Financial Ratios

Here is the fourth article in the series Understanding Financial Accounting. There is a wide range of ratios that are used while analyzing the company but the basic ratio that every individual can understand with ease are as follows. This Article consists of some basic ratios that can be used by any individual for analyzing the company. Here are the 12 basic ratios that are directly related to the three pillars of Accounting.

1. Current Ratio

  • Current Assets/Current Liabilities
  • The current ratio simply tells you how much liquidity a company has – in other words, how much cash it could raise if it absolutely had to pay off its liabilities all at once.

Practical Use: A low ratio means the company may not be able to source enough cash to meet near-term liabilities, which would force it to seek outside financing or to divert operating income to pay off those liabilities.

2. Quick Ratio

  • Quick Ratio= (Current assets – Inventories)/Liabilities
  • The Quick Ratio is a more conservative test of a company’s liquidity, than the Current Ratio.
  • By taking inventories out of the equation, Quick Ratio lets us find out if a company has sufficient liquid assets to meet its short-term operating needs.

Practical Use: It is especially useful to check this ratio for manufacturing firms and for retailers because both of these types of firms tend to have a lot of their cash tied up in inventories.

3. Debt to Equity

  • (Total Debt/Shareholders Equity)
  • Total debt of the company divided by the Shareholders’ Equity.
  • Debt to equity ratio varies considerably depending on the business of the company

Practical Use:

  • A high debt equity ratio for a firm indicates it has been aggressively financing its growth with debt.
  • Due to the additional interest expenses that have to be borne by the firm, this can result in volatile earnings.
  • A company could potentially generate more earnings if a lot of debt is used to finance increased operations (high debt to equity) than it would have if it did not have access to this external financing.
  • Shareholders would benefit if this resulted in increased earnings by an amount greater than the debt cost (interest).
  • However, the cost of this debt financing may become too much for the company to handle, especially if earnings are cyclical and volatile, and outweigh the return that the company generates on the debt.
  • Companies in heavy industries such as auto, fertilizers and steel which require large investments in property, plant and machinery, or technology usually have higher debt to equity ratio.

4. Debtor Days

  • (Sundry Debtors/Sales Turnover)*365
  • The Debtor day’s metric measures how quickly cash is being collected from debtors.
    • A low debtor days number may indicate that the company is efficient in its collections or that credit standards are too restrictive and depressing sales.
    • A large number may indicate that the company is having difficulty collecting the money it is owed and its credit standards are too lax.

Practical Use:

  • Watch debtor day’s trends over the years.
  • Is the company becoming more efficient in collecting its outstanding dues or is the company offering looser credit terms to increase sales.
  • Average debtor days vary from one industry to another. Comparing debtor days within the industry may show up the more efficient player.

5. Inventory Days

  • Inventory days= (Inventories/Cost of Sales)*365
  • Inventories soak up capital.
  • Cash that’s been converted into inventory sitting in a warehouse can’t be used for anything else.
  • Inventory Days is a metric defined to indicate how long a company takes to convert its inventory into sales.
  • Essentially the same metric as Inventory Turnover. Another related cash conversion efficiency metric is Debtor Days.

Practical Use

  • The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time its available for use elsewhere.
  • Average Inventory days varies from one industry to another.
  • Comparing Inventory days within the industry may show up the more efficient player.

6. Inventory Turnover

  • Inventory Turnover= Cost of Sales/Inventories
  • Inventories soak up capital.
  • Cash that’s been converted into inventory sitting in a warehouse can’t be used for anything else.
  • Inventory Turnover is a metric defined to measure the efficiency or speed with which a company converts its inventory into sales.
  • Essentially the same metric as Inventory Days.

Practical Use

  • The speed at which a company turns over its inventory can have a huge impact on profitability because the less time cash is tied up in inventory, the more time its available for use elsewhere.
  • Average Inventory turns vary from one industry to another. Comparing Inventory turns within the industry may show up the more efficient player.

7. Payable Days Outstanding

  • Days Payable Outstanding = (Accounts Payable / COGS) x 365
  • Days Payable Outstanding shows the time in days a business has to pay back its creditors. On the flip side, it also shows how long the company can utilize the cash before paying it back.
  • The longer a company can delay payments, the better.
  • Working Capital Cycle
  • Working Capital Days/ Cash Conversion Cycle- (Avrg Working Capital/Annual Revenues*365) 
  • Working Capital: Current Assets- Current Liabilities, Working Cap Ratio- CA/CL  (Inventory+ Receivables-Payables) OR (days inventory +receivables days- payable days). 

Practical Use

  • It is one of the most important ratios that a stock market investor should follow.
  • The lower the better, a healthy working capital cycle shows the true financial health of a company.
  • A working capital cycle under proper check can help company borrow less and the same time control the leverage of the company. Hence the lower the better.
  • A healthy working capital cycle eventually impacts everything from your cash flows operations to the eventual dividend payout. 

9. Asset Turnover

  • Asset Turnover Ratio= Sales/Total Assets
  • Asset Turnover tells us roughly how efficient a company is at generating revenue from each dollar/rupee of Assets

10. Sales Turnover

  • Sometimes labeled as just “Sales”, this is simply how much money the company has brought in during the year from actual operations.
  • It does not include Other Income.

11. Financial Leverage

  • Financial Leverage= Total Debt/Shareholders’ Equity
  • The degree to which a business is utilizing borrowed money.
  • Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt.

Practical Use

  • Financial Leverage is something you need to watch carefully.
  • As with any kind of debt, a judicious amount can boost returns, but too much can lead to disaster.
  • Look at the kind of business a firm is in. If it’s fairly steady, a company can probably take on large amounts of debt without too much risk because there’s only a small chance of the business falling off a cliff and the company being caught short when interest payments become due.
  • On the flip side, be very wary of a high financial leverage ratio if a company’s business is cyclical or volatile.
  • Because interest payments are fixed, the company has to pay them whether business is good or bad.

12. Free Cash Flow (FCF)

  • Free Cash Flow= Cash Flow from Operations – Capital Expenditure
  • Free cash flow (FCF) is calculated by subtracting Capital Expenditure from Operating Cash Flow.
  • Cash Flow from Operations measures how much cash a company generates.
  • It is the true touchstone of corporate value creation because it shows how much cash a company is generating from year to year.
  • As useful as the Cash Flow statement is, it does not take into account the money that a firm has to spend on maintaining and expanding its business.
  • To do this, we need to subtract Capital Expenditures, which is money used to buy fixed assets.

Practical Use

  • Free Cash Flow enables us to separate out businesses that are net users of Capital – ones that spend more than they take in- from businesses that are net producers of Capital, because its only that excess cash that really belongs to shareholders.
  • Free Cash Flow is sometimes referred to as “Owners Earnings” because that’s exactly what it is: the amount of money the owner of a company could withdraw from the treasury without harming the company’s ongoing business.
  • Most analysts focus on earnings while ignoring the real cash that a firm generates. While earnings can often be clouded by accounting tricks, it’s much tougher to fake cash flow. For this reason, seasoned investors believe that FCF gives a much clearer view of the ability to generate cash (and thus profits).

13. Interest Coverage Ratio

  • Interest Coverage Ratio= Profit before Interest and Taxes (PBIT)/Interest Expense
  • Interest Coverage ratio is a measure of a company’s ability to pay its debt.
  • Divide Profit before Interest & Taxes (PBIT) by Interest & Financial charges, and you will know how many times the company could have paid the interest expense on its debt.

Practical Use: The more times the company can pay its interest expense, the less likely that it will run into difficulty if earnings should fall unexpectedly.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s