They are used by individual investors and professional analysts, and there are a variety of ratios to use. Financial ratios are typically cast into four categories:. In this article, we'll look at each category and provide examples of simple-to-use ratios that can help you easily gain important insight into companies you may want to invest in.
Profitability is a key aspect to analyze when considering an investment in a company. This is because high revenues alone don't necessarily translate into high earnings or high dividends. In general, profitability analysis seeks to analyze business productivity from multiple angles using a few different scenarios. Profitability ratios help provide insight into how much profit a company generates and how that profit relates to other important information about the company.
These are used to assess a business's ability to generate earnings relative to its revenue, operating costs , balance sheet assets, and shareholders' equity over time, using data from a specific point in time. Some key profitability ratios include:. One of the leading ratios used by investors for a quick check of profitability is the net profit margin.
In general, the higher a company's profit margin , the better. Profit margin levels vary across industries and time periods as this ratio can be affected by several factors. With net profit margin, there can be a few red flags you should watch out for, especially if the company sees decreasing profit margins year-over-year. Oftentimes, this suggests changing market conditions, increasing competition, or rising costs.
If a company has a very low-profit margin, it may need to focus on decreasing expenses through wide-scale strategic initiatives. A high-profit margin relative to the industry may indicate a significant advantage in economies of scale , or potentially some accounting schemes that may not be sustainable for the long term. Liquidity measures how quickly a company can repay its debts.
It also shows how well company assets cover expenses. They also show how quickly and easily a company generates cash to purchase additional assets or to repay creditors quickly, either in an emergency situation or in the course of normal business. Some of the key liquidity ratios include:. The current and quick ratios are great ways to assess the liquidity of a firm.
Both ratios are very similar. The current ratio is calculated by dividing current assets by current liabilities. A higher current ratio is favorable as it represents the number of times current assets can cover current liabilities. The quick ratio is nearly the same; however, it subtracts inventory from current assets.
This gives better insight into the short-term liquidity of the firm by narrowing the current assets to exclude inventory. Again, a higher quick ratio is better. Solvency ratios, also known as leverage ratios , are used by investors to get a picture of how well a company can deal with its long-term financial obligations.
As you might expect, a company weighed down with debt is probably a less favorable investment than one with a minimal amount of debt on its books. Some of the most popular solvency ratios include:. Both review how debt stacks up against other categories on the balance sheet. The total-debt-to-total-assets ratio is used to determine how much of a company's assets are tied up by debt.
It is calculated as follows:. As a general rule, a number closer to zero is generally better because it means that a company carries less debt compared to its total assets.
The more solvent the assets, the better. When using this ratio to analyze a company, it can help to look at both the company growth phase and the industry as a whole. This tells the owners of the Doobie Company that current liabilities are covered by current assets 1. The current ratio answers the question, "Does the business have enough current assets to meet the payment schedule of current liabilities, with a margin of safety? A common rule of thumb is that a "good" current ratio is 2 to 1.
Of course, the adequacy of a current ratio will depend on the nature of the business and the character of the current assets and current liabilities. There is usually very little uncertainty about the amount of debts that are due, but there can be considerable doubt about the quality of accounts receivable or the cash value of inventory. That's why a safety margin is needed. A current ratio can be improved by increasing current assets or by decreasing current liabilities.
Steps to accomplish an improvement include:. A high current ratio may mean that cash is not being utilized in an optimal way. For example, the excess cash might be better invested in equipment. The Quick Ratio is also called the "acid test" ratio.
That's because the quick ratio looks only at a company's most liquid assets and compares them to current liabilities. The quick ratio tests whether a business can meet its obligations even if adverse conditions occur. Assets considered to be "quick" assets include cash, stocks and bonds, and accounts receivable in other words, all of the current assets on the balance sheet except inventory.
Using the balance sheet data for the Doobie Company, we can compute the quick ratio for the company. In general, quick ratios between 0. So the Doobie Company seems to have an adequate quick ratio. In this section we will look at four that are widely used. There may be others that are common to your industry, or that you will want to create for a specific purpose within your company. The inventory turnover ratio measures the number of times inventory "turned over" or was converted into sales during a time period.
It is also known as the cost-of-sales to inventory ratio. It is a good indication of purchasing and production efficiency. The data used to calculate this ratio come from both the company's income statement and balance sheet. Here is the formula:. Using the financial statements for the Doobie Company, we can compute the following inventory turnover ratio for the company:.
In general, the higher a cost of sales to inventory ratio, the better. A high ratio shows that inventory is turning over quickly and that little unused inventory is being stored. The sales-to-receivables ratio measures the number of times accounts receivables turned over during the period. The higher the turnover of receivables, the shorter the time between making sales and collecting cash.
A reminder: net sales equals sales less any allowances for returns or discounts. Net receivables equals accounts receivable less any adjustments for bad debts. This ratio also uses information from both the balance sheet and the income statement. It is calculated as follows:. Using the financial statements for the Doobie Company and assuming that the Sales reported on their income statement is net Sales , we can compute the following sales- to-receivables ratio for the company:.
This means that receivables turned over nearly 12 times during the year. This is a ratio that you will definitely want to compare to industry standards. Keep in mind that its significance depends on the amount of cash sales a company has. For a company without many cash sales, it may not be important. Also, it is a measure at only one point in time and does not take into account seasonal fluctuations.
The days' receivables ratio measures how long accounts receivable are outstanding. Business owners will want as low a days' receivables ratio as possible. After all, you want to use your cash to build your company, not to finance your customers. Also, the likelihood of nonpayment typically increases as time passes.
The "" in the formula is simply the number of days in the year. The sales receivable ratio is taken from the calculation we did just a few paragraphs earlier.
Using the financial statements for the Doobie Company, we can compute the following day's receivables ratio for the company. This means that receivables are outstanding an average of 31 days. Again, the real meaning of the number will only be clear if you compare your ratios to others in the industry. The return on assets ratio measures the relationship between profits your company generated and assets that were used to generate those profits.
Return on assets is one of the most common ratios for business comparisons. It tells business owners whether they are earning a worthwhile return from the wealth tied up in their companies.
In addition, a low ratio in comparison to other companies may indicate that your competitors have found ways to operate more efficiently. Publicly held companies commonly report return on assets to shareholders; it tells them how well the company is using its assets to produce income.
These ratios are of particular interest to bank loan officers. They should be of interest to you, too, since solvency ratios give a strong indication of the financial health and viability of your business. It shows how much of a business is owned and how much is owed. Using balance sheet data for the Doobie Company, we can compute the debt-to-worth ratio for the company. If the debt-to-worth ratio is greater than 1, the capital provided by lenders exceeds the capital provided by owners.
Bank loan officers will generally consider a company with a high debt-to-worth ratio to be a greater risk. Debt-to-worth ratios will vary with the type of business and the risk attitude of management. Working Capital Working capital is a measure of cash flow, and not a real ratio.
It represents the amount of capital invested in resources that are subject to relatively rapid turnover such as cash, accounts receivable and inventories less the amount provided by short-term creditors. Working capital should always be a positive number. Lenders use it to evaluate a company's ability to weather hard times. Loan agreements often specify that the borrower must maintain a specified level of working capital. Using the balance sheet data for the Doobie Company, we can compute the working capital amount for the company.
Net Sales to Working Capital The relationship between net sales and working capital is a measurement of the efficiency in the way working capital is being used by the business. It shows how working capital is supporting sales.
It is computed as follows:. Click on the link for "Industry Peers" for your company's data compared to that of its competitors. At the bottom of the table are the industry averages.
Click on the link for "Key Ratios" that is in the same row as the "Quote" link near the top under the company's name. Under the heading of "Key Ratios" on that page, you will see links for profitability, growth, cash flow, financial health, and efficiency ratios for your company for a range of years.
Click on the links for "Valuation" and for "Bonds" that are in the same row as the "Quote" and "Key Ratios" link near the top under the company's name. Company data and industry averages are on both of those pages.
Click on the link below. Type the company's ticker symbol in the "Quote Lookup" box and press the enter key. The Summary page is shown on which you can find the PE ratio and Earnings per Share for the trailing 12 months.
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