Financial ratio analysis
Ratios condense financial statements into comparable measures of liquidity, efficiency, leverage, profitability, and market value.
Using ratios
Ratios let analysts compare a company over time and against competitors of different sizes. They are most meaningful in context: trends over several years, industry averages, and the company's strategy. No single ratio tells the whole story.
Liquidity ratios
Liquidity ratios measure the ability to meet short-term obligations. Current ratio = current assets / current liabilities. Quick ratio = (current assets - inventory) / current liabilities. Cash ratio = cash and equivalents / current liabilities. Lenders watch these closely.
Efficiency ratios
Efficiency (asset management) ratios show how well assets generate sales. Inventory turnover = cost of goods sold / inventory; days sales outstanding = receivables / (annual sales / 365); total asset turnover = sales / total assets. Higher turnover generally means more efficient use of assets.
Leverage ratios
Leverage (solvency) ratios measure the use of debt. Debt ratio = total debt / total assets; debt-to-equity = total debt / total equity; equity multiplier = total assets / total equity; times interest earned = EBIT / interest expense. Higher leverage increases both potential returns and financial risk.
Profitability ratios
Profit margin = net income / sales. Return on assets (ROA) = net income / total assets. Return on equity (ROE) = net income / total equity. Gross and operating margins show profitability at different levels of the income statement.
The DuPont identity
ROE = profit margin x total asset turnover x equity multiplier. This breaks down whether a company's ROE comes from profitability, efficiency, or leverage. Two companies with the same ROE may have very different risk if one relies heavily on debt.
Market value ratios
Market ratios link financial results to share prices. Price-to-earnings (P/E) = share price / earnings per share. Market-to-book = market value per share / book value per share. Enterprise value (market value of equity + debt - cash) divided by EBITDA is a common valuation multiple.
Worked example
A company has sales of 1,000,000 dollars, net income of 50,000, total assets of 800,000, and equity of 400,000. Profit margin = 5%; asset turnover = 1.25; equity multiplier = 2. ROE = 5% x 1.25 x 2 = 12.5%, the same as 50,000 / 400,000. ROA = 50,000 / 800,000 = 6.25%.
Key takeaways
Ratios are meaningful with trends and benchmarks. Liquidity ratios include current, quick, and cash ratios. Efficiency ratios include inventory turnover, days sales outstanding, and asset turnover. Leverage ratios include debt ratio, debt-to-equity, equity multiplier, and times interest earned. Profitability ratios include profit margin, ROA, and ROE. DuPont splits ROE into margin, turnover, and leverage. Market ratios include P/E, market-to-book, and EV/EBITDA.
Flashcard
Current assets / current liabilities
Check your understanding
A firm has total assets of 600,000 dollars and equity of 200,000 dollars. What is its equity multiplier?