The World of Financial Ratios

Gordan Ramsay, Warren Buffet, and every driver on the road. The one thing that they all have in common is the use of ratios!

There can be potentially countless ratios that can be created, but only a very small portion of these ratios are specifically useful to us. The two values must be related to each other in a meaningful way. For example, the number of employees in relation to the average inventory of a business isn’t going to be particularly helpful in most cases. The cost of goods sold in relation to the average inventory, however, can be very useful for stakeholders curious about a company’s inventory turnover rate.

Financial ratios only become useful when compared to past levels, projected future levels, competitors, and industry averages. That is how you are able to actually understand what the ratio says about the business in context. Cross-industry comparisons don’t typically work as well, considering different industries operate very differently due to varying obstacles, rates of innovation, etc.

Profitability Ratios

Profit maximization is ultimately the goal of every publicly traded corporation, ergo profitability ratios are extremely important. The goal of these ratios is to measure a company’s potential for generating profit relative to some other metric.

Profit margins are one of the most infamous financial ratios, and that’s for good reason. These ratios tell us how much a company’s costs exceed its income at a proportional rate. There are two profit margin ratios. Gross profit margin (GPM) tells us how much revenue increases only the company’s cost of goods sold (COGS). It is calculated through subtracting COGS from revenue, then dividing by revenue. The net profit margin (NPM) on the other hand offers a more accurate representation of a company’s operations. This is because it takes operating expenses into account, whilst GPM does not. It’s calculated through subtracting operating expenses from gross profit, then dividing by revenue.

The Banana Phone Company™ reports quarterly revenue of $10 million and total expenses of $7 million, of which $4 million was spent on the production of the Banana Phones™ that they sold. This would mean that their GPM is 60% and NPM is 30%.

There are three more profitability ratios that are sometimes referred to as the return ratios. These include return on investment (ROI), return on equity (ROE), and return on assets (ROA). As with profit margins, the higher, the better. Each of these ratios is calculated by dividing return a.k.a. net profit over some period, by the divisor metric over that same period. ROI is used to measure benefit relative to the initial investment, whilst ROE measures benefit relative to equity which can fluctuate over time. ROA measures benefits relative to a company’s total assets. Higher ROA means that a company is more efficient with its assets.

A profitability ratio must not be looked at in and of itself or even only compared to industry benchmarks. A profitability ratio has to be seen relative to itself during previous periods to truly understand financial momentum and direction.

The Papaya Phone Company® has an ROI of 25% over the previous year, whilst The Banana Phone Company™ has an ROI of 20%. You are enticed to buy Papaya shares®, but you take my advice and decide to take a closer look first. You are in shock! Papaya shares® had an ROI of 55% for the preceding year, meaning that their return has dropped 30%. “Phew,” you say to yourself, “Good thing I read that investBETA article!”

Valuation Ratios

Valuation ratios are used to determine whether a security is undervalued or overvalued respective to some other metric. The most common valuation ratio is the price-to-earnings or P/E ratio, and was covered in-depth in last week’s article “What Makes a Strong Business?”

There are four more valuation ratios that you should be aware of, and they are the price-to-book (P/B ratio), the price-to-sales (P/S ratio or PSR), the price-to-cash-flow (P/CF ratio), and the price/earnings-to-growth (PEG ratio).

The P/B ratio gives the multiple of the market value of a company relative to its book-value, where book-value is simply total liabilities subtracted from total assets. P/B ratios are typically positive, meaning that investors expect that the company will increase profits. A P/B ratio below one indicates that investors believe that the company’s reported asset values are inflated. PSR is a company’s market value as a multiple of its sales or revenues. A PSR below the industry average can be indicative of an undervalued security and a PSR above the industry average can be overvalued. A PSR drastically deviating from the average may instead represent investors’ expectations that sales will be increasing or decreasing over ensuing quarters.

The P/CF is the market value of a company can be calculated by dividing the market value by operating cash flow. It does not take depreciation or amortization into account. Rather, it aims to value the actual capital a company creates.

The PEG ratio is a combination of two other very common metrics: price-to-earnings and projected earnings-per-share growth. It is calculated by dividing the former by the latter, and offers a way to evaluate the value of a company based on both earnings as well as growth. This ratio provides a more holistic approach as it tells us if the stock price is low or high based on projected earnings. A lower PEG ratio below 1 can mean the security is undervalued, and vice versa.

Solvency Ratios

Solvency ratios, also known as leverage ratios, are used to illustrate the ability of a business to meet its long-term financial obligations.

The total debt ratio or D/A ratio is determined by dividing total debt by total assets. A lower percentage is better as it means that the company has less debt for each dollar of assets. A higher ratio also means a higher risk of insolvency which could result in bankruptcy. A higher ratio also means that the company’s level of risk will increase more drastically during a recession. The debt-to-equity or D/E ratio is total debt divided by its shareholder equity.

The interest coverage ratio (ICR), also referred to as the times interest earned (TIE ratio), measures the ability of a company to pay interest payments. It is the earnings (before interest and taxes) over some period divided by total interest payments over that same period. When the ICR of a business is below 1.5, it’s considered highly risky, especially if it has many variable-rate obligations or earnings are expected to face headwinds.

Liquidity Ratios

Liquidity ratios are similar to solvency ratios, though are used to determine the ability of a business to pay off its short-term liabilities or potential emergencies requiring quick cash. An asset is considered liquid if it is either cash, or can be converted to cash within 30 days.

The current ratio is a measure of current assets over current liabilities. Current assets are defined as assets that are cash or expected to be converted into cash within one year, such as capital, cash equivalents, accounts receivable, short-term investments, and product inventory. Current liabilities are financial obligations a company expects to pay off within one year, such as short-term debt, dividends, accounts payable,etc. If the current ratio is below 1, it should worry investors as the company would be at a high risk of bankruptcy if they do not raise enough capital. A current ratio also shouldn’t be too high or it may indicate inefficiently use of assets. A ratio between 1.2 and 2 is generally considered healthy in most industries, but once again, this may vary from industry to industry.

The quick ratio is very similar to the ratio, though it only takes assets into account that can be converted to cash within 90 days. It includes only cash, marketable securities, and accounts receivable. Since the number of assets it takes into account is less than or equal to those from the current ratio, and it uses the same liabilities, the quick ratio will always be lower than the current ratio and is more relevant in short-term and emergency cases. The cash ratio is even more selective as it accounts for only cash and marketable securities assets.

The operating cash flow ratio, or OCF ratio, gives investors a picture of how well operating cash flow covered current liabilities over a specific period. It’s calculated by taking away operating expenses over some period from revenues over that same period, then dividing by current liabilities. This ratio is most effectively used when looked at alongside the company’s cash flow statement, in order to understand where the money is actually coming from. This is to ensure that revenues are coming from sustainable sales volumes and not through the panicked liquidation of company assets.

Activity Ratios

Also sometimes listed as efficiency ratios, activity ratios are a subset of liquidity ratios. They measure how efficiently and effectively a business converts assets into useable, liquid cash.

The inventory turnover ratio demonstrates the rate at which goods can be sold and turned into cash. To look at inventory turnover during a specific time of the year, value of sales can be divided by ending inventory. Instead, when looking at the mean rate over a longer period, the COGS can be divided by average inventory. A higher inventory turnover rate is better.

Kevin O’Leary runs a store called Kevin’s Coconuts. In 2018, the coconuts he sold cost him a total of $2 million and he had an average of 10,000 coconuts at a time. This means that Kevin’s Coconuts has an inventory turnover rate of 200. Ergo, Kevin O’leary sold his inventory 200 times over the course of the year.

The receivables turnover ratio demonstrates how well a business is able to collect on debt. Although many transactions occur right away, many are collected through credit payments over a number of days, months, or years. The ratio can be found by dividing net credit sales by average accounts receivables. A higher number is usually goods because it means that the company collects on debts quickly, and is able to then use that money to put back into the business. A ratio too large, however, can mean that the company is too strict and is losing out on potential sales and revenue.

The working capital turnover ratio demonstrates how effectively working capital is being used to sustain and grow sales. It is evaluated as sales revenue over working capital. The higher this number, the better working capital is being used to translate into more sales.

Market Prospect Ratios

Market prospect ratios are most commonly used in basic fundamental analysis, though they are not considered to be exclusive to only this category. This is in the sense that market prospect ratios are picked from the other, more formally defined categories we went over above. They include earnings-per-share, the P/E ratio, dividend payout ratio, and dividend yield.

Industry Applications

Financial ratios are useful for more than just individual investors understanding the fiscal conditions and performance of companies. They have become an integral part of all institutions and aspects of our economy.

Major banks and security exchanges have set capital requirements for companies that wish to be listed and traded to ensure some base-level of liquidity and solvency. These standards are in the best interest of investors, especially for amateurs with a lack of knowledge and experience. All of these standards are laid out through financial ratios to ensure relativity and fairness for companies of all different sizes, maintaining competition.

Another example of financial ratios in-use is in regulatory capital requirements. These requirements govern the level of liquid capital that must be maintained for an entity relative to total assets. Uncertain investment environments may result in more stringent rules regarding the minimum acceptable ratio to counteract the economic doubt and potential irresponsible financial decisions that may result therefrom.

Conclusion

Now we’ve covered all the different categories of financial ratios and how they are used in the real world. Don’t expect yourself to know them all now, and don’t try to blindly memorize their formulas. The goal was to gain an overall understanding of the each concept, and you know have that.

Feel free to bookmark this article and come back to it later to analyze a stock you’re looking into or to find the definition of a common financial ratio you see somewhere.

Hopefully this article helped you learn what financial are and why they are so important. If so, be sure to review key takeaways and take a look at some next steps you can take to support us and further your learning.

Key Takeaways

1. The two values in a ratio must be related to each other in a meaningful way to be useful.
2. Financial ratios only become useful when compared to past levels, projected future levels, competitors, and industry averages.
3. Cross-industry comparisons don’t typically work as well.
4. The goal of profitability ratios is to measure a company’s potential for generating profit.
5. Valuation ratios are used to determine whether a security is undervalued or overvalued respective to another metric.
6. Solvency ratios are used to illustrate the ability of a business to pay long-term liabilities.
7. Liquidity ratios are used to determine the ability of a business to pay short-term liabilities or financial emergencies.
8. Activity ratios measure how efficiently a business converts assets into liquid capital.
9. Market prospect ratios are used in basic fundamental analysis to gauge future potential.
10. Financial ratios are used by not just individual investors, but also by major banks, exchanges, and government regulators.

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