =
cates a positive trend. Average Number
of Shares of Common
Net Sales − Operating Expenses Stock Outstanding
___________________________
Return on Sales (or ROS) =
Net Sales Net Income after Preferred Stock Dividends is often found on
a firm's income statement and Number of Shares of Common
Net Sales and Operating Expense numbers are found on a firm's Stock Outstanding is often found on the firm's balance sheet.
income statement. Return on Sales looks at the profit margin To calculate Average Number of Shares of Common Stock
from an operational perspective. It excludes the impact of Outstanding, simply add the previous year and current year's
financing and interest payments. As with Net Profit Margin, be Number of Shares of Common Stock Outstanding and divide by
mindful of the situation of the firm and the industry when doing 2. The Earnings per Share ratio provides the profit generated for
a comparison. Just as was seen with Net Profit Margin, upward each share of stock. Investors like to see growth in this ratio year
movement over time indicates a positive trend. over year.
Net Sales − Cost of Goods Sold Activity/Efficiency Ratios

___________________________
Gross Profit Margin = Activity Ratios provide insight into how effectively the assets of
Net Sales the organization are being managed. Putting together the results
of several of these metrics will show how quickly the firm can
Net Sales numbers are found on a firm's income statement. Cost convert assets into cash. Proficient asset utilization will lessen
of Goods Sold is usually found on the income statement. How- the need for additional capital.
ever in some cases, this information is not available in published
financial statements. Gross Profit Margin shows the percentage Net Sales
_____________________
of revenue left after subtracting out the expenses incurred pro- Asset Turnover =
ducing the product (e.g., materials and labor). The same caveats Average Total Assets
EBSCO Research Starters® • Copyright © 2014 EBSCO Information Services, Inc. • All Rights Reserved Page 2
Financial Ratios
Net Sales numbers are found on a firm's income statement and creditors. How quickly the company pays has implications on
Total Assets are found on the firm's balance sheet. To calculate the cash flow.
Average Total Assets, simply add the previous year and current
year's Total Assets and divide by 2. This ratio measures how well To get an idea of the cash conversion cycle for a firm, you can
the company is utilizing its assets to create revenue. take Day's Receivables plus Days Inventory and then subtract
Day's Payables. The result provides insight into how long funds
Average Inventory are tied up before they are converted into cash. The shorter the
_____________________
Days of Inventory = cycle, the more liquid the company is.
Cost of Goods Sold ÷ 365
Net Sales
_____________________
Inventory is found on the firm's balance sheet and Cost of Goods Working Capital Turnover =
Sold is usually found on the income statement. However in some Average Current Assets
cases, this information is not available in published financial − Average Current
statements. To calculate Average Inventory, simply add the pre- Liabilities
vious year and current year's Inventory and divide by 2. Days of
Inventory reveals the number of days a product is held in inven- Net Sales are found on the firm's income statement and Current
tory until it is sold. This ratio helps determine how successfully Assets and Current Liabilities are found on the balance sheet.
the organization is managing its inventory and it can reveal how Current Assets less Current Liabilities is commonly referred to
accurate their forecasting is. Typically, lower numbers are viewed as Working Capital. To calculate Average Current Assets, simply
more favorably. However, if inventories are too low then it will add the previous year and current year's Current Assets and
hamper the firm's ability to react quickly to surges in demand. divide by 2. Use the same methodology for determining Aver-
age Current Liabilities. Working Capital Turnover measures how
Cost of Goods Sold effectively the company is using its working capital to generate
_____________________
Inventory Turnover = sales. A higher turnover indicates a more effective use of work-
Average Inventory ing capital funds.
Using the same information as the Days of Inventory ratio, we Liquidity Ratios
can come up with and Inventory Turnover metric. This metric Liquidity Ratios provide valuable information on how solvent
reveals the number of times that inventory turns over in a year. the company is. These ratios can provide an estimate for the
If this number is high, it can indicate an efficient inventory man- amount of cash the company can quickly come up with. Analyz-
agement strategy. The more inventory that is turned over, the ing these metrics will show the effectiveness with which a firm
higher the sales and the less inventory carrying costs. meets its short-term obligations. Creditors and lenders can use
these ratios to assess a firm's ability to repay short-term debts.
Average Accounts Receivable
_________________________
Day’s Receivables = Current Assets
_____________________
(or Average Collection Period) Net Sales ÷ 365 Current Ratio =
Current Liabilities
Accounts Receivable is found on the firm's balance sheet and
Net Sales is found on the income statement. To calculate Average Current Assets and Current Liabilities are found on the firm's
Accounts Receivable, simply add the previous year and current balance sheet. This ratio is a test of liquidity, or its ability to pay
year's Accounts Receivable and divide by 2. Day's Receivables off current liabilities with current assets. A healthy company will
reveals the approximate number of days it takes to collect pay- have a ratio of at least 1. However, the specific benchmark for an
ment from customer after the sale. The duration of this collection attractive Current Ratio is dependent on the industry. Cash flow
period is extremely important because a longer collection period and liquid assets vary significantly between industries.
can put significant strain on the firm's cash flow. In general, a low
ratio is viewed positively. Cash + Short-Term
Investments + Receivables
_________________________
Average Accounts Payable Quick Ratio ( or Acid Test) =
_______________________
Day’s Payables = Current Liabilities
Net Sales ÷ 365
Cash, Short-Term Investments, Receivables and Current Liabili-
Accounts Payable is found on the firm's balance sheet and Net ties are found on the firm's balance sheet. This ratio serves a
Sales is found on the income statement. To calculate Average similar purpose as the Current Ratio, but takes the assets one step
Accounts Payable, simply add the previous year and current closer to actual cash. This ratio only utilizes assets which can
year's Accounts Payable and divide by 2. Day's Payable provides be reliably liquidated on very short notice. This ratio excludes
a metric for how long it takes the firm to pay its suppliers and assets such as inventory, which might take some time to sell
Financial Ratios
off or may require significant discounts in order to close a sale Current Market Price per Share is published continuously while
quickly. the markets are open. Due to the intense fluctuations of many
stocks, the Market Price per Share is often calculated using an
Leverage Ratios average over a specific period of time. The formula for Earn-
Leverage Ratios measure the amount of financial leverage, or ings per Share was given in the previous section of this article
debt, a company is saddled with. This is an important ratio for that discussed Profitability Ratios. The PE Ratio is of particular
stockholders because they will only get paid once the debt obli- interest to investors because it measures the price investors are
gations have been met. In the case of liquidation, stockholders willing to pay for each dollar of earnings. Higher PE ratios indi-
must wait in line. A firm that has higher debt is usually consid- cate confidence in the firm's future and growth prospects.
ered more risky.
Annual Dividends
Total Debt per Share of Stock
______________ _____________________
Debt Ratio = Dividend Yield Ratio =
Total Assets Market Price
per Share of Stock
Total Assets and Total Debt are found on the firm's balance sheet.
This ratio reveals the extent to which capital was borrowed in Dividends paid out are found on a firm's Cash Flow statement.
order to fund the firm's operations. The higher the Debt Ratio, As seen with the PE ratio, Market Price per Share is often calcu-
the more levered the firm. Highly levered firms are considered lated using an average over a specific time. This ratio measure
riskier because of the possibility of being forced into bankruptcy the return investors receive in the form of dividends. However,
if the firm has trouble meeting its interest or principle payments. the dividend is only part of an investor's total return. Investors
can benefit from the dividend as well as appreciation of the
Total Debt stock. Therefore, a low dividend yield in itself does not neces-
________________________
Debt to Equity Ratio = sarily translate to a poor return for the investor.
Total Stockholder’s Equity
Annual Dividends
Total Debt and Total Stockholder's Equity are found on the per Share of Stock
_____________________
firm's balance sheet. The Debt to Equity Ratio is another way to Dividend Payout Ratio =
communicate the extent of leverage a firm is employing. It also Earnings Per Share
shows the mix of Debt versus Equity that was used to finance
operations. In this ratio, healthy firms usually have a ratio less Dividends paid out are found on a firm's Cash Flow statement.
than 1. The formula for Earnings per Share was given in the previous
section of this article which discussed Profitability Ratios. Divi-
EBIT dend Payout Ratio indicates the percentage of net income that
_________________
Times Interest Earned = was paid out to investors in the form of dividends. Both the Divi-
(or Coverage Ratio) Interest Expense dend Yield and Dividend Payout provide an investor with insight
into future dividend streams that may be paid out to common
stock holders.
EBIT (Earnings before Interest and Taxes) and Interest Expenses
are found on the firm's income statement. This ratio determines
whether or not a firm is able to pay its annual interest costs. The Further Insight
higher the ratio, the more cushion the firm has if profits dip below
expectations. Lenders want to ensure that the firm can weather DuPont Model
downturns and usually require a minimum Coverage Ratio of 2x The DuPont Model was developed by F. Donaldson Brown, an
to ensure creditworthiness. employee of E.I. du Pont de Nemours & Company, in the 1920's.
This formula integrates various ratios together to provide an
Market Value Ratios integrative look at highlights from both the income statement
Market Value Ratios provide a mechanism for combining and the balance sheet.
accounting and stock market information. Current stockholders
and future investors may use this information to make a buy, sell Net Profit Margin ×
or hold decisions. Asset Turnover ×
Assets
_____________________
Current Market Price DuPont Model (ROE) =
per Share of Stock Equity
_____________________
Price Earnings Ratio (or PE) =
Earnings per Share
Financial Ratios
Although we already covered the formula for ROE in this Terms & Concepts
article, the DuPont Model is a different way of looking at the
equation. This model is one that a manager might find valu- Accounts Payable: Outstanding balance of money a company
able because it requires examination into several key areas in owes to its creditors, suppliers and vendors for goods and ser-
one formula. This model touches on profitability (Net Profit vices. This is generally of a short-term nature, requiring payment
Margin), activity/efficiency (Asset Turnover) and leverage in less than 12 months.
(Assets/Equity).
Accounts Receivable: The balance of money owed to a company
Common Size Financial Statements for the goods and services it provided. This is treated as a current
Common size financial statements are often used by analysts asset on the balance sheet.
to make comparisons. In a common size Income Statement, all
entries of the income statement will be expressed as a percent- Asset: Anything having value that is owned by a company and
age of sales. In a common size Balance Sheet, all entries are that can be used to pay off debts. Categories of assets can include
expressed as a percentage of total assets. Presenting the data in current assets (e.g., cash, accounts receivables, inventory), fixed
this way highlights changes in the operations or capital structure. assets (e.g., capital equipment, buildings) and intangible assets
It is much easier to uncover inconsistencies when presented in (e.g., goodwill, patents).
these absolute terms. It also allows for easier comparisons of
different sized firms. Debt: The amount of money the firm has borrowed from credi-
tors.
Issues Dividend: Portion of the company profits that is distributed to

stockholders.
Financial ratios are widely used in the business environment.
However, these ratios are just one tool of many that should be Equity: Stockholders' ownership interest in a corporation
utilized in a comprehensive business analysis. Financial ratios (includes both common and preferred stockholders).
are a great starting point, but there are many other factors that
must be considered. A robust examination must take into account Leverage: The extent to which a business is using borrowed
such factors as a company's long term strategy and changes in capital in its operations.
the industry environment. These details will not be uncovered
using financial ratios alone. Liquidity: The degree to which assets can quickly and reliably
be converted to cash.
The financial ratios discussed in this article are lagging indi-
cators. The performance results contained in the financial
statements are based on past decisions. To truly understand the Bibliography
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Financial Ratios
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Essay by Heather Wall Beckham, MBA

Heather Wall Beckham is the former Vice President of Strategic Planning for the Turner Division of Time Warner. She has also served as
a strategic consultant with Bain & Company, a financial analyst with Ford Motor Company, and an adjunct professor in the Economics
and Business Department of Agnes Scott College. She holds an undergraduate degree from Duke University and an MBA from Harvard
Business School.
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RESEARCH STARTERS

ACADEMIC TOPIC OVERVIEWS

easily compared and contrasted. Examination of these ratios can

Net Sales − Cost of Goods Sold Activity/Efficiency Ratios

Issues Dividend: Portion of the company profits that is distributed to

Essay by Heather Wall Beckham, MBA

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