The Complete Guide To Financial Ratios (2021)
Explore the most important financial ratios which investors use to evaluate investments in the stock market.
In this post, we’ll take a look at:
To make sense of financial statements investors use financial ratios. Financial ratios are used to measure the performance of an investment. They provide investors with information about the company's profitability, liquidity, and stability and help them to evaluate the financial strength or weakness of a company.
What Are Financial Statements?
Investors use financial statements issued by a company to gain a better understanding of the current state of a company and how it is performing. These financial statements play a key role in determining a timely and final decision to invest into a company. The following financial documents are the most important for investors:
- Balance sheet
- Income statement
- Cash flow statement
Balance Sheet
The balance sheet is a financial statement which shows what assets a company owns and what liabilities a company has. The difference between the assets and liabilities of a company is referred to as the book value or shareholders equity of the company. A balance sheet is always created for a specific point in time. It is called a balance sheet because the assets and liabilities have to balance.
Income Statement
An income statement is a financial report that shows how much money a company has earned and spent during a specific period of time. It includes the revenues, expenses and profits of the company over a defined period of time.
Cash Flow Statement
A cash flow statement is a financial report that shows how much money has come in and gone out over a period of time. Therefore it gives an overview how cash flow got affected by activities outlined in the balance sheet and income statement. It is usually categorized into operating, investing and financing activities.
What Time Periods Are Considered In Financial Ratios?
When investors check financial ratios they will often check them for specific time periods. The most common time periods used for financial ratios are:
- TTM: The last twelve trailing month from the current date. Using the last twelve trailing months ensures that investors analyze financial data in an annualized format.
- LFY: The financial data for the last complete full year.
- 5Y: The last 5 full years.
- 10Y: The last 10 full years.
In general financial ratios should always be compared over longer time periods to detect any positive or negative trends. It also makes sense to compare these financial ratios across companies within the same industry to understand which companies might be the best investment.
Evaluation Ratios
Net Earnings Per Common Share
This ratio is often just referred to as earnings per share (EPS) and helps investors to determine how much they should pay per share. It can be calculated by dividing net earnings by the number of outstanding shares of common stock.
The resulting value stands for the earnings of a company belonging to each outstanding common share. Preferred shares are usually excluded from the calculation as the calculation is intended to show how many earnings belong to a common shareholder.
Investors are interested in earnings per share as it is presumed that the more a company earns the more it is able to pay out in dividends. The earnings per share also have a direct influence on how the share price will appreciate.
While investors measure using earnings per share these earnings are not paid out directly to shareholders but instead are being retained by the company. Some companies will pay out earnings as a dividend. If that is the case the higher the earnings per share will be the higher the dividend will most likely be.
While it is good to know what the current earnings per share are it is much more interesting to understand how the value will change in the upcoming years. Investors tend to invest based on expected future earnings per share instead of the current value.
Price-to-Earnings
While the earnings per share point out the absolute earnings per share the price-to-earnings ratio (P/E ratio) puts earnings into perspective to the current share price. The ratio is being calculated by dividing the current share price by the earnings per share.
A company might have extraordinary gains or losses listed in its financial statements. These can impact the result of the price-to-earnings ratio and make it hard to compare price-to-earnings ratios. Therefore it is recommended to exclude these extraordinary items from the calculation.
Enterprise Value-to-EBITDA
By using the enterprise value-to-EBITDA (EV/EBITDA ratio) metric investors can look at a company from the eyes of a potential acquirer. It includes not just earnings but also assets and liabilities. It has been used by corporate raiders and buyout firms in the past to find acquisition targets. It is equivalent to the Acquirer's Multiple.
The ratio is calculated by dividing the enterprise value by operating earnings. The enterprise value includes the market cap of the company minus its cash plus all of its debt, preferred stock and minority interest. It reflects the actual price needed to pay for the whole company while the operating earnings reflect the value that the investor gets back. EBITDA are the earnings before interest, taxes, depreciation and amortization.
Price-to-Book Value
Like the price-to-earnings ratio (P/B ratio) the price-to-book value can help investors to find undervalued companies. If the price is lower than one signals to investors that the stock is undervalued while a price above one signals them that it is overvalued. The price-to-book value ratio can be calculated by dividing the current share price by the book value.
Book Value Per Common Share
The book value of a company is equal to the equity belonging to all shareholders of a company. The book value per common share ratio simply divides the book value of a company by the number of all outstanding common shares.
The ratio tells investors how much money each share of common stock is expected to pay out in the case the company is being liquidated. In this case the company will be paying of all debts and sell all assets. If any proceeds are left they will be distributed to its shareholders.
The book value per share may not be an accurate reflection of the actual money a shareholder will receive. Usually inventories will be sold below their original value and other assets like factories or equipment might be worn out and sell for less than their book value. As a result the actual achievable book value per share will depend on the condition and demand of assets carried on the balance sheet.
If company shares are being sold below their book value per share they are usually a great bargain to pick up. In this case someone could theoretically buy the whole company, liquidate it and earn a profit. Therefore stocks sold below book value per share are usually not being undervalued for long.
Tangible Book Value Per Share
Some investors prefer to exclude intangible assets from the book value per share calculation. Intangible assets are assets which lack physical substance, like intellectual property rights or brand names, which make valuation difficult.
The tangible book value per share can be calculated by dividing the total tangible assets by the number of all outstanding common shares.
Dividend Payout Ratio
The dividend payout ratio give insights into how much earnings are being paid out as dividends per each outstanding share of common stock. It is being calculated by dividing the dividend per share by the earnings per share.
Dividend Yield
The dividend yield is the amount of dividends paid divided by the current share price.
When investors mention the dividend yield they generally mean the dividend expected over the next 12 months dividend by the most recent share price. As the current share price is constantly changing so is the dividend yield.
Profitability Ratios
Gross Profit Margin
The gross profit is the difference between sales and costs of goods sold. When dividing the gross profit by sales an investor will get the gross profit margin.
The gross profit margin is an excellent indicator to compare the profitability of multiple companies. It can also be used to understand the profitability of a single company over time.
However investors should keep in mind that gross profit margins can differ between different industries. Hence it only makes sense to compare gross profit margins of related companies.
In addition outside factors can temporarily influence costs of goods sold and therefore the gross profit margin. For example a shortage of materials might increase prices and therefore lower the profitability until the shortage has been resolved.
Operating Profit Margin
The operating profit margin can be used to measure the effectiveness of the management of a company. It excludes operating expenses which are under the control of the company from sales.
When the operating profit margin of a company improves it is generally well received by investors. This improvement is known as margin expansion and can have multiple underlying reasons:
- The company was able to increase reales with a smaller increase in costs.
- The management was able to raise prices without losing customers.
- The management was able to reduce operating costs.
The operating profit is also sometimes referred to as earnings before interest and taxes (EBIT).
Pretax Profit Margin
The pretax profit is the profit of a company before taxes where deducted. When dividing it by the total sales for the same period investors will get the pretax profit margin.
Like the operating profit margin the pretax profit margin helps investors to identify efficiently managed companies. If two companies with the same size and products have different pretax profit margins the one with the higher margin is most likely more efficiently managed. However this might not be true if companies are of different sizes as larger companies can spread their expenses over more units sold.
Within a given industry the company with the highest pretax profit margin is considered to be the safest investment. If sales or profitability were about to decline due to external factors like price wars between competitors this company would suffer the least.
Net Profit Margin
The net profit margin is the same as the pretax operating margin but after taxes have been paid. This ratio generally only makes sense to compare when two companies have different tax rates.
Management Effectiveness Ratios
Return On Invested Capital
The return on invested capital ratio helps investors to identify how well a company is using its invested capital to generate a profit. The invested capital is the amount of capital which circulates within the company. This ratio can be used as a basis for comparing companies in the same industry. It tends to vary widely by industry and tends to be lower in more competitive ones.
It is being calculated by dividing the net profit after tax by the total capital available to the company.
As the profit is generally achieved using the capital available at the beginning of the calculated period it makes sense to use the capital at the beginning of the period and the net profit after tax from the end of the period. Some analysts also use averages of the capital at the beginning and end of the period. As the capital constantly fluctuates during the period this is meant to improve accuracy.
Return On Capital Employed
While return on capital capital and return on capital employed both measure how efficient capital is being used they differ slightly in what they measure. Return on capital employed is being calculated by dividing earnings before interest and tax by the employed capital. Unlike invested capital the employed capital includes the total capital of the company. As the formula excludes interest and tax it measure the efficiency of the business operations from the perspective of the company. This is different to the return on invested capital which includes interest and tax into the calculation and therefore measures how efficient the whole company uses its capital from the perspective of investors.
Return On Equity
The return on equity ratio looks at how profitable a company is from the perspective of shareholders. As it is based on the shareholder’s equity it measures the return on the capital provided by the owners of the company.
It is being calculated by dividing the net income of the company by the book value of shareholders equity.
Return On Total Assets
The return on assets ratio measures how effectively the management of a company is using its assets to generate profits. It can be calculated by dividing net income by total assets.
It can be used to compare companies in the same industry or watch a company over time. As the need to maintain assets is different between industries it is not advisable to compare the return on assets across industries. For example a software company might need fewer assets than a car manufacturer.
Financial Strength Ratios
Interest Coverage
Using the interest coverage ratio investors can understand if a company will be able to meet its interest charges. The interest coverage ratio is calculated by dividing the earnings before interest and taxes (EBIT) by the total interest payments. As interest charges are deducted before pretax profit and taxes are being calculated the ratio uses the gross profit rather than the net profit. Also note that the calculation is usually being done using the full year’s result.
Debt owners can force a company into bankruptcy by demanding the company to pay off the debt at once in case it is unable to meet its interest charges. As a result investors watch this ratio carefully to ensure the company will meet its financial obligations. They want to ensure that the company is generating sufficient cash in a period of time to meet its interest obligations over the same period.
Using the interest coverage ratio investors can answer multiple questions:
- How much money is the company earnings that is available to pay interest?
- How many times larger is the available amount of earnings than its needs to be?
Fixed Charge Coverage
The fixed charge coverage ratio works similarly than the interest coverage ratio. However rather than just taking interest payments into account it also includes other fixed charged like lease payments.
Debt-to-Total Capitalization
By dividing long-term debt by the total capitalization of the company investors get the debt to total capitalization ratio. It determines how easy a company can borrow additional money. The lower the ratio the more likely it is to borrow money.
Total Debt Ratio
By using the total debt ratio investors can quickly understand how much debt a company has relative to its total assets. The ratio can be calculated by dividing the total liabilities by the total assets of the company.
Unlike the debt-to-total capitalization ratio the total debt ratio includes both current and non-current liabilities. As a result the total debt ratio might flag possible problems which the debt-to-total capitalization ratio might miss.
A company with a total debt ratio above 0.5 is considered highly levered and therefore a risky investment.
Financial Condition And Liquidity Ratios
Current Ratio
The current ratio measures the company’s ability to pay off its short-term liabilities as new current assets are constantly added through inventory or accounts receivable. It is being calculated by dividing current assets by current liabilities.
A high current ratio reflects high liquidity which makes these companies less risky from the perspective of creditors. However a high current ratio can also indicate an inefficient use of cash or poor control of inventory. Therefore it makes sense to compare it against companies within the same industry to catch any anomalies.
Quick Ratio
Like the current ratio, the current ratio measures the company‘s ability to pay for its short-term obligations. However, unlike the current ratio, inventory is being removed from current assets as it usually not considered to be one of the liquid assets which can be sold immediately. The quick ratio is calculated by subtracting inventory from current assets before dividing it by current liabilities.
Cash Ratio
The cash ratio is a stricter version of the quick ratio. It is being calculated by adding marketable securities to cash before dividing by current liabilities.
Efficiency Ratios
Total Asset Turnover
Investors can measure the management‘s effectiveness in using the company‘s assets to generate sales by using the total asset turnover ratio. It is being calculated by dividing sales by total assets.
A higher result indicates that the company is more effective in generating sales using its assets. Like the return on invested capital the total asset turnover ratio is more accurate when dividing by the average total assets of the year.
Inventory-to-Sales
A company generally want to ensure that it always has enough inventory to fulfil its sales but not too much inventory which produces costs for the company. As companies generally schedule manufacturing and inventory scheduling in advance a slow in sales can cause the inventory to pile up. The inventory to sales ratio can detect slowing sales early by looking at the relationship between inventory and sales.
Accounts Receivable-to-Sales
Like the inventory to sales ratio the accounts receivable to sales ratio can point to possibly issues with a company when being watched over longer periods. If the ratio would suddenly jump it can point to customers not paying their bills which can have a big impact on the financial condition of the company.
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