Financial Ratio Analysis

Financial Ratio Analysis is your passport to mastering the language of finance. In this article, I'll demonstrate how corporate finance ratios offer a crystal-clear picture of any company's performance.

Ratio Analysis?

Ratio analysis, in my experience, is a fundamental tool in corporate finance that involves the quantitative assessment of businesses through various financial metrics. These ratios serve as crucial instruments for stakeholders like financial analysts, investors, and managers to gauge a company's financial health. They offer benefits such as facilitating comparisons between companies of different sizes and quantifying operational efficiency and profitability. Corporate finance ratios can be categorised into 4 main groups, each measuring different aspects of a company's financial status.

Profitability Ratio:

Profitability ratios are vital financial metrics utilised to assess a company's capacity to generate income in relation to revenue, balance sheet assets, operating costs, and shareholders' equity within a specific period. These ratios offer insights into how efficiently a company utilises its assets to generate profit and create value for shareholders.

A. Return Ratios

1. Return on Equity (ROE): Measures the company's ability to generate profit from shareholders' equity. ROE = Net Income / Shareholders' Equity
2. Return on Assets (ROA): Evaluates the company's efficiency in generating profit from its total assets. ROA = Net Income / Total Assets
3. Return on Capital Employed (ROCE): Assesses the company's profitability concerning the capital employed in its operations. ROCE = EBIT / (Total Assets - Current Liabilities)

B. Margin Ratios

1. Gross Margin Ratio: Reflects the company's profitability after deducting the cost of goods sold from revenue. Gross Margin Ratio = (Total Revenue - COGS) / Total Revenue
2. Operating Profit Margin: Shows the proportion of revenue that translates into operating profit after deducting operating expenses. Operating Profit Margin = EBIT / Total Revenue
3. Net Profit Margin: Illustrates the percentage of revenue that remains as net profit after deducting all expenses, including taxes and interest. Net Profit Margin = Net Income / Total Revenue

Leverage Ratios

Leverage ratios assess the proportion of borrowed money used by a business and its implications on financial risk and capital structure. Despite the risks associated with high leverage, it can also offer certain benefits.

1. Debt-to-Equity Ratio: This ratio compares a company's total debt to its shareholders' equity, indicating the proportion of financing derived from debt versus equity. A higher ratio suggests higher financial risk, as the company relies more on borrowed funds for its operations. Debt-to-Equity Ratio=(Short-Term Debt + Long-Term Debt + Other Fixed Payment) / Shareholders' Equity
2. Equity Ratio: The equity ratio measures the proportion of the company's assets financed by shareholders' equity. It is calculated by dividing shareholders' equity by total assets. A higher equity ratio indicates a lower reliance on debt financing, signifying a stronger financial position. Equity Ratio = Shareholders' Equity / Total Assets
3. Debt Ratio: The debt ratio evaluates the proportion of a company's assets financed by debt. It is calculated by dividing total debt by total assets. A higher debt ratio indicates a higher level of debt financing, which may increase financial risk but can also provide tax benefits and leverage for growth opportunities. Debt Ratio=(Short-Term Debt + Long-Term Debt) /Total Assets

Efficiency Ratios

Efficiency ratios gauge a company's effectiveness in utilizing its assets and resources. These ratios typically measure how efficiently a business can complete certain metrics within a specific period or the time it takes to fulfill operational segments.

1. Accounts Receivable Turnover Ratio: This ratio measures how many times a company collects its average accounts receivable balance within a particular period, indicating how efficiently it manages its credit and collection policies. Accounts Receivable Turnover Ratio =Net Credit Sales / Average Accounts Receivable
2. Accounts Receivable Days: Accounts receivable days represent the average number of days it takes for a company to collect payments from its customers, providing insights into its efficiency in managing receivables. Accounts Receivable Days = # of Days in Period / Accounts Receivable Turnover Ratio
3. Asset Turnover Ratio: The asset turnover ratio evaluates a company's ability to generate revenue from its assets by comparing net sales to average total assets, indicating how efficiently the company utilizes its assets to generate sales. Asset Turnover Ratio = Net Sales / Average Total Assets
4. Inventory Turnover Ratio: This ratio measures the number of times a company sells its entire inventory within a specific period, reflecting its efficiency in managing inventory levels and turnover. Inventory Turnover Ratio = COGS / Average Inventory
5. Inventory Turnover Days: Inventory turnover days represent the average number of days it takes for a company to sell its inventory, providing insights into its inventory management efficiency and the liquidity of its inventory. Inventory Turnover Days = # of Days in Period / Inventory Turnover Ratio

Liquidity Ratios

Liquidity ratios serve as vital tools for financial analysts in assessing a company's financial health. These ratios evaluate a company's ability to meet both short-term and long-term debt obligations and are instrumental in determining the riskiness of extending credit to the firm.

A. Asset Ratios

1. Current Ratio: This ratio measures the company's ability to cover its short-term liabilities with its current assets. It is calculated by dividing current assets by current liabilities. Current Ratio = Current Assets / Current Liabilities
2. Quick Ratio: Also known as the acid-test ratio, it evaluates the company's ability to meet its short-term liabilities with its most liquid assets, excluding inventory. It is calculated by subtracting inventory from current assets and then dividing the result by current liabilities. Quick Ratio = (Cash + Securities + Account Recievable) / Current Liabilities
3. Cash Ratio: The cash ratio assesses the company's ability to cover its short-term liabilities with its cash and cash equivalents alone. It is calculated by dividing cash and cash equivalents by current liabilities. Cash Ratio = (Cash + Cash Equivalents) / Current Liabilities
4. Defensive Interval Ratio: This ratio measures how many days a company can operate without needing to access additional funding, considering its cash balance and operating expenses. Defensive Interval Ratio = Current Assets / Daily Expenditures

B. Earnings Ratios

1. Times Interest Earned Ratio: Also known as the interest coverage ratio, it measures the company's ability to cover its interest expenses with its earnings before interest and taxes (EBIT). TIE-CB = EBIT / Interest Expense

C. Cash Flow Ratios

1. Times Interest Earned (Cash Basis) Ratio: Similar to the times interest earned ratio, but it uses cash flows to cover interest expenses instead of earnings. TIE = Adjusted Operating Cash Flow / Interest Expense
2. CAPEX to Operating Cash Ratio: This ratio assesses how much of a company's operating cash flow is being used to fund capital expenditures. CAPEX to Operating Cash Ratio= Cash Flow from Operations / Capital Expenditures
3. Operating Cash Flow Ratio: It measures the company's ability to cover its short-term debt obligations with its operating cash flow. Operating Cash Ratio= Cash Flow from Operations / Current Liabilities

In summary, ratio analysis plays a pivotal role in evaluating company's financial performance and making informed decisions. By understanding and utilising these ratios effectively, one can gain valuable insights into company's strengths, weaknesses, and overall financial health, enabling him to navigate the complex landscape of corporate finance with confidence.