Financial ratios

There are many financial ratios used by analysts to assess various attributes of a company's financial strength or operating results. They all involve the comparison of elements from a balance sheet or income statement, and are crafted with particular points of focus in mind.

Financial ratios can be broken down into four main categories with several specific ratio calculations prescribed within each:

Profitability or Return on Investment

a. Gross profitability: Gross Profits/Net Sales - measures the margin on sales the company is achieving. Can be a measure of manufacturing efficiency, or marketing effectiveness.

b. Net profitability: Net Income/Net Sales - measures the overall profitability of the company; how much is being brought to the bottom line. Strong gross with weak net profitability may indicate a problem "below the line" with indirect operating expenses, such as G&A expense, or non-operating items, such as interest expense.

c. Return on assets: Net Income/Total Assets - indicates how effectively the company is deploying its assets.

d. Return on investment 1: Net Income/ Owners' Equity - indicates how well the company is utilizing its equity investment. Due to leverage, this measure will generally be higher than return on assets.

c. Return on investment 2: Dividends + /- Stock Price Change/Stock Price Paid - from the investor's point of view, measures the gain (or loss) reaped from placing an investment over a period of time.

f. Earnings per share: Net Income/No. of Shares Outstanding - states profits in terms of per share basis; helpful in further comparison to market price of stock.

Liquidity

a. Current ratio: Current Assets/Current Liabilities - measures the ability of an entity to pay its near-term obligations. Current usually is defined as within one year.

b. Quick ratio (or "acid test"): Quick Assets/Current Liabilities, where "quick assets" consist of cash, marketable securities and receivables - measures a more strict definition of the company's ability to make payments on current obligations.

c. Cash to total assets: Cash/Total Assets - measures the portion of a company's assets held in cash or marketable securities. Although a high ratio may indicate some degree of safety from a creditor's viewpoint, excess amounts of cash may be viewed as inefficient.

Leverage

a. Debt/equity ratio: Debt/Owners' Equity -indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio, that is a higher proportion of owner-supplied capital.

b. Debt ratio: Debt/Total Assets - measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratio is similar, and can easily be converted to, the debt to equity ratio.

c. Interest coverage: Earnings Before Interest & Taxes/Interest Expense - indicates how comfortably the company can handle its interest payments.

Inventory and Receivables Management

a. Inventory turnover/year: Cost of goods sold for Year/Average Inventory - shows how efficiently the company is managing its production, warehousing and distribution of product, considering its volume of sales. Generally, higher ratios are thought to be better.

b. Inventory holding period: 365/Inventory Turnover/Year - calculates the number of days, on average, that elapse between finished goods production and sale of product.

c. Inventory to assets ratio: Inventory/Total Assets - shows the portion of assets tied up in inventory. Generally, the lower the better.

d. Accounts receivable turnover: Net (credit) Sales/Average Accounts Receivable - gives a measure of how quickly credit sales are turned into cash. Alternatively, the reciprocal of this ratio indicates the portion of a year's credit sales that are outstanding at the particular point in time.

e. Collection period: 365/Accounts receivable turnover - measures the average number of days the company's receivables are outstanding, between the dates of credit sale and collection of cash.