Key Financial Ratios

The goal of this posting is to demonstrate simple meaning of financial ratios that are used to demonstrate the health of a company. The point of view expressed here is that financial ratios are extremely useful in making decisions to invest, or even something like seeking employment within a company, especially at higher levels. This posting will briefly describe what each of the covered ratios tells about the health of a company, and also sometimes things that a particular ratio might not tell, or even disguise.

Financial ratios to be covered include liquidity ratios (quick and cash ratios), asset management (total asset turnover), long-term solvency ratios (long-term debt, times interest earned), measures of profitability (profit margin, return on assets, return on equity), and market valuation measures (price-earnings).

It should be noted that financial ratios can quite often have multiple meanings and also multiple methods of calculation. There is as always with financial accounting, some scope for manipulating how a company’s finances appear by altering the way that ratios are calculated. Nothing is quite what it seems is as applicable in financial accounting as it is to anything else.

Quick Ratio

The quick ratio is defined as follows:

quick ratio = ( current assets – inventory ) / current liabilities

The quick ratio is often known as the acid test ratio, which is a severe and conclusive test to establish quality, genuineness, worth (dictionary.com). This ratio is a very quick test of a company’s liquidity, or its ability to cover its short term debts. If you examine the balance sheet shown in Figure 1, when excluding inventory, the current assets are cash on hand added to what a company is expecting to get paid from debtors in the short term (accounts receivable).

Figure 1. A Sample Balance Sheet

The inventory is removed from the quick ratio test because inventory cannot rapidly be converted in cash if creditors come-calling for their money. For example, a very low quick ratio could indicate a company has manufactured or purchased far more than they can sell. Then again, other types of companies such as drop shippers have no inventory at all so the quick ratio is meaningless to them. People who watch television financial news channels may have heard a lot of talk about inventory levels in the last few years because companies have been deliberately holding back on over producing; an unpredictable economy requires very careful management of inventory levels. In some respects companies do not want to be caught napping and have no product to sell, but on the other hand if they over produce they could become insolvent – even non-perishable goods require storage that costs money. If a company has a very high quick ratio it could mean they are not putting money to work, or are just sitting on cash and not generating revenue with it. So the quick ratio can mean a lot of things, depending on the company and the circumstances. See http://accountingexplained.com/financial/ratios/quick-ratio.

Cash Ratio

The cash ratio is defined as:

cash ratio = cash / current liabilities

The cash ratio is a shorter term liquidity ratio than the quick ratio because it only focuses on cash immediately on hand, with which a company can use to pay creditors (current liabilities as shown in Figure 2).

Figure 2. A Sample Balance Sheet

For example, a company with cash ratio above 1 can pay its salaries, and those employees can continue to come to work and keep the business operational; buying, selling, and making more inventory items. Again, a value well over 1 could indicate a cash rich company that is not doing very much. See http://accountingexplained.com/financial/ratios/cash-ratio.

Total Asset Turnover

The total asset turnover is defined as:

total asset turnover = sales / total assets

Every dollar of fixed assets generates a dollar amount in sales (Ross). How well are the assets working in the operating of a business? In specific terms does a company’s buildings and delivery vehicles help to generate revenue for the company? For example, a company buys electronic parts from China shipped to their factory door, puts them together, and ships finished goods directly off their factory floor. If they decide to outsource goods delivery to UPS, retaining a fleet of delivery vehicles would not be a sensible use of asset value; those vehicles should probably be sold and the proceeds applied somewhere else in the business. Then again, a company that recently underwent massive expansion and exchanged for much more expensive business premises, might show a temporary very low asset turnover as they expand their operational capacity into the new facility. In general a healthy company is going to have as high an asset turnover as possible. Even when fixed assets involve immense initial cost, over time there should be an increase in return on that initial investment, by putting those new assets to work. See http://accountingexplained.com/financial/ratios/asset-turnover.

Long-Term Debt Ratio

The long-term debt ratio is a long-term solvency ratio that can be defined as follows:

long-term debt ratio = long-term debt / ( long-term debt + total equity )

This ratio measures dependence upon debt to finance the operation of its business, as well as being able to service its debt load. Historical data for long-term debt analysis is useful, because it can describe if a company is becoming less reliant on debt to finance itself, which is a good sign. On the contrary and company perhaps becoming reliant on debt might even be digging itself into a hole, perhaps even leading to a bankruptcy in the future. See http://bizfinance.about.com/od/financialratios/f/LTDebt_Total_Cap.htm and http://www.investopedia.com/terms/l/long-term-debt-to-total-assets-ratio.asp.

Times Interest Earned Ratio

The times interest earned or TIE ratio is another measure of long-term solvency and is calculated as follows:

total interest earned ratio = EBIT / interest

, where EBIT is Earnings Before Interest and Tax

The TIE ratio describes how well a company services its debt (paying interest on debt). Can the company make its mortgage payments on land and buildings? Can it pay its long-term loans on its delivery vehicle fleet, assuming it has fleet of delivery vehicles?

If the ratio is 1 then a company is only just servicing its debt and perhaps not really making money enough to service a higher debt load. So creditors may not allow the company to take on more debt on the grounds that the payments might not be met. However, past trend comparisons as well as trend comparisons with competitors might be factors in making decisions about extending further credit. See http://accountingexplained.com/financial/ratios/times-interest-earned.

Profit Margin

The profit margin is known as a profitability measure of a company and is a measure of how much money a company is making doing business, and as is defined as follows:

profit margin = net income / sales

A goal of low expenses (the cost of doing business) in relation to its sales should be aimed at by producing a high amount of net income relative to sales. Lowering sales prices in order ship larger numbers of products could result in higher overall sales, and preferably a higher net income; but the profit margin percentage could still remain consistent. Bigger is not always better in business because bigger is more complex and difficult to control and run. Making more things to sell more things can increase supply and thus potentially flooding a market, and so prices must be dropped to maintain a good profit margin, in order to sell the extra goods, thus decreasing the net margin per unit sold.

Net profit and thus profit margin is a good measure of how well a company converts its operation into profits, which is why they are in business in the first place (unless they are a non-profit). There are some interesting pointers to note about profit margin. For example, when the profit margin is low then there is not too far to fall when times are hard, and thus companies with higher profit margins can better weather a negative economic down turn. On the contrary, essential goods such as food items do not suffer nearly as much as more specialized goods during economic down turns. For example, a person does not have to buy a new luxury model car but they do have to eat and consumers tend to cut back on non-essential luxury items when money is tight. See http://www.ccdconsultants.com/documentation/financial-ratios/net-profit-margin-interpretation.html.

Comparing profit margins over time and with other companies to display trends can also help to not denigrate an otherwise healthy business that has recently increased debt load or spent cash to fund sensible expansion.

Return On Assets

The return on assets or ROA is another profitability measure that describes how much profit is being generated in relation to the total asset value (both current and fixed assets) of a company. ROA is defined as follows:

return on assets = net income / total assets

The ROA ratio shows if a company is increasing or decreasing profitability over time but unloading assets might help to temporarily conceal a company that might be in trouble (other ratios can detect problems). Another fact about the ROA is that some industry types require very expensive capital investments in fixed assets, and some do not; so inter-industry comparisons of ROA values can be very misleading, or even pointless. See http://accountingexplained.com/financial/ratios/return-on-assets.

Return On Equity

The return on equity or ROE ratio describes how well shareholders are doing out of their investment because the ROE compares net income directly with outstanding share value (total equity). The return on equity ratio is defined as follows:

return on equity = net income / total equity

Potential investors can use the ROE to help them to make investment decisions, but trends over a number of years should also be examined. It is especially important to examine debt loads and any recent increases. The reason why is because debt load and debt financing can be increased for no reason other than to reduce total equity, thus making the ROE artificially higher because the denominator drops in the calculation, making the result appear better than it really is. See http://accountingexplained.com/financial/ratios/return-on-equity.

Price-Earnings or Price to Earnings Ratio

Last but certainly not least is the market value measure, the price to earnings ratio or the PE. The PE is frequently heard on television financial news stations such as CNN and Bloomberg and is important. The PE is defined as follows:

price-earnings ratio = share price / earnings per share

This one is not really rocket science in that a company sells X number of shares to finance its operations, and thus each share is worth a value based on how much money the company is making (kind of). So the more shares a company issues for sale, the more that the equity or ownership of the company is diluted and thus the less each share is worth (relatively). Unless of course the stock price rises consistently, constantly increasing the value of the company and thus the value of the investment for shareholders. So as stock prices rise, PE ratios fall and as stock prices fall then PE ratios rise. When PEs go down people buy more stock because it is cheaper and conversely as the PE goes up, the stock is more expensive, returns less profit, and possibly stagnates, or even falls. Warren Buffett says that when people are afraid he buys and that when people are exuberant he gets scared and sells. Does Warren Buffett watch PE ratios more than less wily investors?

PE ratios are highly significant for investors, describing the price of shares in terms of how much one pays per share based on net income for a company. What this means is that a company makes a profit and that net profit can technically be divided up amongst all shares. PE ratios can vary substantially both for different types of companies and in varying economic times, and so some caution should be exercised. See http://bizfinance.about.com/od/financialratios/f/what-is-price-earnings-ratio.htm.

Growth phases will increase PE ratios because earnings are low and thus investment is heavier and impacting profitability with profits lower; growth implies investment not profit taking. The late 1990’s tech. bubble saw tech stocks go too high because of investor over enthusiasm, even though losses were obvious and PE ratios were probably way too high. In truth many highly profitable new companies did emerge from the tech. bubble, but also many crazy ideas fell by the wayside and lost less fortunate investors huge amounts of money. The higher the PE ratio then the higher the risk, because there is less scope for return. When the economy trends downwards the PE ratios tend to descend because investment trends towards safer things such as bonds and high value commodities, where equities are generally considered as high risk commodities (mostly). See http://bizfinance.about.com/od/financialratios/f/what-is-price-earnings-ratio.htm.

The graphics shown at http://www.advisorperspectives.com/dshort/updates/PE-Ratios-and-Market-Valuation.php are very interesting in describing how the PE ratio relates to various events and trends over time. The first image, duplicated in Figure 3, clearly shows a huge spike in PE ratios for the S&P 500, where stock holders were paying 123.7 times the value of stocks, around the time of the Great Recession of 2009; companies were not making any money.

Figure 3. S&P Index and PE Ratio from 1871-Present (www.advisorperspectives.com)

Can the tech bubble be seen in Figure 3 at around 34 and 46.7 respectively, implying that stocks reached unsustainable heights? The first high PE was before the bubble burst and the second about a year or so after the bubble burst. PE ratios are currently relatively low so the predicted trend is upward mobility for the stock market for now, barring any major economic events or political shocks. For now it might be safe to invest in stocks but when Warren Buffet stops buying it might be time to start selling off stocks and moving back into bonds and precious metals again. Stock investing is a little bit of a lottery for the unprofessional and the undedicated, and competing with professional traders and large investment houses using artificially intelligent computers running sophisticated high frequency trading software, is not for the feint-of-heart, or those without money to burn and lose! Prudence for the unwary might include mutual funds and ETFs.

Conclusion

One can learn much from even a very basic understanding of financial ratios, because that small amount of knowledge can help to predict trends in business, and some kind of predictive vision is critical. How will a company CEO know when to invest more in inventory? Can a boom be predicted ahead of time in order to proactively double inventory size in advance of competitors? On the contrary the company that gets stuck with twice as much inventory as it can sell could wind up with over-priced, out-dated, worthless items that nobody wants to buy, and a huge loss to the company and shareholders. Even vague ability to predict trends is important to the survival of many businesses and a critical skill for an MBA; however, there is no such thing as crystal ball gazing – the only way that Nostradamus saw things in bowls of water was after having wondered around a green summer French field picking hallucinogenic mushrooms.

From a personal perspective, financial ratios have been a curiosity for many years and having even a very small amount of knowledge is of great value, not only in terms of analyzing investment decisions, but also in making decisions about joining the workforce of a public company, especially for short term consulting work involving trouble shooting. Indicators of a company in poor health can help to give a better of picture of how to advise and assist in dealing with problems.