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Financial ratio

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In finance, a financial ratio or accounting ratio is a ratio of two selected numerical values taken from an enterprise's financial statements. There are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies.[1] If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Values used in calculating financial ratios may be taken from the balance sheet, income statement, cash flow statement and (rarely) statement of retained earnings. These comprise the firm's "accounting statements" or financial statements.

Ratios may be expressed as a decimal value, such as 0.10, or the equivalent percent value, such as 10%. Some ratios are usually quoted as percentages, especially ratios that are usually or always less than 1, such as earnings yield, while others are usually quoted as decimal numbers, especially ratios that are usually more than 1, such as P/E ratio; these latter are also called multiples. Given any ratio, one can take its reciprocal; if the ratio was above 1, the reciprocal will be below 1, and conversely. The reciprocal expresses the same information, but may be more understandable: for instance, the earnings yield can be compared with bond yields, while the P/E ratio cannot be: for example, a P/E ratio of 20 corresponds to an earnings yield of 5%.

Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. Financial ratios are categorized according to the financial aspect of the business which the ratio measures. Liquidity ratios measure the availability of cash to pay debt.[2] Activity ratios measure how quickly a firm converts non-cash assets to cash assets.[3] Debt ratios measure the firm's ability to repay long-term debt.[4] Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.[5] Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.[6]

Financial ratios allow for comparisons

  • between companies
  • between industries
  • between different time periods for one company
  • between a single company and its industry average

The ratios of firms in different industries, which face different risks, capital requirements, and competition are not usually comparable.

Contents

[edit] Sources of data for financial ratios

Financial ratios are based on summary data presented in financial statements. This summary data is based on the accounting method and accounting standards used by the organization.

[edit] Accounting methods and principles

Financial ratios may not be directly comparable between companies that use different accounting methods or follow various standard accounting practices. Most public companies are required by law to use generally accepted accounting principles for their home countries, but private companies, partnerships and sole proprietorships may not use accrual basis accounting. Large multi-national corporations may use International Financial Reporting Standards to produce their financial statements, or they may use the generally accepted accounting principles of their home country.

There is no world-wide standard for calculating the summary data presented in all financial statements, and terminology is not always consistent between companies, industries, countries and time periods.

[edit] Abbreviations and terminology

Various abbreviations may be used in financial statements, especially financial statements summarized on the Internet. Sales reported by a firm are usually, technically, net sales, which deduct returns, allowances, and early payment discounts from the charge on an invoice.

Companies that are primarily involved in providing services based on man-hours do not generally report "Sales" based on man-hours. These companies tend to report "revenue" based in income from services provided.

[edit] Other ratios

[edit] Profitability ratios

Profitability ratios measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.

= (Revenue - Cost of sales) / Revenue
= (Net sales - Cost of goods sold) / Net sales[7]
= Operating earnings / Net sales[8]
  • Operating margin, Operating Income Margin, Operating profit margin or Return on sales (ROS)
= Operating income / Net sales[9][8]
Note: Operating income is the difference between operating revenues and operating expenses, but it is also sometimes used as a synonym for EBIT and operating profit.[10] This is true if the firm has no non-operating income. (Earnings before interest and taxes / Sales[11][12])
= Net Income / Sales[13]
= Net profits after taxes / Sales[14]
= Net profits after taxes / Stockholders' equity or tangible net worth [14]
= Net profit / Equity[15]

[edit] Liquidity ratios

Liquidity ratios measure the availability of cash to pay debt.

[edit] Activity ratios

Activity ratios measure the effectiveness of the firms use of resources.

  • Average collection period = Accounts receivable / (Annual credit sales / 365 days)[3]
  • DOL = Degree of Operating Leverage = % change in net operating income /  % change in sales
  • DSO Ratio = Accounts receivable / Average Sales per Day[19]
  • Collection period (period end)
  • Average payment period = Accounts payable / (Annual credit purchases / 365 days)[3]
  • Asset turnover = Sales / Assets[20]
  • Inventory turnover ratio = Cost of goods sold / Average inventory[21]
  • Receivables Turnover Ratio = Net credit sales/ Average net receivables[22]
  • Inventory turnover ratio = Cost of goods sold / Average inventory[23][24]
  • Inventory conversion ratio = Inventory conversion to cash period (days) = 365 days / Inventory turnover[4]
  • days Inventory
  • Cash Conversion Cycle = Inventory conversion period (in days) + Receivables conversion period (in days) – Payables conversion period (in days)
  • Inventory conversion period = (Inventory/COGS)*(No. of Days in a Year)
  • Receivables conversion period = (Receivables/Sales)*(No. of Days in a Year)
  • Payables conversion period = (Purchases/Accounts Payable) where Purchases = Ending Inventory + COGS - Beginning Inventory

[edit] Debt ratios

Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage.

[edit] Market ratios

Market ratios measure investor response to owning a company's stock and also the cost of issuing stock.

= Dividend per share / Earnings per share[28]
Note:Earnings per share is not a ratio, it is a value in currency. Earnings per share = Expected earnings / Number of outstanding shares[27]

Other Market Ratios

Sector-specific ratios:

  • EV/capacity
  • EV/output

[edit] Derivative valuation

[edit] See also

[edit] References

  1. ^ Groppelli, Angelico A.; Ehsan Nikbakht (2000). Finance, 4th ed. Barron's Educational Series, Inc.. pp. 433. ISBN 0764112759. 
  2. ^ Groppelli, p. 434.
  3. ^ a b c Groppelli, p. 436.
  4. ^ a b Groppelli, p. 439.
  5. ^ Groppelli, p. 442.
  6. ^ a b Groppelli, p. 445.
  7. ^ Williams, P. 265.
  8. ^ a b Williams, p. 1094.
  9. ^ Williams, Jan R.; Susan F. Haka, Mark S. Bettner, Joseph V. Carcello (2008). Financial & Managerial Accounting. McGraw-Hill Irwin. pp. 266. ISBN 9780072996500. 
  10. ^ http://www.investorwords.com/3460/operating_income.html Operating income definition
  11. ^ Groppelli, p. 443.
  12. ^ Bodie, Zane; Alex Kane and Alan J. Marcus (2004). Essentials of Investments, 5th ed. McGraw-Hill Irwin. pp. 459. ISBN 0072510773. 
  13. ^ Professor Cram. "Ratios of Profitability: Profit Margin" College-Cram.com. 14 May 2008 <http://www.college-cram.com/study/finance/presentations/104>
  14. ^ a b Groppelli, p. 444.
  15. ^ Bodie, p. 456.
  16. ^ Professor Cram. "Ratios of Profitability: Return on Assets" College-Cram.com. 14 May 2008 <http://www.college-cram.com/study/finance/presentations/107>
  17. ^ Professor Cram. "Ratios of Profitability: Return on Assets Du Pont" College-Cram.com. 14 May 2008 <http://www.college-cram.com/study/finance/presentations/112>
  18. ^ a b Groppelli, p. 435.
  19. ^ Professor Cram. "Ratios of Asset Management Study Sheet" College-Cram.com. 14 May 2008 <http://www.college-cram.com/study/finance/presentations/275>
  20. ^ Bodie, p. 459.
  21. ^ Groppelli, p. 438.
  22. ^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 800.
  23. ^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.
  24. ^ Weygandt, J. J., Kieso, D. E., & Kell, W. G. (1996). Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. p. 801-802.
  25. ^ Groppelli, p. 440; Williams, p. 640.
  26. ^ a b c Groppelli, p. 441.
  27. ^ a b Groppelli, p. 446.
  28. ^ Groppelli, p. 449.
  29. ^ a b Groppelli, p. 447.
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