A Brief Guide to Engineering Financial Calculations: Financial Ratios
Financial ratios extract information from the statements that relate to operational and financial performance, and, from market information, how investors might assess the value of a company’s stock. There are five Classes of Ratios.
Liquidity Ratios are financial ratios that measure the likelihood that a business will remain solvent in the short term (e.g. Current Ratio, Quick or Acid Test Ratio). Will the company stay solvent in the short term?
Activity Ratios are financial ratios that measure how effectively assets are being used in the business (e.g. Inventory Turnover, Average Collection Period, Fixed Asset Turnover, Total Asset Turnover). Also called Asset Management Ratios or Efficiency Ratios. Is management making good use of the company’s assets?
Leverage Ratios are financial ratios that measure how effectively a business is likely to repay its total debt (e.g. Debt Ratio, Times Interest Earned, Fixed Charge Coverage). Also called Debt Management Ratios. Will the business be able to service the debt it has undertaken, paying both interest and principal?
Profitability Ratios: Financial ratios that measure the profitability of the business (e.g. Profit Margin on Sales, Return on Total Assets, Return on Equity). Is the company earning enough on the assets or equity that has been given to the business?
Market Value Ratios are financial ratios that measure stock price against earnings and book value of equity (e.g. Price/Earnings, Market/Book). For publicly traded companies, how does the stock value compare to earnings and the book value of assets?
A single ratio does not give a complete picture of the operational and financial situation of a company.
There are at least four uses of financial ratios:
Trend analysis (internal and external), an examination of ratios over time, which tries to determine whether the ratio is changing in a favourable or unfavourable direction;
Comparison to industry averages (internal and external), where industry average ratios provide a benchmark for comparison, if a ratio is too far from the industry average, something may be wrong;
Setting and evaluating company goals (internal), as company goals are often stated in terms of financial ratios (for example, it is common for management to set goals regarding the firm’s ROE);
Restrictive debt covenants (external), for example, a borrower might be required to maintain a debt to equity ratio of less than 1.0 and a current ratio greater than 2.0
Summary List of Comparative Ratios
Liquidity Ratios: Measures of the likelihood that a business will remain solvent in the short term.
Current Ratio: Current Assets divided by Current Liabilities.
Quick Ratio or Acid Test: (Current Assets minus Inventories) divided by Current Liabilities.
Activity Ratios (Also Called Asset Management Ratios): Measures of how effectively assets are being used in the business.
Average Collection Period: See Days Sales Outstanding.
Days Sales Outstanding: Receivables divided by (Annual Sales/360), which measures how well the company gets its customers to pay.
Fixed Asset Turnover: Annual Sales divided by Net Fixed Assets.
Inventory Turnover: Annual Sales divided by Inventory.
Total Asset Turnover: Annual Sales divided by Total Assets.
Leverage Ratios (Also called Debt Management Ratios): Measures of how effectively a business is likely to repay its total debt
Debt Ratio: Total Debt divided by Total Assets. Also called Total Debt to Total Assets Ratio. Note: If someone talks about Debt Ratio or Debt-to-Equity Ratio, one should confirm their definition: sometimes Debt ratio is called debt to equity ratio, but technically Debt to Equity is Total Debt divided by (Total Assets – Total Debt).
Debt to Equity Ratio: Total Debt divided by (Total Assets – Total Debt). The term is often mistakenly used when Debt Ratio is actually meant.
Fixed Charge Coverage Ratio: (EBIT plus Lease Payments) divided by (Interest Charges plus Lease Payments),
Times Interest Earned Ratio: Earnings Before Interest and Taxes divided by Interest Charges.
Total Debt to Total Assets Ratio: Total Debt divided by Total Assets. Also called Debt Ratio.
Profitability Ratios: Measures of the profitability of the business.
Profit Margin on Sales Ratio: A Profitability Ratio, calculated as Operating Income divided by Annual Sales.
Return on Equity Ratio: A Profitability Ratio, calculated as Net Income divided by Shareholder’s Equity (which is Capital Shares plus Retained Earnings). Crucial to the shareholder, and thus a driver of the Share Price.
Return on Total Assets Ratio: A Profitability Ratio, calculated as Operating Income divided by Total Assets.
Market Value Ratios: Measures of stock price against earnings and book value of equity
Market/Book Ratio: Market price per share divided by Book value of Equity per Share. Market to Book value assesses the premium that a stock price has over a conservative valuation. Not derived solely from financial statements, and relates to a company’s market value.
Price/Earnings Ratio: Price per Share divided by Earnings per Share, which equals Market Capitalization divided by Net Income. Not derived solely from financial statements, and relates to a company’s market value.
Although most ratios have a standard definition, one should check what parameters are actually being used by a company to calculate its ratios. Some ratios do not follow generally accepted accounting practice (GAAP), and they are prone to possible misrepresentation.