Financial Ratios

1.Financial Ratio

A financial ratio is a relative magnitude of two selected numerical values taken from a Company’s Financial Statements. There are many standard ratios that can be used to evaluate the overall financial condition of a company. Financial ratios can be used by managers of a firm or shareholders (both current and potential) or banks or anyone else to gauge the financial strength of the company. They can be used also to compare the strengths and weaknesses of two or more organizations.

For Ex: If I were to buy a banking stock from the Indian stock market, I can compare the financial ratios of a few of the country’s leading banks like ICICI, HDFC, SBI etc and then choose the one which I feel has the most impressive financial background and strengths.

Sources of Data for Financial Ratios:

Financial ratios of all company’s can be calculated based on their financial statements that would be declared during their quarterly result announcement. Balance Sheet, Income Statement, Statement of Cashflows, Statement of Earnings etc are some of the documents from which the information required for calculating these financial ratios can be picked up. Also, if the company is listed in the stock market, its current stock price too is used for calculating some of these ratios.

2.Types of Ratios:

There are many different types of financial ratios that can be calculated based on their purpose. They include:

1. Liquidity Ratios        – Ability of the company to pay off debt
2. Activity Ratios         – How quickly a firm can convert its non-cash assets to cash assets
3. Debt Ratios             – Ability of the firm to repay long-term debt
4. Profitability Ratios    – To Measure the firms use of its assets and control of its expenses to generate an acceptable rate of return
5. Market Ratios          – To Measure the investor response to owning a company’s stock and also the cost of issuing stock


Use of Financial Ratios:

Financial ratios can be used for comparison
• between two or more companies (ex: comparison between ICICI and HDFC Banks)
• between two or more industries (ex: comparison between the Banking and Auto industry)
• between different time-periods for the same company (ex: comparison on the results of the company in the current financial year and the previous year)
• between a single company and the industry performance

Ratios are generally meaningless unless we benchmark them against something else. Like say past performance or another company. Ratios of firms that operate in different industries, which face different risks, capital requirements, competition, customer demand etc can be very hard to compare.

Terms from a financial statement that will be used in calculation of a ratio:

1. Sales – This refers to the net sales done by the company during the reporting period (After deducting returns, allowances and discounts charged on the invoice)
2. Net Income – Amount earned by the company after taxes, depreciation, amortization and payment of interests
3. COGS – Cost of goods sold or cost of sales
4. EBIT – Earnings before Interest and Taxes
5. EBITDA – Earnings before Interest, Taxes, Depreciation and Amortization
6. EPS – Earnings Per Share

3.Profitability Ratios

Profitability Ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return. The purpose of these ratios is to help us identify how profitable an organization is. As an investor I would like to invest only in company’s that are profitable and in best case profitable than all their industry peers.

Some of the ratios that can help us identify a company’s profitability are:

1. Gross Margin or Gross Profit Margin
2. Operating Margin or Operating Profit Margin or Return on Sales (ROS)
3. Profit Margin or Net Profit Margin
4. Return on Equity (ROE)
5. Return on Investment (ROI)
6. Return on Assets (ROA)
7. Return on Assets DuPont (ROA DuPont)
8. Return on Equity DuPont (ROE DuPont)
9. Return on Net Assets (RONA)
10. Return on Capital (ROC)
11. Risk Adjusted Return on Capital (RAROC)
12. Return on Capital Employed (ROCE)
13. Cash Flow Return on Investment (CFROI)
14. Efficiency Ratio
15. Net Gearing or Gearing Ratio
16. Basic Earnings Power Ratio


3.1.Gross Margin or Gross Profit Margin:

Gross margin or gross profit margin is the difference between the sales and the production costs of the company after excluding overhead, payroll, taxation, and interest payments. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each rupee of a company's revenue is utilized to cover the costs of goods sold.

Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income.

Most company’s work towards attaining a particular gross profit margin or bettering it. So in many cases, the selling price of the finished goods is determined based on the margin that the company wishes to attain by selling these goods.

Example: Let us say Mr.X manufactures leather belts and sells them to retail show-rooms. The cost that Mr.X incurs during the production of a single premium quality belt is Rs. 400/- He wishes to maintain a profit margin of 25% on his products. So the price he would sell his belts to his retailers is Rs. 500/-

Formula:

1. Gross Profit / Net Sales or
2. (Net Sales – COGS) / Net Sales

3.2 Operating Margin:

Operating Margin is a measurement of what proportion of a company’s revenue is left over, before taxes and other indirect costs are incurred, after paying for variable costs of production like wages, raw materials etc.

A good operating margin is required for a company to be able to pay for its fixed costs like interest on its debt. A higher operating margin means that the company has less financial risk.

Formula:

Operating Margin = (Operating Income / Revenue)

Operating income is the difference between operating revenues and operating expenses

3.3 Net Profit Margin:

Net Profit margin is an indicator of the profitability of an organization. This refers to the actual amount of profit the company makes after deducting taxes and operating expenses. All company’s strive to attain a good or rather high net profit margin. A net profit margin is also an indicator of the ability of the organization to control cost and also a good pricing strategy.

Formula:

Net Profit Margin = (Net Profit (After Taxes)/ Revenue) * 100%

Note: It is easy to confuse gross profit margin and net profit margin. Gross profit is the amount of money left after paying for the operating expenditure. Net profit is the amount of money left after paying for operating expenses as well as government taxes. This is the actual amount of profit that goes into your pocket.

3.4 Return on Equity:

Return on Equity is a measure of the returns generated by every share of common stock of a company. High ROE does not mean any immediate benefits but an increasing ROE year-on-year means that the company is doing well and is able to grow on its profits.

Formula:

ROE = Net Income / No. of Shares

Net Income – This is the total income of the company after paying preferred stock dividends
No. of Shares – This is the total number of common shares in the market (Does not include Preferred Shares)

3.5 Return on Investment:

Return on Investment or Rate of Return or just return is the ratio of the money gained or lost on an investment relative to the amount of money invested. In business perspective, return on investment is the amount of money earned relative to the amount of money put up as capital. ROI is usually expressed as a percentage.

Formula:

ROI = Net Income/Average Owners Equity or

ROI = Net Income/Invested Capital

3.6 Return on Assets:

Return on Assets percentage shows us how profitable a company’s assets are in terms of generating revenue. This number tells us what the company can do with the assets it has i.e., how many rupees the company has earned based on every rupee of asset they control. It is a useful number for comparing two evenly matched or competing companies in the same industry. This number may vary widely when we compare companies across industries. Usually companies in capital intensive industries will have lower return on assets.

Formula:

ROA = Net Income from Assets / Total Assets

3.7 Return on Assets DuPont:

Return on Assets DuPont is a ratio that shows how the return on assets depends on both asset turnover and profit margin. The DuPont Method or Formula breaks out these two components (asset turnover & profit margin) in order to determine the impact of each on the profitability of the company. This ratio helps to highlight the impact of changes in asset turnover and profit margin.

Formula:

ROA DuPont = (Net Income/Sales) * (Sales/Total Assets)

3.8 Return on Equity DuPont:

DuPont Corporation created this type of calculation for Return on Equity. This theory breaks down ROE into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) returns by comparison with companies in the same industry or even between industries.

Formula:

ROE DuPont = Profit Margin * Asset Turnover * Equity Multiplier

Profit Margin = Net Profit / Sales
Asset Turnover = Sales / Assets
Equity Multiplier = Net Profit / Equity

3.9 Return on Net Assets:

The Return on Net Assets is a measure of the financial performance of a company that considers the use of its assets into account. The assets the company has at its disposal is also considered as a source of income while calculation of this parameter. Higher the RONA, the better it is for the investors. This directly means that the company is putting its assets to effective use and is generating additional revenue out of the assets rather than let them stay idle like say in a bank account.

Formula:

RONA = Net Income / (Fixed Assets + Working Capital)

If you see this formula, the working capital is also taken into consideration. This is because; the company is anyways using its working capital to generate revenue/income. This number RONA would equate to the Return on Investment if the company’s assets are generating zero revenue.

3.10 Return on Capital:

Return on Capital is a financial measure that qualifies how well a company can generate cash flows (income) relative to the capital that was invested in the business. Here capital invested includes all monetary capital invested into the business like long-term debt, common and preferred shares etc.

When the ROC is greater than the cost of capital, the company is generating value a.k.a, the company is making profits. Whereas if the ROC is less than the cost of capital, the company is making losses.

Formula:

ROC = (Net Operating Profit – Adjusted Taxes) / Invested Capital

ROC is usually indicated as a percentage.

3.11 Risk Adjusted Return on Capital:

RAROC is a risk based profitability measurement for analyzing the risk-adjusted financial performance of the company and for providing a consistent view of the profitability across businesses. RAROC is usually used in banking parlance where companies have to handle the risk of losses.

In business enterprises, risk is traded off against benefits. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is required to secure the survival of the organization in a worst case scenario; it is a buffer against expected shocks in the market values. Economic capital is a function of credit risk, market risk and operational risk and is often calculated by VaR (Value at Risk). This use of capital based on risk improves the capital allocation across the different functional areas of banks, insurance companies or any other business in which capital is placed at risk for an expected return above the risk-free rate.

Formula:

RAROC = Expected Return / Economic Capital or
RAROC = Expected Return / Value at Risk

Return on Capital Employed:

ROCE compares the earnings of the company based on the capital invested in the company. We compare the pre-tax operating income and the money invested as capital to run the business to derive the ROCE

Formula:

ROCE: EBIT / Capital Employed

EBIT – Earnings before Interest and Taxes
Capital Employed – This is actually the capital investment required to run the company. It can be shareholder funds, bank loans and other debt etc

Capital Employed = Total Assets – Current Liabilities

Cash Flow Return on Investment:

CFROI is a valuation that assumes that the stock market sets prices based on the company's cash flow and not on the corporate performance and earnings. It is calculated by comparing the gross cash flow generated by the company and the gross investment done into the same.

Formula:

CFROI = Gross Cash Flow / Gross Investment

Here Gross Investment refers to the Market Capitalization of the company.

Efficiency Ratio:

Efficiency ratio is a ratio that is usually applied to banks. It is used to determine how effectively an organization is able to carry out its operations. It is calculated by comparing the operating expenses and the revenue. A lower percentage is always better because it means lower expenses and higher earnings.

Formula:

ER = Expenses / Revenue

Net Gearing:

Also called as Gearing Ratio, this ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.

Formula:

Gearing Ratio = Net Debt / Equity

Basic Earnings Power Ratio:

The basic earning power ratio (or BEP ratio) compares earnings apart from the influence of taxes or financial leverage, to the assets of the company. It is just a ratio of the earnings of the company and its assets and does not include the capital invested into the company or the tax and interest liabilities.

Formula:

BEPR = EBIT / Total Assets 

Liquidity Ratios

Liquidity refers to the ability of a borrower to pay his debts as and when they fall due. Good liquidity is a requirement of all companies especially banks and other financial institutions. Imagine going to your bank to withdraw cash and the cashier at the counter says, I don't have enough money in the branch come back later. It would be frustrating wouldn't it be? This would not happen if the bank had enough liquidity to meet its daily customer withdrawal needs.

Ok, now coming back to the topic, Liquidity Ratios are the ratios that can be used to measure the liquidity of a company. As a rule of the thumb, all companies must have good liquidity ratios.

The four main ratios that fall under this category are:

1. Current Ratio or Working Capital Ratio
2. Acid-test Ratio or Quick Ratio
3. Cash Ratio
4. Operation Cash-flow ratio

Let us take a look at each of them in detail.

Current Ratio:

The Working Capital Ratio or Current Ratio is a financial ratio that measures whether or not a company has enough cash to pay off all the debt payments that are due over the next 1 year (12 months) It compares the organizations current assets and its current liabilities.

Formula:

WCR = Current Assets / Current Liabilities

Ex: Let us say ABC Corp has total assets of 5 crores and owes State Bank of India a loan of 3 crores to be repaid before the end of next year, the WCR for them would be

WCR = 5,00,00,000/3,00,00,000 = 1.66

This effectively means that, as of today ABC corp has 1.66 rupees for every rupee of debt it owes SBI.

Though this is good, an acceptable WCR in market terms is 2 or greater which shows that the company is sufficiently liquid and financially stable.

Acid Test Ratio:

Acid-test or Quick Ratio measures the ability of a company to use its cash or near cash assets to extinguish or pay-off its current liabilities immediately. Near cash assets are those that can be quickly converted to cash at close to their book values.

Formula:

ATR = (Current Assets – (Inventories + Prepayments)) / Current Liabilities

A company with a quick ratio of less than 1 cannot currently pay-off all its current liabilities. Any good company would want to maintain their acid test ratio to be greater than 1 at all times.

Cash Ratio:

Cash Ratio is a financial ratio that is used to identify the amount of a company’s assets that are maintained as cash or near cash entities. This is extremely important for banks and financial institutions (If you go back to the beginning of this article to the bank – cash withdrawal example, you can now relate the fact that I was in fact talking about this ratio only)

Formula:

Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.

Companies strive to maintain a good cash ratio but at the same time try to ensure that they do not hold on to too much cash that is lying idle in their bank accounts.

Operation Cash Flow Ratio:

Operation Cash Flow Ratio is a financial ratio that is used to identify the percentage of money raised by the company as part of the operation cash flow to the total debt the company owes. Operating cash flow is the cash generated from the operations of the organization after excluding taxes, interest paid, investment income etc.

Formula

OCFR = Operation Cash Flow / Total Debts 

Activity Ratios

Activity Ratios or Efficiency Ratios are used to measure the effectiveness of a firm’s use of resources. Good companies would always put their resources to optimum utilization. Better the activity or efficiency ratio, the better it is for the company and it means the company is utilizing its resources properly and effectively.

The ratios that come under this category are:

1. Average Collection Period
2. Degree of Operating Leverage
3. Days Sales Outstanding Ratio
4. Average payment period
5. Asset Turnover Ratio
6. Stock Turnover Ratio
7. Receivables Turnover Ratio

Let us take a look at these ratios in a little bit more details.

Average Collection Period:

Most organizations make sales on credit. They usually deliver goods/services to their customers without taking the payments due immediately. There could be a credit cycle understanding between them and their customers who would make periodic payments for the goods/services rendered to them. This ratio is used to calculate the efficiency with which an organization is able to collect the payments due to them from their customers.

Formula:

ACP = Accounts Receivable / (Annual Credit Sales / 365 days)

Here, only credit sales are taken into consideration. Cash sales that are settled immediately are not considered for this calculation.

Degree of Operating Leverage:

DOL is a ratio that is used to identify the changes in the operating leverage that a company requires with growth in sales and income. As and when a company grows and its sales increases, the operating costs also increase and the operating leverage required by the promoters also changes. This ratio helps us identify that value.

Formula:

DOL = Percentage Change in Net Operating Income / Percentage Change in Sales

Days Sales Outstanding Ratio:

The DSO ratio is a financial ratio that illustrates how well a company’s accounts receivables are being managed. Here accounts receivables refer to the amount of money due to the company for the services/goods provided to its customers.

Formula:

DSO = Accounts Receivable / Average sales per day or

DSO = Accounts Receivable / (Annual Sales / 365)

Average Payment Period:

Average Payment Period is the total opposite of the Average Collection Period. This is the average time taken by the company to pay off its credit purchases.

Formula:

APP = Accounts Payable / (Annual Credit Purchases / 365)

Asset Turnover:

Asset Turnover is a financial ratio that measures the efficiency of a company’s use of its assets in generating revenue or income for the company. A higher asset turnover ratio implies that the company is operating efficiently and is able to generate solid revenue income using the assets at their disposal.

Formula:

Asset Turnover = Sales / Average Total Assets

Stock Turnover Ratio:

Also called the Inventory Turnover Ratio, this is a measure of the number of times inventory is sold or used in a time period corresponding to the average inventory held by the company. This ratio can help us determine how efficiently the company is using its inventory (raw materials) to generate revenue and income. i.e., how quickly is the company able to transform the inventory into finished goods that can be sold and generate an income.

A high turnover rate means that the company is utilizing its available inventory effectively but a very high value may cause risks of inadequate inventory levels. Whereas, a low turnover rate means that the company is overstocking or there are deficiencies in the production strategies.

Formula:

STR or ITR = Total cost of goods sold / Average Inventory

Receivables Turnover Ratio:

The Receivables turnover ratio is used to measure the number of times on an average; the receivables are collected during a particular timeframe. A good receivables turnover ratio implies that the company is able to efficiently collect its receivables.

Formula:

RTR = Net Credit Sales / Average Net Receivables 

Debt or Leveraging Ratios

Debt Ratios measure the company’s ability to repay its long-term debt commitments. They are used to calculate the company’s financial leverage. Leverage refers to the amount of money borrowed in order to maintain the stable/steady operation of the organization.

The Ratios that fall under this category are:

1. Debt Ratio
2. Debt to Equity Ratio
3. Interest Coverage Ratio
4. Debt Service Coverage Ratio

Debt Ratio:

Debt Ratio is a ratio that indicates the percentage of a company’s assets that are provided through debt. Companies try to maintain this ratio to be as low as possible because a higher debt ratio means that there is a greater risk associated with its operation.

Formula:

Debt Ratio = Total Liability / Total Assets

Debt to Equity Ratio:

This ratio is used to identify the financial leverage of the company i.e. to identify the degree to which the firm’s activities are funded by the owners money versus the money borrowed from creditors.

The higher a company’s degree of leverage, the more the company is considered risky.

Formula:

DER = Net Debt / Equity

Note: This is the same as the Gearing Ratio that was discussed in Efficiency Ratios

Interest Coverage Ratio:

This ratio is used to determine how easily a company can repay the interest outstanding on its debt commitments. The lower the ratio, the more the company is burdened by debt commitments. When a company’s interest coverage ratio is 1.5 or lower, its ability to meet its interest expenses becomes questionable. An interest coverage ratio of < 1 indicates that the company is not generating sufficient revenue to satisfy its interest expenses. Formula:

ICR = EBIT / Interest Expenses

EBIT – Earnings Before Interest and Taxes

Debt Service Coverage Ratio:

DSCR is similar to the other debt ratios. This is a measure of the amount of cash flow available with the company to meet its annual interest and principal payments on its debt obligations. A DSCR of less than 1 means a negative cash flow. i.e., the company is not generating enough cash flow to meet its debt obligations. Company's try to keep their DSCR to be a value much higher than 1.

Formula:

DSCR = Net Operating Income / Total Debt Service

Market Ratios

Market Ratios are useful in measuring investor response to owning a company’s shares and also the cost of issuing shares to the public. Almost all of these ratios can be used to take decisions as to whether we should invest in a company’s stock or not. The ratios that fall under this category are:

1. Earnings Per Share (EPS)
2. Payout Ratio
3. Dividend Cover
4. P/E Ratio
5. Dividend Yield
6. Cash Flow Ratio
7. Price to Book Value Ratio (P/B or PBV)
8. Price to Sales Ratio
9. PEG Ratio

Earnings Per Share:

EPS is a very good indicator of a company's performance. It measures the amount of earnings per each outstanding share of a company’s stock.

Formula:

EPS = Net Profit / Total No. of Common Shares or

EPS = Net Income / Total No. of Common Shares

Here the EPS calculated from the Net Profit would always be lesser than the one calculate from the Net Income but invariably both give us a good measure of the ability of the company to grow and generate additional revenue.

Usually EPS values are compared between companies or between values of the same company over a period of years.

Payout Ratio:

Payout Ratio a.k.a Dividend Payout Ratio is the ratio that tell us the amount of dividend paid by the company to its common stock holders in comparison to its total income for the same time period. This percentage tells us how much dividend is paid by a company in comparison to its total revenues.

Formula:

DPR = Dividends Paid / Net Income for the same time period

A Good DPR is always a sign of a well performing company. If two stocks from the same industry are picked for comparison, the one with the higher DPR always scores more than the one that has little or no DPR.

Dividend Cover:

Dividend Cover is actually the inverse of the Dividend Payout Ratio. It is calculated by comparing the Earnings Per Share (EPS) and the actual dividend paid out per share.

Formula:

DC = EPS / Dividend Paid

P/E Ratio:

P/E Ratio also called Price to Earning Ratio refers to the price paid for a share relative to the annual net income/profit earned by the company per share. The P/E ratio is an indicator of how much investors are willing to pay for a company's share. A higher P/E ratio means that investors are willing to pay a higher premium for a company’s share in comparison to its actual value. A stock with a higher P/E is more expensive than the one with a lesser P/E.

Formula:

P/E = Market Price Per Share / Diluted EPS

The P/E value of a share keeps changing everyday based on the market price fluctuation of the company’s stock.

Dividend Yield:

The Dividend Yield refers to the ratio that helps us identify the dividend income generated by a company for its share holders. A good dividend yield means that the company is doing good business and is also sharing its profits with its investors/share holders.

Formula:

Dividend Yield = Dividend Per Share / Current Market Price per Share

Or

Dividend Yield = Total Dividend Paid / Market Capitalization

Cash Flow Ratio:

The Cash Flow Ratio is used to compare a company's market value to its cash flow.

Formula:

CFR = Market Price per Share / Present Value of Cash Flow per Share

Cash Flow per Share = Total Cash Flow / Total No. of outstanding Shares

Price to Book Value Ratio:

The PBV is a financial ratio that is used to compare a company’s book value to its current market price. Book value denotes the portion of the company held by shareholders.

Formula:

PBV = Market Capitalization / Total Book Value as per the Balance Sheet

Or

PBV = Market Value per Share / Book Value per Share

Book Value per Share = Total Book Value / Total No. of outstanding shares

A point to note here is that, PBV ratios do not directly provide us any information on the company’s ability to generate profits for itself or its shareholders. It gives us some idea of whether an investor is paying too much for what would be left if the company were to go bankrupt immediately.

Price to Sales Ratio:

The Price to Sales Ratio (PSR) is a valuation ratio for stocks that is similar to the EPS ratio we saw earlier in this article. It is used to identify how much of revenue is generated compared to the company’s market price.

Formula:

PSR = Market Capitalization / Total Revenue

Or

PSR = Current Market Price per Share / Revenue per Share

Revenue per Share = Total Revenue / Total No. of Outstanding Shares

PEG Ratio:

Price/Earnings to Growth Ratio is used to determine the relative trade-off between the price of a stock, the EPS and the company’s expected growth. In general, the P/E ratio is higher for a company with a higher growth rate. Thus, using just the P/E ratio would make high growth companies appear to be overvalued in comparison to its peers. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is better for comparing companies with different growth rates.

Formula:

PEG Ratio = PE Ratio / Annual EPS Growth

PEG ratio is a widely employed indicator of a stocks possible true value. Similar to PE ratios, a lower PEG means the stock is undervalued. The PEG is favored by many over the PE ratio because it also considers the company’s growth prospects. The PEG ratio of 1 is sometimes said to represent a fair trade-off between the values of cost and the values of growth, indicating that a stock is reasonably valued given the expected growth. A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns