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Types of Financial Ratios: Their Analysis and Interpretation - Penpoin.
Types of Financial Ratios: Their Analysis and Interpretation - Penpoin.
In this article, I will describe various financial ratios, including their formulas
and interpretations.
But, the interpretation may not be as simple as the calculation. Ratios must
be meaningful and refer to economically important relationships, thus
helping us interpret the company’s financial performance and soundness.
1. Efficiency Ratio
2. Liquidity ratio
3. Solvency ratio
4. Profitability ratio
Efficiency Ratio
The efficiency ratio tells us how effectively a company manages its assets
and liabilities. Of course, we like it when the company is productive and
efficient in carrying out day-to-day operations. We also call this the activity
ratio, and it includes:
Inventory turnover
Days of inventory on hand (DOH)
Accounts receivable turnover
Days sales outstanding (DSO)
Accounts payable turnover
Days payable outstanding (DPO)
Working capital turnover
Fixed asset turnover
Asset turnover ratio
Inventory turnover
On the other hand, a low ratio could indicate a problem. For example,
companies may stockpile goods in warehouses due to sales problems. Or,
the company rebuilds its inventory too quickly even though market demand
is still weak.
Yet, a high ratio can also indicate insufficient inventory. So, it could be a
problem if the future demand outlook is strong. The company cannot meet
demand because of insufficient inventory, so sales are less than optimal.
We can then use the inventory turnover ratio to calculate another financial
ratio, namely days of inventory on hand (DOH). It shows us how long it took
the company to convert its inventory into sales. The DOH formula is as
follows:
DOH has an inverse relationship with inventory turnover. The higher the
inventory turnover ratio, the lower the DOH, and the faster the company
converts inventory into sales.
Conversely, if the receivables turnover is low, the company may be too lax in
providing credit. Or it happens because the company is having trouble
collecting payments from customers.
But, as a note to us, a high receivables turnover ratio can also occur due to
too-strict credit terms or collection policies. It can hurt sales if competitors
offer customers more lenient credit terms.
Accounts payable turnover shows us how well the company utilizes credit
facilities from its suppliers. It’s the opposite of the accounts receivable
turnover ratio.
Next, to calculate the accounts payable turnover ratio, we can use the
following formula:
The formula shows how many times a company pays its suppliers in a year.
Thus, a low ratio is desirable because the company obtains more lenient
credit terms from its suppliers. So, the company can use the cash for other
purposes before paying it to them.
On the other hand, a high ratio may indicate the company is spending too
quickly. As a result, it reduces the company’s financial flexibility. Several
reasons explain why it happened:
1. Companies may not take full advantage of available credit facilities and
pay creditors too quickly.
2. Suppliers have too strict policies.
3. Companies make early payments to get discounts.
Then, we can also use the accounts payable turnover above to calculate the
days payable outstanding (DPO). It shows how long the company pays its
suppliers. The formula is as follows:
The higher the accounts payable turnover, the lower the DPO, indicating it
pays its suppliers earlier. For example, the DPO value is 90, which shows us,
the average company takes 90 days to pay its suppliers.
Fixed asset turnover shows us how effectively a company uses its fixed
assets to generate revenue. Fixed assets consist of property, plant, and
equipment (PP&E). We can find it in non-current assets on the balance
sheet.
The asset turnover ratio highlights the overall operating efficiency. It shows
how well management is managing and using assets, both short-term and
long-term. The higher the asset turnover ratio, the better.
We calculate the asset turnover ratio by dividing the revenue on the income
statement by the average total assets on the balance sheet.
Liquidity ratio
The liquidity ratio measures the company’s ability to meet its short-term
obligations, such as short-term debt and accounts payable. In general, to
get the liquidity ratio, we have to divide the accounts in current assets by the
total current liabilities. The three commonly used ratios are:
1. Current ratio
2. Quick ratio
3. Cash ratio
Apart from these three, two other ratios for measuring liquidity are:
Defensive interval ratio
Cash conversion cycle
Current ratio
This ratio shows us whether the company’s current assets are sufficient to
pay its short-term liabilities. A current ratio value equal to 1 is usually a limit,
which means current assets are equal to current liabilities. If it is less than
one, it can mean the company has a liquidity problem.
Quick ratio
The quick ratio uses only certain current asset accounts. They are cash and
cash equivalents, short-term investments (marketable securities), and
accounts receivable.
We exclude less liquid items such as inventory because the company may
not be able to convert them into cash immediately. So, when inventory is
illiquid, this ratio is a better liquidity indicator than the current ratio.
A higher ratio indicates the more liquid and the better the company’s ability
to pay obligations in one operating cycle.
Cash ratio
As with quick ratios, a higher cash ratio generally means the company has
higher liquidity.
The defensive interval ratio measures the company’s ability to cover daily
expenses using the most liquid assets without obtaining additional financing.
The higher the ratio, the better.
The cash conversion cycle measures how long it takes a company to convert
inventory into cash after adjusting for payments to suppliers. The following is
the cash conversion cycle formula:
Days sales outstanding (DSO) describes how quickly the company collects
payments from customers. Days of inventory on hand (DOH) measures how
quickly a company converts inventory into sales. Meanwhile, days payable
outstanding (DPO) shows how many days the company pays its suppliers.
Shorter cycles are desirable, indicating better liquidity. This is because the
company can convert inventory into cash immediately and pay its suppliers.
Conversely, longer cycles indicate lower liquidity.
Solvency ratio
When the company has high debt, we say the company’s financial leverage
is high. High leverage is a cause for concern. The company must pay large
interest charges regularly, even when they are not generating revenue. It
reduces the profit and cash flow of the company.
Then, shareholders also do not like it if the debt is too high. That’s because
when the company goes bankrupt, fewer assets are left to them. Hence, the
higher the debt, the higher the risk of default and the riskier the stock.
As the name suggests, we calculate the debt to assets ratio by dividing total
debt by total assets. We can find these two numbers on the balance sheet.
The total debt I mean here is interest-bearing debt, both short-term and
long-term.
Debt to capital
A higher ratio indicates higher financial risk, and therefore, it is not preferred.
So, why don’t companies prefer equity over debt?
The company uses debt in its capital composition because it is cheaper. The
cost of debt is tax-deductible.
But, too much debt is also not good. The company has to pay interest
regularly.
Hence, the company must find the optimal capital structure in which the
costs are minimal. Then, to measure the cost of capital, we can use the
weighted average cost of capital (WACC).
Debt to equity
The debt to equity ratio (DER) shows how much the company’s debt is
relative to equity capital. Again, we can find both in the balance sheet, in the
liability and shareholder equity section.
The interest coverage ratio measures the company’s ability to pay interest.
We can calculate it by dividing earnings before interest and tax (EBIT) by
interest expense.
EBIT is the profit a company receives from its core business. Financial
statements may not be presented separately. Therefore, we have to
calculate it ourselves. Here’s the formula:
How to calculate EBIT may vary. Some exclude other income (expenses),
while others include it. They are usually unstable and may not continue in the
future, so some financial analysts prefer to exclude them.
Profitability ratio
The profitability ratio measures the extent to which the company generates a
profit. There are two approaches to calculating it.
First, we divide the profit metrics by revenue, which we call the profitability
margin. It measures how effective the company is in converting revenue into
profit.
Second, we divide net income by balance sheet items, such as assets,
equity, and capital. In this case, the ratio shows how high the company’s rate
of return is for each asset, equity, and capital used.
Gross profit is revenue minus the cost of goods sold (COGS). COGS
represents the direct costs associated with producing goods or providing
services.
A high gross profit margin is more desirable, indicating more money is left to
cover indirect costs. A lower ratio indicates the opposite condition.
A differentiation strategy allows the company to earn high margins for each
unit sold since it can charge a premium price.
The operating profit margin tells us what percentage of dollars the company
has left on each sale after paying all operating expenses. It measures how
profitable the company’s core business is.
The operating profit margin is more complete and accurate than the gross
profit margin in measuring the company’s profitability performance. This is
because this ratio considers direct and indirect costs such as selling, general
and administrative expenses (SG&A expenses), which represent fixed costs.
Companies have to spend money on SG&A expenses, even when the
company stops production and makes no sales.
A higher value is more desirable. We also call it net profit margin or net
earning margin.
Return on assets
Return on assets (ROA) measures how well a company uses its assets to
generate profits. We measure it by dividing net income by total assets. To
avoid variations in asset values due to seasonal factors, we can use the
average total assets.
The higher the ROA, the more able the company to generate net profit from
each asset used. And, it is more desirable.
Return on equity
Observing only one or two ratios can also be misleading. We can err in
concluding, making unobjective judgments. We need references or
benchmarks to interpret financial ratios. Benchmarks are important to
answer whether the financial ratios in a given year are better or worse.
Historical trend
Peers or industry average
For historical trends, we compare the same numbers over time. In this case,
we can use their average in the last three or five years as a benchmark.
In my opinion, calculating the average for several years makes more sense
than using the previous year as a benchmark. This is because trends from
year to year tend to fluctuate due to cyclical factors. And, it can increase our
subjectivity if we only use the previous year.
All four affect the company’s business strategy. And it ultimately affects the
company’s finances.
When one analyst calculates the ratio, the results may differ from other
analysts. The reason is because they use different justifications. For
example, one analyst may include a specific item. But, others exclude it.
Each has a strong and logical reason.
Thus, when we calculate financial ratios, we must know why we use certain
items. What is the reason? For example, two analysts may use different
accounts to calculate the interest coverage ratio. One uses EBIT as the
numerator. Others use earnings before interest, taxes, depreciation,
amortization (EBITDA). But, to be sure, both have their own reasons for
doing so.