Financial ratios express relationships between financial statement items. Although they provide historical data, management can use ratios to identify internal strengths and weaknesses, and estimate future financial performance. Investors can use ratios to compare companies in the same industry. Ratios are not generally meaningful as standalone numbers, but they are meaningful when compared to historical data and industry averages. Show
Liquidity and the Current RatioThe most common liquidity ratio is the current ratio, which is the ratio of current assets to current liabilities. This ratio indicates a company's ability to pay its short-term bills. A ratio of greater than one is usually a minimum because anything less than one means the company has more liabilities than assets. A high ratio indicates more of a safety cushion, which increases flexibility because some of the inventory items and receivable balances may not be easily convertible to cash. Companies can improve the current ratio by paying down debt, converting short-term debt into long-term debt, collecting its receivables faster and buying inventory only when necessary. Solvency Ratios and Financial StabilitySolvency ratios indicate financial stability because they measure a company's debt relative to its assets and equity. A company with too much debt may not have the flexibility to manage its cash flow if interest rates rise or if business conditions deteriorate. The common solvency ratios are debt-to-asset and debt-to-equity. The debt-to-asset ratio is the ratio of total debt to total assets. The debt-to-equity ratio is the ratio of total debt to shareholders' equity, which is the difference between total assets and total liabilities. Profitability Ratios and MarginsProfitability ratios indicate management's ability to convert sales dollars into profits and cash flow. The common ratios are gross margin, operating margin and net income margin. The gross margin is the ratio of gross profits to sales. The gross profit is equal to sales minus cost of goods sold. The operating margin is the ratio of operating profits to sales and net income margin is the ratio of net income to sales. The operating profit is equal to the gross profit minus operating expenses, while the net income is equal to the operating profit minus interest and taxes. The return-on-asset ratio, which is the ratio of net income to total assets, measures a company's effectiveness in deploying its assets to generate profits. The return-on-investment ratio, which is the ratio of net income to shareholders' equity, indicates a company's ability to generate a return for its owners. Common Efficiency RatiosTwo common efficiency ratios are inventory turnover and receivables turnover. Inventory turnover is the ratio of cost of goods sold to inventory. A high inventory turnover ratio means that the company is successful in converting its inventory into sales. The receivables turnover ratio is the ratio of credit sales to accounts receivable, which tracks outstanding credit sales. A high accounts receivable turnover means that the company is successful in collecting its outstanding credit balances.
What are financial ratios?Financial ratios are basic calculations using quantitative data from a company’s financial statements. They are used to get insights and important information on the company’s performance, profitability, and financial health. Common financial ratios come from a company’s balance sheet, income statement, and cash flow statement. Businesses use financial ratios to determine liquidity, debt concentration, growth, profitability, and market value. Why are financial ratios so important?Financial ratios are sometimes referred to as accounting ratios or finance ratios. These ratios are important for assessing how a company generates revenue and profits using business expenses and assets in a given period. Internal and external stakeholders use financial ratios for competitor analysis, market valuation, benchmarking, and performance management. Financial Ratios inside a businessFinancial planning and analysis professionals calculate financial ratios for the following reasons for internal reasons. ● To measure return on capital investments ● To calculate profit margins ● To assess a company’s efficiency and how costs are allocated ● To determine how much debt is used to finance operations ● To identify trends in profitability ● To manage working capital and short-term funding requirements ● To identify operating bottlenecks and assess inventory management systems ● To measure a company’s ability to settle debt and liabilities How analysts and external stakeholders use Financial RatiosExternal stakeholders use financial ratios to: ● Carry out competitor analysis ● Determine whether to finance a company in the form of debt ● Assess how profitable a company is ● Determine whether to provide equity financing or buy shares in the company ● Calculate tax liabilities ● Measure a company’s market value ● Calculate return on shareholders’ equity ● Perform market analysis 5 Essential Financial Ratios for Every BusinessThe common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios. 1) Liquidity ratiosCompanies use liquidity ratios to measure working capital performance – the money available to meet your current, short-term obligations . Simply put, companies need liquidity to pay their bills. Liquidity ratios measure a company’s capacity to meet its short-term obligations and are a vital indicator of its financial health. Liquidity is different from solvency, which measures a company’s ability to pay all its debts. In the sporting world, Italian football club Lazio faces a now-infamous liquidity ratio preventing it from signing new players. Italian clubs are required to communicate their liquidity indicator to the football authorities twice a year. This indicator cannot be any lower than a certain threshold set by the football authorities. There are different forms of liquidity ratio. Current ratio: Current Assets / Current Liabilities The current ratio measures how a business’s current assets, such as cash, cash equivalents, accounts receivable, and inventories, are used to settle current liabilities such as accounts payable. Quick ratio (Acid-test ratio): Current Assets – Inventories / Current Liabilities Also known as the acid-test ratio, the quick ratio measures how a business’s more liquid assets, such as cash, cash equivalents, and accounts receivable can cover current liabilities. This ratio excludes inventories from current assets. A quick ratio of 1 is considered the industry average. A quick ratio below 1 shows that a company may not be in a position to meet its current obligations because it has insufficient assets to be liquidated. (Acid test refers to a quick and simple test gold miners used to determine whether samples of metal were true gold or not. Acid would be added to a sample; if it dissolved, it wasn’t gold. If it stood up to the acid, it likely was). From a great real example on the Street.com see how Apple’s Quick Ratio stacks up: Quick Ratio Example: Apple (NASDAQ: AAPL) The following figures are as of March 27th, 2021, and come from Apple’s balance sheet. Numbers are in millions of dollars. Cash and cash equivalents: $38,466 Accounts receivable: $18,503 Marketable securities: $31,368 Current liabilities: $106,385 QR = Liquid Assets / Current Liabilities QR = ($38,466 + $18,503 +$31,368) / $106,385 QR = $88,337 / $106,385 QR = 0.83 Based on this calculation, Apple’s quick ratio was 0.83 as of the end of March 2021. This number could be higher if more assets were included in its calculations. Cash ratio: Cash and cash equivalents / Current Liabilities The cash ratio measures a business’s ability to use cash and cash equivalent to pay off short-term liabilities. This ratio shows how quickly a company can settle current obligations. 2) Leverage ratiosCompanies often use short and long-term debt to finance business operations. Leverage ratios measure how much debt a company has. Molson Coors Beverage Co. , the maker of Coors Light and Miller Lite beer for instance, had been saddled with debt, after an acquisition in the industry according to the Wall Street Journal. Its CFO Tracey Joubert signaled to the market the company’s plans “reduce its leverage ratio to below 3 times by the end of this year.” The types of leverage ratio to consider are: Debt ratio: Total Debt / Total Assets The debt ratio measures the proportion of debt a company has to its total assets. A high debt ratio indicates that a company is highly leveraged. Debt to equity ratio: Total Debt / Total Equity The debt-to-equity ratio measures a company’s debt liability compared to shareholders’ equity. This ratio is important for investors because debt obligations often have a higher priority if a company goes bankrupt. Interest coverage ratio: Operating income / Interest expenses Companies generally pay interest on corporate debt. The interest coverage ratio shows if a company’s revenue after operating expenses can cover interest liabilities. 3) Efficiency ratiosEfficiency ratios show how effectively a company uses working capital to generate sales. For instance an analyst reported that Seattle-based bank Washington Federal’s company’s efficiency ratio was 58.65%, down from 59.02% recorded a year ago. A fall in efficiency ratio indicates improved profitability. There are several ways to analyze efficiency ratios: Asset turnover ratio: Net sales / Average total assets Companies use assets to generate sales. The asset turnover ratio measures how much net sales are made from average assets. Inventory turnover: Cost of goods sold / Average inventory For companies in the manufacturing and production industries with high inventory levels, inventory turnover is an important ratio that measures how often inventory is used and replaced for operations. Days sales in inventory ratio: 365 days / Inventory turnover ratio Holding inventory for too long may not be efficient. The day sales in inventory ratio calculates how long a business holds inventories before they are converted to finished products or sold to customers. Payables turnover ratio: Cost of Goods sold (or net credit purchases) / Average Accounts Payable The payables turnover ratio calculates how quickly a business pays its suppliers and creditors. Days payables outstanding (DPO): (Average Accounts Payable / Cost of Goods Sold) x Number of Days in Accounting Period (or year) This ratio shows how many days it takes a company to pay off suppliers and vendors. A lower days payables outstanding implies that a business is letting go of cash too quickly and may not be taking advantage of longer credit terms. On the other hand, when the DPO is too high, it means a company delays paying its suppliers, which can lead to disputes. Receivables turnover ratio: Net credit sales / Average accounts receivable Accounts receivables are credit sales made to customers. It is important that companies can readily convert account receivables to cash. Slow paying customers reduce a business’s ability to generate cash from their accounts receivable. The receivables turnover ratio helps companies measure how quickly they turn customers’ invoices into cash. A high receivables turnover ratio shows that a company quickly generates cash from accounts receivables. 4) Profitability ratiosA business’s profit is calculated as net sales less expenses. Profitability ratios measure how a company generates profits using available resources over a given period. Higher ratio results are often more favorable, but these ratios provide much more information when compared to results of similar companies, the company’s own historical performance, or the industry average. Some of the most common profitability ratios are: Gross margin: Gross profit / Net sales The gross margin ratio measures how much profit a business makes after the cost of goods and services compared to net sales. Comparing companies can be illustrative – such as finding that Home Depot has a 33.6% gross profit margin versus Walmart’s 25.1%. Operating margin: Operating income / Net sales The operating margin measures how much profit a company generates from net sales after accounting for the cost of goods sold and operating expenses. Return on assets (ROA): Net income / Total assets Companies use the return on assets ratio to determine how much profits they generate from total assets or resources, including current and noncurrent assets. Return on equity (ROE): Net income / Total equity Shareholders’ equity is capital investments. The return on equity measures how much profit a business generates from shareholders’ equity. For instance a company with a declining ROE could be seen as having more risk than a company in the same industry with an increasing ROI. 5) Market Value ratiosMarket value ratios are used to measure how valuable a company is. These ratios are usually used by external stakeholders such as investors or market analysts but can also be used by internal management to monitor value per company share. Earnings per share ratio (EPS): Net earnings / Total shares outstanding The earnings per share ratio, also known as EPS, shows how much profit is attributable to each company share. Price earnings ratio (P/E): Share price / Earnings per share The PE ratio is a key investor ratio that measures how valuable a company is relative to its book value earnings per share. Book value per share ratio: Total Equity – Preferred Equity / Total shares outstanding A company’s common equity is what common shareholders own after all liabilities and preference shares have been settled from total assets. The book value per share measures the value per share for common equity owners based on the balance sheet value of assets less liabilities and preference shares. Dividend yield ratio: Dividend per share / Share price The dividend yield ratio measures the value of a company’s dividend per share compared to the market share price. When companies pay out dividends to shareholders, the value of dividends received for each share owned is known as the dividend per share. Shareholders and analysts compare the dividend per share to the company’s share price using the dividend yield ratio. Best Practices For Using Financial RatiosFinancial ratios help senior management and external stakeholders measure a company’s performance. These best practices will drive effective decision-making. ● Compute financial ratios with accurate financial numbers ● Compare ratios across periods to identify performance trends ● Use relative competitor and industry benchmarks to measure performance ● Calculate ratios using balance sheet averages where applicable ● Interpret financial ratios correctly to support key business decisions ● Calculate and analyze ratios using the balance sheet, income statement, and cash flow statement to get a holistic view of the business’s performance Final ThoughtsFinancial ratios are good key performance indicators used to measure a company’s performance over time compared to competitors and the industry. Calculating accurate financial ratios and interpreting the ratios help business leaders and investors make the right decisions. Which types of financial ratios measure how well the managers of the organization are creating value from the organizations assets?Which type of financial ratio measures how well the managers of the organization are creating value from the organization's assets? Activity ratios provides measures of how well managers are creating value from organizational assets.
Which type of financial ratio indicates the degree to which the organization uses debt or equity to finance its ongoing operations?A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or that assesses the ability of a company to meet financial obligations.
Which of the following financial measures is a result of dividing a company's operating profit by its sales revenues?It is the ratio of operating profits to revenues for a company or business segment. Expressed as a percentage, the operating margin shows how much earnings from operations is generated from every $1 in sales after accounting for the direct costs involved in earning those revenues.
What are four main types of financial ratios used in ratio analysis quizlet?Liquidity (short-term solvency or liquidity ratios). Leverage (long-term solvency or financial leverage ratios). Turnover (asset management or turnover ratios). Profitability.. Market.. |
Which type of financial ratio measures how well the managers of an organization are creating value from the organizations assets?
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