Finance

Financial Ratios

  Financial Ratios: Detailed Applications and Analysis

           Jacob Mack

   Northcentral University

              FIN-7015

            Dr. Halstead

          March 30, 2020

    Introduction

 In this paper I discuss financial ratios and delve into the five most important financial ratios for a potential equity investor, for a potential bond investor within a corporate bond issuance, for a bank investment within a short-term corporate loan, and for a shareholder to assess stock buying decisions. First I provide an overview of financial ratios and a detailed discussion on their various applications.  I also introduce the weighted average cost of capital (WACC) exposition its utility with financial ratios, and argue it is itself a financial ratio, and in fact, the most robust in general. I also provide numerical examples to illustrate how financial ratios work in the investment world. Finally, I asses Kaminski, Wetzel, and Guan (2004) the research being conducted, why, how, along with the methods used, and conclusions reached.

                                                   Financial Ratios Overview

           Financial ratios are quantitaive representations taken from data from financial statements and they analyze positions like liquidity, leverage, growth, margins, profitability, rates of return, valuation, and expected future capital values (CFI, 2020). There are five general financial ratio categories which are liqudity ratios, leverage ratios, efficiency ratios, profitability ratios, and market value ratios (CFI, 2020). Financial ratios can assist in tracking firm performance, comparing performance of one company to another within the same industry, assist investors, and bond holders in making purchaisng, or sell-off decisions as well (Gibson, 2012). There are internal and external users of financial ratios, which means, persons inside and outside of a given company (CFI, 2020). External users may inlcude financial analysts, retail investors, and tax regulators (CFI, 2020). Internal users may include the management team, employees, and owners (Gibson, 2012).

           Short-term, mid-term, and long-term financial health are evaluated via the three financial statements, the balance sheet, income statement, and cash flow statement, and the financial ratios can quanitfy key elements of each financial statement, like liquidity, solvency, and pure cash flows (Wealthy Education, 2020). Financial ratios also serve as a benchmark to compare the financial statement information with stock market trading data and serve as an overarching framework in economic decision making for firms to engage in profit maximization (Wealthy Education, 2020). Calculating financial ratios are approximations and not an exact science or statistical financial endeavor, as the data is noisy and financial industry circumstances can often change rapidlly (Wealthy Education, 2020). While this paper is not about the weighted average cost of capital per se (WACC) it is WACC that affects the outcomes of financial health analyses and is itself technically a financial ratio (Wallstreetprep, 2020). Cost of capital can affect both stock investors and bond holders for differing reasons but both related to the cost of capital as a statistical average (Wallstreetprep, 2020). The ubiquity of WACC calculations and potential effects exerted upon financial statements makes it the most robust financial ratio. The WACC calculation along with the other financial ratios will be discussed in the next sections. However the WACC will be discussed via the context of five ratios for each category of the assignment rather than replacing any financial ratios to be discussed.

Depending upon what an analyst, manager, or investor is most concerned with different financial ratios can be applied to various quantitative metrics within equity investments, bond investments, (loans) banks investments, and evaluating whether to buy a particular stock or not (Wallstreetprep, 2020). An investor who already owns stocks might want to undertand better if they should hold, buy more, or sell of their stocks. A bond holder looks more for stability, via solvency than higher risk investment decisions that may lead to greater capital gain or loss ().

Five Most Important Financial Ratios For Equity Investors

           For equity investors the five ratios I chose are the current ratio, the acid-test ratio, the cash ratio, the operating cash flow ratio and the debt ratio, with the first four examples being from the liquidity ratios, and the last one from the leveraging financial ratios (CFI, 2020). The current ratio is calculated via current assets/current liabilities, the acid-test ratio is current assets – inventories/current liabilities, the cash ratio is found via cash and cash equivalents/current liabilties, the operating cash flow raio is operating cash flow/current liabilities (CFI, 2020).

           My reasoning for these five financial ratios is they provide a robust means to evaluate where the stocks might go next, and how that relates to the given company’s performance to increase capital which is what shareholders look for as opposed to bondholders who are more risk averse and want to see more stability with long-term solvency from less risky handling of capital or assets (CFI, 2020).

                                                       Weighted Average Cost of Capital

The WACC formula is WACC=E/V ?Re+D/V ?Rd?(1?Tc) where Re is cost of equity, Rd is cost of debt, E is market value of a firm’s equity, D is market value of a firm’s debt, V = E + D is total market value of of a firm’s financing, D/V is the percentage of financing that is debt, and Tc is the coroprate tax rate (Wallstreetprep, 2020). The WACC includes all capital sources like common stock, preferred stock, bonds, and all long-term debt (Wallstreetprep, 2020). In short the WACC quantifies risk and sets an appropriate cost of capital (debt and equity) to the company (Wallstreetprep, 2020).  

Five Most Important Financial Ratios For Bond Investors

For bond investors I chose the asset turnover ratio,  the inventory turnover ratio, the reveivables turnover ratio, the day sales in inventory ratio, and the cash flow to sales ratio (CFI, 2020). The asset turn over ratio is calculated via net sales/total assets,  the inventory turnover ratio is cost of goods sold/average inventory, the receivables turnover ratio is net credit sales/average accounts receivable, the day sales inventory ratio is 365 days/inventory turnover ratio, and the cash flow to sales ratio is operating cash flow/net sales (CFI, 2020).

My reasoning for using these five financial ratios is they generally indicate how stable a given company is which is a preferred metric for bondholders who act more as loaners, and are more risk-averse than shareholders (CFI, 2020). Slow and steady is more the bondholder’s style.

WACC calculations can estimate weighted parameters to provide a reaonsable capital return from the company based upon the bond’s overall risk from the current purchase to the full maturity and payout (Wallstreetprep, 2020).

Five Most Important Financial Ratios For Bank Investments

           For bank investments I chose the interest coverage ratio, the interest expense to debt ratio, the fixed charge coverage ratio, the capilitazation ratio, and debt to EBITDA ratio (CFI, 2020). The interest-rate coverage ratio is found via operating income/interest expenses, the interest expense to debt ratio is calculated by, total interest expense/total debt, the fixed charge coverage ratio is, EBIT + fixed charge before tax/fixed charge before tax + interest, the capitalization ratio is found via, long-term debt/long-term debt + shareholder’s equity, and debt to EBITA ratio is calculated via, total debt/EBITDA (CFI, 2020).

           My reasoning for choosing these methods is these ratios properly evaluate important metrics for bank investment potential returns, as well as, evaluate risks associated with such investments. WACC calculations here can be usful to gain a more clear picture of how expensive capital will be from both debt and equity sources (Wallstreetprep, 2020).

Five Most Important Financial Ratios For Potential Shareholders

           For potential shareholders I chose debt to net-worth ratio, long-term debt to equity ratio, long-term debt to capitilization ratio, the financial leverage index, and the long-term debt ratio (CFI, 2020). The net-worth ratio is found via, total debt/total net worth * 100, for the long-term debt to equity ratio it is, long-term debt/averagre shareholder’s equity, long-term debt/total available capital, it is ROE/ROA, and for the long term debt ratio it is long term debt/total assets (CFI, 2020).

           Potential shareholders need to better understand financial leverage at the time they are considering to invest, as well as, long-term equity and deb risk to pay-offs, and that is why I chose these financial ratios here. WACC can also make it more clear the direction of debt and equity sources of capital.

                                               Article Review Kaminski et., al (2004)

           Kamonski et., al (2004) researched the question if financial ratios can help detect fraudulent financial reporting via comparing financial ratios between bad acting companies and those companies that do not engage in financial statement  reporting fraud. A longitudinal cross-comparison (not cross sectional) methodology was applied (Kamonski, et., al 2004). The research employs mixed methods as Kamonski, et., al (2004) look at analytical qualitative data, and they apply univariate, and multivariate statistical methods to analyse the data. Multivariate analysis was found to be more robust with 21 ratios acting as independent variables, but even so financial ratios were found to only have a limited utility in detecting financial reporting fraud (Kominski, 2004).

                                                                       Conclusion

           Financial ratios indicate a plethora of indicators that various types of stakeholders care about. The WACC is itself its own kind of financial ratio but it is also foundational for a plethora of other financial ratios both directly and indirectly via its statistical weighting of paramters within an average cost of capital. Kominski et., al (2004) only found a weak corrleation between financial ratios and fraudulent financial reporting with many aspects havin no correlation. Kominski et., al (2004) used a mixed methods approach but applied a robust statistical analyis to the data set. I believe that WACC while taught in undergraduate courses periodically, and in MBA programs more robustly, then in PhD programs at a variable rate, is fundamental to all of the financial ratios and understanding all three financial statements. The more accurately WACC is calculated and reported the less fraud there can be elsewhere (Wallstreetprep, 2020).

   References

CFI (2020). Financial Ratios, The Use of Financial Figures to Gain Significant Information

About a Company. Corporate Finance Institute, retrieved from:

https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-ratios/

Gibson, C. (2012). Financial Reporting & Analysis Using Financial Accounting (13e)

Australia: South-Western Cengage Learning

Kaminski, K., Wetzel, S., & Guan, L. (2004). Can Financial Ratios Detect Fraudulent Reporting?

Managerial Auditing Journal 19(1), 15-28.

Wallstreetprep (2020). WACC (Weighted Average Cost of Capital): WACC Formula and Real

Examples, retrieved from: https://www.wallstreetprep.com/knowledge/wacc-weighted-average-cost-capital-formula-real-examples/

Wealthy Education (2020). The Ulitmate Guide to Financial Ratios, Retrieved from:

https://wealthyeducation.com/financial-ratio-categories/