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Financial Ratios: A Primer

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Kevin Lowther

Financial ratios are quantitative measures used to assess the performance and the overall financial health of a business. The end goal of using ratio analysis is to improve the decision making process. Ratio analysis not only compares similar companies against each other, but also can be used to track the performance of a company year to year.

In this article I classify the financial ratios into five categories: profitability, leverage, liquidity, efficiency and growth.

Profitability ratios

Profitability ratios are financial metrics used to measure and evaluate the ability of a company to generate profit relative to revenue, assets, operating costs and shareholders’ equity during a specific period of time. They show how well a company utilizes its assets to produce profit and value to its shareholders. Profitability ratios are broken down into two categories: return ratios and margin ratios.

Return ratios represent the company’s ability to generate returns for its shareholders. These ratios typically compares a return metric versus certain balance sheet items: return on equity and return on assets. These are used to measure how well capital is deployed in a business. For example, if the business only generates a 3 percent return for the owner, would the capital be better used elsewhere, such as the stock market?

Margin ratios measure how well the company converts sales into profits at various degrees of measurement. Margin ratios look at returns when compared to the top line revenue. Typically, it compares the following income statement (profit and loss statement) items: gross margin, operating profit margin and net profit margin. Margin ratios show the operating consistency of the business year to year. If gross margins are falling for example, can the business source a cheaper supplier for their goods or pass costs through to customers?

Leverage ratios

Leverage ratios represent the extent to which a business is utilizing borrowed money. These ratios indicates the level of debt incurred by a business entity against other accounts in its balance sheet, income statement, or cash flow statement.

Debt-to-equity ratio is a total measure of coverage of debt (short and long term) to the owner’s equity in the business. Lenders may be concerned if total liabilities exceed net worth.

Interest coverage shows the ability of the company to at least pay its interest expense. It is typically calculated as EBITDA (earnings before interest, tax, depreciation and amortization) divided by interest expense. Lenders expect to see a ratio in excess of 1.0.

Liquidity ratios

Liquidity ratios are closely linked to leverage ratios. They are used to evaluate the financial soundness of a company. These ratios measure a company’s ability to repay both short-term and long-term debt obligations. The two most common ratios are the current ratio and the quick ratio.

The current ratio is calculated by dividing current assets by current liabilities. The ratio indicates to what extent cash on hand and disposable assets are enough to pay off near term liabilities.

The quick ratio is applied as a more stringent test and is calculated as cash plus accounts receivable divided by current liabilities, indicating liquid assets available to cover current liabilities. It is also known as the acid ratio.

Efficiency ratios

Efficiency ratios are used to measure how well a company utilizes its assets and resources. These ratios examine how many times a business can accomplish a metric within a certain period of time, or how long it takes for a business to fulfill segments of its operations. For example, the inventory turnover ratio shows how many times a business can sell an entire stock of inventory in a period of time. Typical ratios in this group are inventory turnover, days sales outstanding and fixed asset turnover. I have previously discussed the cash conversion cycle (KBJ Oct. 30, 2020) as an example of how efficiently a company turns its inventory and sales into cash.

Growth

We use growth ratios to see how well the company has performed in terms of revenue and profitability over a single period or multiple periods. To measure profitability over one year we take the year end profit of 2020 and divide by the year end profit of 2019 then subtract one:

Profit 2020Profit 2019 – 1 equals percentage change in profitability over one year. 

For multiple years we use a geometric calculation. For example if we wanted to see the five year annual percentage profitability from say 2016 to 2020 we would use this formula:

Profit 2020Profit 2016 ^14 – 1 equals compound annual growth.

Benchmarking

Benchmarking allows us to make sense of the ratios we have calculated. We can use internal measures of the performance of the company from year to year or we can utilize industry statistics provided by BizMiner or Risk Management Associates.

Conclusion

Ratio analysis provide valuable information to help make decisions and provide quantitative information on how the company is being run. A ratio analysis spreadsheet is available for download from our website: centralpacval.com/ratios.

Kevin Lowther, AM-ASA, ABV, FMVA is a partner with Bakersfield-based Central Pacific Valuation. He provides business valuation and financial analytics services.

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