Financial ratios are the most common and widespread tools used to analyse the financial standing of a business. They look at the relationships between individual values and relate them to how a company has performed in the past, and how it might perform in the future. Though your investment decision cannot be entirely based just on the values of these ratios, it gives you basic understanding about a company’s performance.
Moreover, financial statements of a company aim at providing financial information about a business enterprise to meet the information needs of the decision-makers. Financial statements prepared by a business enterprise in the corporate sector are published and are available to the decision-makers & investors for analyzing the profitability & growth of the company. These statements provide financial data which require analysis, comparison and interpretation for taking decision by the external as well as internal users of accounting information. This act is termed as financial statement analysis. It is regarded as an integral and important part of accounting. The most commonly used techniques of financial statements analysis are comparative statements, common size statements, trend analysis, accounting ratios and cash flow analysis. Ratio analysis involves the construction of ratios using specific elements from the financial statements in ways that help identify the strengths and weaknesses of the firm.
Financial analysis is the process of taking accounting and other financial data and organizing them into a form which reveals a firm’s strength and weaknesses. Fundamental analysis, of which financial ratio analysis is but one subset, looks at a company’s financial statements, management, health and position in the competitive landscape to determine a share price valuation.
The theory of financial ratio analysis was first popularised by Benjamin Graham who is considered by many to be the father of fundamental analysis. Benjamin Graham, who from 1928 was a professor at Columbia Business School as well as a very successful investor in his own right, was mentor and teacher to Warren Buffett.
There are different financial ratios to analyze different aspects of a business’ financial position, performance and cash flows. Financial ratios calculated and analyzed in a particular situation depend on the user of the financial statements.
Financial ratios can be broadly classified into
1) Liquidity ratios
2) Current ratio
3) Quick ratio
4) Cash ratio
5) Solvency ratios
6) Debt ratio
7) Debt to Equity ratio
8) Debt to Capital ratio
9) Earning per Share (EPS)
10) Price-Earning (P/E) ratio
11) Book Value per Share
12) Return on Capital Employed (ROCE)
13) Return on Equity (ROE)
1) Liquidity Ratios
Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current. In other words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.
Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it will be for the company to raise enough cash or convert assets into cash. Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term. Thus, all of these assets go into the liquidity calculation of a company. Some of the important liquidity ratios are Current ratio, Quick ratio (also called acid-test ratio) & Cash ratio.
2) Current Ratio
Current ratio is one of the most fundamental liquidity ratio. It measures the ability of a business to repay current liabilities with current assets.
Current assets are assets that are expected to be converted to cash within normal operating cycle, or one year. Examples of current assets include cash and cash equivalents, marketable securities, short-term investments, accounts receivable, short-term portion of notes receivable, inventories and short-term prepayments.
Current liabilities are obligations that require settlement within normal operating cycle or next 12 months. Examples of current liabilities include accounts payable, salaries and wages payable, current tax payable, sales tax payable, accrued expenses, etc.
Formula
The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric format rather than in decimal format. Here is the calculation:
Companies are required by Generally Accepted Accounting Principles (GAAP) to classify assets and liabilities into current and non-current on their balance sheets. This simplifies calculation of current ratio for liquidity analysis. All we need to do is to obtain the current assets and current liabilities figure and divide the former by later.
3) Quick Ratio
Quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days. Marketable securities are traded on an open market with a known price and readily available buyers. The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base metal and of no value. The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.
Formula: The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current receivables together then dividing them by current liabilities.
The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm's ability to pay off its current liabilities with only cash and cash equivalents. The cash ratio is much more restrictive than the current ratio or quick ratio because no other current assets can be used to pay off current debt but only by cash.
This is why many creditors look at the cash ratio. They want to see if a company maintains adequate cash balances to pay off all of their current debts as they come due. Creditors also like the fact that inventory and accounts receivable are left out of the equation because both of these accounts are not guaranteed to be available for debt servicing. Inventory could take months or years to sell and receivables could take weeks to collect. Cash is guaranteed to be available for creditors.
Formula: The cash coverage ratio is calculated by adding cash and cash equivalents and dividing by the total current liabilities of a company.
A ratio of 1 means that the company has the same amount of cash and equivalents as it has current debt. In other words, in order to pay off its current debt, the company would have to use all of its cash and equivalents. A ratio above 1 means that all the current liabilities can be paid with cash and equivalents. A ratio below 1 means that the company needs more than just its cash reserves to pay off its current debt. Investors while analyzing companies should select stocks of those companies whose cash ratio is above 1 since it is considered to be a good liquidity measure.
5) Solvency Ratios
Solvency ratios assess the long-term financial viability of a business i.e. its ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc. Some of the Key solvency ratios are Debt ratio, Debt to equity ratio, Debt to capital ratio etc.
6) Debt Ratio
Debt ratio (also known as debt to assets ratio) is a measure of a business’s financial risk, the risk that the business’ total assets may not be sufficient to pay off its debts and interest thereon. Since not being able to pay off debts and interest payments may result in a business being wound up, debt ratio is a critical indicator of long-term financial sustainability of a business.
While a very low debt ratio is good in the sense that the company’s assets are sufficient to meet its obligations, it may indicate underutilization of a major source of finance which may result in restricted growth. A very high debt ratio indicates high risk for both debt-holders and equity investors. Due to the high risk, the company may not be able to obtain finance at good terms or may not be able to raise any more money at all. Businesses set their target debt ratio based on their target capital structure. It involves trade-off between the financial risk and growth. Debt ratio is very industry-specific ratio. It should be analyzed in comparison with competitors and together with other ratios such as times interest earned, etc.
Formula: The debt ratio is calculated by dividing total liabilities by total assets. Both of these numbers can easily be found in the balance sheet. Here is the calculation:
Formula: The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on the balance sheet.
Lower values of debt-to-equity ratio are favourable indicating less risk. Higher debt-to-equity ratio is unfavourable because it means that the business relies more on external lenders, thus it is at higher risk, especially at higher interest rates. A debt-to-equity ratio of 1.00 means that half of the assets of a business are financed by debts and half by shareholders' equity. A value higher than 1.00 means that more assets are financed by debt than those financed by money of shareholders' and vice versa. An increasing trend in debt-to-equity ratio is also alarming because it means that the percentage of assets of a business which are financed by the debts is increasing. Investors while analyzing companies should select stocks of those companies whose debt to equity ratio is lower since it implies a more financially stable business.
8) Debt to Capital Ratio
The debt to capital ratio calculates a company’s use of financial leverage by comparing its total obligations to total capital. In other words, this metric measures the proportion of debt a company uses to finance its operations as compared with its capital.
This ratio is really a measure of risk and allows us to calculate how well a company can handle a down turn in sales because it highlights the relationship between debt and equity financing. Financing operations through loans carries some level of risk because the principal and interest must be paid to the lender. Thus, companies with higher ratios are considered more risky because they must maintain the same level of sales in order to meet their debt servicing obligations. A down turn in sales could spell solvency issues for the company.
Earnings Per Share or EPS is an important financial measure, which indicates the profitability of a company. It is calculated by dividing the company's net income with its total number of outstanding shares. It is a tool that market participants use frequently to gauge the profitability of a company before buying its shares. It is calculated as:
PE ratio is one of the most widely used tools for stock selection. It is calculated by dividing the current market price of the stock by its Earning Per Share (EPS). It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company. A relatively low P/E ratio could indicate that the company is under-priced. Conversely, investors expect high growth rate from companies with high P/E ratio. It is calculated as:
Book Value per share indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the company is divided by the average common shares outstanding. It is calculated as:
Return On Capital Employed (ROCE) is the ratio of net operating profit of a company to its capital employed. It measures the profitability of a company by expressing its operating profit as a percentage of its capital employed. Capital employed is the sum of stockholders' equity and long-term finance. Alternatively, capital employed can be calculated as the difference between total assets and current liabilities. It is calculated as:
Investors while analyzing companies should select stocks of those companies whose ROCE is higher than the rate at which the company borrows otherwise any increase in borrowing will reduce shareholders' earnings, and vice versa.
13) Return On Equity (ROE)
Return On Equity or Return On Capital is the ratio of net income of a business during a year to its stockholders' equity during that year.
It is a measure of profitability of stockholders' investments. It shows net income as percentage of shareholder equity. Return on equity is an important measure of the profitability of a company. Higher values are generally favorable meaning that the company is efficient in generating income on new investment. It is calculated as:
There are many advantages derived from ratio analysis. These are summarised as follows:
A) Helps to understand effectiveness of decisions:
The ratio analysis helps you to understand whether the business firm has taken the right kind of operating, investing and financing decisions. It indicates how far they have helped in improving the performance.
B) Simplify complex figures and establish relationships:
Ratios help in simplifying the complex accounting figures and bring out their relationships. They help summarise the financial information effectively and assess the managerial efficiency, firm’s credit worthiness, earning capacity, etc.
C) Helpful in comparative analysis:
The ratios are not to be calculated for one year only. When many year figures are kept side by side, they help a great deal in exploring the trends visible in the business. The knowledge of trend helps in making projections about the business which is a very useful feature.
D) Identification of problem areas:
Ratios help business in identifying the problem areas as well as the bright areas of the business. Problem areas would need more attention and bright areas will need polishing to have still better results.
E) Enables SWOT analysis:
Ratios help a great deal in explaining the changes occurring in the business. The information of change helps the management a great deal in understanding the current threats and opportunities and allows business to do its own SWOT (Strength-Weakness-Opportunity Threat) analysis.
Various comparisons: Ratios help comparisons with certain bench marks to assess as to whether firm’s performance is better or otherwise. For this purpose, the profitability, liquidity, solvency, etc. of a business, may be compared:
i. over a number of accounting periods with itself (Intra-firm Comparison/Time Series Analysis),
ii. with other business enterprises (Inter-firm Comparison/Cross-sectional Analysis) and
iii. with standards set for that firm/industry (comparison with standard (or industry expectations).
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