Glossary

6.1 Ratios: Condensing Information into Smaller Pieces

4 min read•june 18, 2024

Financial ratio analysis is a powerful tool for assessing a company's financial health. It uses various ratios to evaluate liquidity, solvency, efficiency, and profitability, providing insights into a firm's ability to meet obligations and generate profits.

By comparing ratios to and competitors, businesses can identify strengths and weaknesses. helps forecast future performance and guide strategic decisions, making financial ratio analysis essential for investors and managers alike.

Financial Ratio Analysis

Financial ratio analysis

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  • evaluate a company's ability to meet short-term financial obligations
    • compares to (cash, inventory, )
      • Formula: Current AssetsCurrent Liabilities\frac{Current\ Assets}{Current\ Liabilities}
      • Higher ratio indicates better liquidity and ability to pay short-term debts
    • focuses on the most liquid assets by excluding inventory (cash, marketable securities, accounts receivable)
      • Formula: Cash+Marketable Securities+Accounts ReceivableCurrent Liabilities\frac{Cash + Marketable\ Securities + Accounts\ Receivable}{Current\ Liabilities}
      • More conservative measure of liquidity compared to the
  • assess a company's ability to meet long-term financial obligations and its overall financial health
    • compares total liabilities to total (loans, bonds, )
      • Formula: Total LiabilitiesTotal Shareholders′ Equity\frac{Total\ Liabilities}{Total\ Shareholders'\ Equity}
      • Higher ratio indicates higher and potentially higher risk
    • measures the proportion of assets financed by debt (loans, bonds, accounts payable)
      • Formula: Total LiabilitiesTotal Assets\frac{Total\ Liabilities}{Total\ Assets}
      • Higher ratio suggests greater financial risk and lower financial flexibility
    • determines how easily a company can pay interest on its outstanding debt (, interest expense)
      • Formula: Earnings Before Interest and Taxes (EBIT)Interest Expense\frac{Earnings\ Before\ Interest\ and\ Taxes\ (EBIT)}{Interest\ Expense}
      • Higher ratio indicates better ability to meet interest payments
  • measure how effectively a company utilizes its assets and manages its operations
    • assesses how efficiently a company manages its inventory (, average inventory)
      • Formula: Cost of Goods SoldAverage Inventory\frac{Cost\ of\ Goods\ Sold}{Average\ Inventory}
      • Higher ratio suggests more efficient inventory management and faster sales
    • Days sales outstanding (DSO) calculates the average time it takes to collect payment from customers (accounts receivable, average daily sales)
      • Formula: Accounts ReceivableAverage Daily Sales\frac{Accounts\ Receivable}{Average\ Daily\ Sales}
      • Lower DSO indicates faster collection of receivables and better cash flow
    • evaluates how efficiently a company uses its assets to generate sales revenue (, average total assets)
      • Formula: Net SalesAverage Total Assets\frac{Net\ Sales}{Average\ Total\ Assets}
      • Higher ratio implies more effective utilization of assets to generate sales
  • assess a company's ability to generate profits from its operations
    • measures the percentage of revenue remaining after subtracting the cost of goods sold (, net sales)
      • Formula: Gross ProfitNet Sales\frac{Gross\ Profit}{Net\ Sales}
      • Higher margin indicates better profitability and pricing power
    • calculates the percentage of revenue remaining after subtracting operating expenses (, net sales)
      • Formula: Operating IncomeNet Sales\frac{Operating\ Income}{Net\ Sales}
      • Higher margin suggests better operational efficiency and cost management
    • determines the percentage of revenue remaining after subtracting all expenses, including taxes and interest (, net sales)
      • Formula: Net IncomeNet Sales\frac{Net\ Income}{Net\ Sales}
      • Higher margin indicates better overall profitability
    • measures how efficiently a company generates profits from its assets (net income, average total assets)
      • Formula: Net IncomeAverage Total Assets\frac{Net\ Income}{Average\ Total\ Assets}
      • Higher ROA suggests more effective use of assets to generate profits
    • evaluates how efficiently a company generates profits from the money invested by shareholders (net income, average shareholders' equity)
      • Formula: Net IncomeAverage Shareholders′ Equity\frac{Net\ Income}{Average\ Shareholders'\ Equity}
      • Higher ROE indicates better returns for shareholders

Benchmarking company performance

  • Industry benchmarks provide a reference point for evaluating a company's financial performance
    • Compare a company's ratios to industry averages or medians (liquidity, solvency, efficiency, profitability)
    • Identify areas where the company outperforms or underperforms relative to the industry (strengths, weaknesses, opportunities, threats)
  • allows for a direct comparison of a company's performance to its main rivals
    • Compare a company's ratios to those of its main competitors (market share, growth, profitability)
    • Assess the company's competitive position and identify strengths and weaknesses (pricing, cost structure, innovation)
  • compares financial ratios across different companies within the same industry at a specific point in time
    • Helps identify industry trends and company-specific performance differences
  • Trend analysis involves examining changes in ratios over time to identify patterns and trajectories
    • Analyze changes in ratios over multiple periods (quarterly, annually) to identify trends (improving, deteriorating, stable)
    • Assess whether the company's performance is improving, deteriorating, or remaining stable (growth, profitability, efficiency)
  • and decision-making use ratio trends to predict future performance and guide strategic choices
    • Use ratio trends to make projections about future financial performance (revenue growth, profitability, cash flow)
    • Identify potential issues or opportunities based on the trends observed (expansion, cost-cutting, financing)
    • Use ratio analysis to guide strategic and operational decisions (investing in new projects, adjusting pricing, managing costs)
  • examines financial ratios over consecutive time periods to identify long-term trends and cyclical patterns

Advanced Analysis Techniques

  • involves a comprehensive review of a company's financial statements to assess its overall financial health and performance
  • requires considering industry norms, company-specific factors, and economic conditions to draw meaningful conclusions
  • uses historical financial data and ratios to create projections and simulate various scenarios for decision-making
  • are specific financial and non-financial metrics used to measure a company's progress towards its strategic goals

Key Terms to Review (51)

Accounts Payable: Accounts payable refers to the short-term debt obligations a company owes to its suppliers or vendors for goods and services received. It represents the amount a company owes to its creditors and is a crucial component of a company's working capital and cash flow management.
Accounts Receivable: Accounts receivable refers to the money owed to a company by its customers for goods or services provided on credit. It represents the outstanding balance that customers have yet to pay for their purchases, and it is considered a current asset on the company's balance sheet.
Accounts receivable aging schedule: An accounts receivable aging schedule is a report that categorizes a company's accounts receivable according to the length of time an invoice has been outstanding. It helps businesses identify overdue payments and manage credit risk.
Competitor Analysis: Competitor analysis is the process of identifying and evaluating the strengths, weaknesses, strategies, and performance of a company's competitors in the market. It is a crucial aspect of strategic planning and decision-making for organizations, as it helps them understand their competitive landscape and make informed choices to gain a competitive advantage.
Cost of Goods Sold: Cost of Goods Sold (COGS) represents the direct costs associated with the production and acquisition of the goods or services a company sells. It is a critical component in determining a company's profitability, as it directly impacts the gross margin and overall financial performance.
Cross-Sectional Analysis: Cross-sectional analysis is a method of studying data that examines different variables or characteristics at a single point in time, rather than tracking changes over time. It provides a snapshot of a particular situation or phenomenon and allows for comparisons between different groups or entities.
Current assets: Current assets are assets that are expected to be converted into cash or used up within one year. They are a crucial component of a company's working capital and liquidity management.
Current Assets: Current assets are the most liquid assets on a company's balance sheet, which can be converted into cash within a year or during the normal operating cycle of the business. These assets are essential for a company's day-to-day operations and are crucial in assessing its short-term financial health and liquidity position.
Current liabilities: Current liabilities are a company's debts or obligations that are due within one year. They are listed on the balance sheet and include items like accounts payable, short-term loans, and accrued expenses.
Current Liabilities: Current liabilities are short-term financial obligations that a company must pay within one year or the normal operating cycle, whichever is shorter. These liabilities represent the company's debts or obligations that are due in the near future and must be settled using current assets or the creation of other current liabilities.
Current ratio: The current ratio measures a company's ability to pay short-term obligations with its current assets. It is calculated by dividing current assets by current liabilities.
Current Ratio: The current ratio is a financial metric that measures a company's ability to pay its short-term obligations using its current assets. It is a key indicator of a company's liquidity and financial health, providing insights into its short-term solvency and operational efficiency.
Debit: A debit is an entry recorded on the left side of a ledger account that increases asset or expense accounts and decreases liability, revenue, or equity accounts. It represents money flowing into an account in double-entry bookkeeping.
Debt-to-assets ratio: The debt-to-assets ratio is a solvency ratio that measures the proportion of a company's assets that are financed by debt. It provides insight into the financial leverage and stability of an organization.
Debt-to-assets ratio: The debt-to-assets ratio is a financial metric that measures a company's or individual's total debt in relation to its total assets. It is a solvency ratio that provides insight into a entity's financial leverage and overall financial health.
Debt-to-equity ratio: The debt-to-equity ratio is a solvency ratio that measures the proportion of a company's debt to its shareholders' equity. It indicates how much debt a company is using to finance its assets relative to the value represented in shareholders’ equity.
Debt-to-Equity Ratio: The debt-to-equity ratio is a financial metric that measures a company's financial leverage by dividing its total liabilities by its total shareholders' equity. This ratio provides insight into a company's capital structure and its ability to meet its financial obligations.
EBIT: EBIT, or Earnings Before Interest and Taxes, is a financial metric that represents a company's operating profit. It measures a company's profitability by calculating the revenue generated from its core business operations, minus the operating expenses incurred, before accounting for interest payments and income taxes.
EBITDA: EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a financial metric that measures a company's operating performance and profitability. It provides a snapshot of a company's financial health by excluding the impact of financing and accounting decisions, allowing for a more accurate assessment of the company's core business operations.
Efficiency Ratios: Efficiency ratios are a set of financial metrics that measure how effectively a company is utilizing its assets and resources to generate revenue and maximize profitability. These ratios provide insights into a company's operational efficiency and management's ability to control costs and optimize processes.
Financial leverage: Financial leverage is the use of borrowed funds to increase the potential return on investment. It involves amplifying both potential gains and potential losses by using debt financing.
Financial modeling: Financial modeling is the process of creating a numerical representation of a financial situation or scenario, often used to forecast a company's financial performance. It involves the use of spreadsheets and formulas to analyze data and make informed decisions regarding investments, budgets, and strategic planning.
Financial Statement Analysis: Financial statement analysis is the process of examining and interpreting a company's financial statements, including the balance sheet, income statement, and cash flow statement, to assess its financial health, performance, and future prospects. This analysis provides valuable insights that inform decision-making for investors, creditors, and managers.
Forecasting: Forecasting is the process of predicting future events, trends, and conditions based on historical data and analysis. It is a crucial tool used in various fields, including finance, to make informed decisions and plan for the future.
Gross Profit: Gross profit is the difference between a company's total revenue and its cost of goods sold (COGS). It represents the profit a company makes before deducting operating expenses, interest, taxes, and other costs, providing an initial measure of a company's profitability and efficiency.
Gross Profit Margin: Gross Profit Margin is a financial ratio that measures the percentage of revenue that a company retains after incurring the direct costs associated with producing the goods or services it sells. It provides insight into a company's operational efficiency and profitability.
Gross working capital: Gross working capital is the total value of a company's current assets, which are assets that are expected to be converted into cash within one year. It includes cash, accounts receivable, inventory, and other short-term assets.
Income statement (net income): An income statement (net income) is a financial report that shows a company's revenues, expenses, and profits over a specific period. Net income is the bottom line of the income statement, indicating the company's profitability after all expenses have been deducted from total revenue.
Industry Benchmarks: Industry benchmarks are standards or points of reference used to measure and compare the performance of a company or industry against its peers. They provide a way to assess how a business is performing relative to its competitors and the overall industry.
Interest Coverage Ratio: The interest coverage ratio is a financial metric that measures a company's ability to make interest payments on its outstanding debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses, providing insight into the company's financial health and its capacity to meet its debt obligations.
Inventory Turnover Ratio: The inventory turnover ratio is a measure of how efficiently a company manages and sells its inventory. It calculates the number of times a company's inventory is sold and replaced over a given period, providing insights into a company's operational efficiency and liquidity.
Key Performance Indicators (KPIs): Key Performance Indicators (KPIs) are quantifiable measurements used to evaluate the success or progress of a business, organization, or individual in achieving their objectives. KPIs provide a focused way to condense complex information into smaller, meaningful pieces that can be easily tracked and analyzed.
Leverage: Leverage refers to the use of debt or other financial instruments to increase the potential return on an investment. It involves using borrowed funds or financial derivatives to magnify the impact of market movements, allowing investors to potentially generate higher returns but also exposing them to greater risk.
Liquidity Ratios: Liquidity ratios are a set of financial metrics that measure a company's ability to meet its short-term obligations and cover its current liabilities with its current assets. These ratios provide insight into a firm's short-term financial health and its capacity to generate cash to cover immediate operational needs.
Net Income: Net income, also known as net profit, is the final and most important financial metric that represents a company's overall profitability and performance. It is the amount of revenue remaining after deducting all expenses, costs, depreciation, taxes, and other charges from a company's total revenue over a specific period of time.
Net Profit Margin: Net profit margin is a financial ratio that measures the percentage of a company's revenue that remains as net income after all expenses, taxes, and interest have been deducted. It provides insight into a company's overall profitability and efficiency in generating profits from its sales.
Net Sales: Net sales, also known as revenue, refers to the total amount of money a company earns from selling its products or services, after deducting any discounts, returns, and allowances. It is a crucial metric for evaluating a company's financial performance and profitability.
Operating Income: Operating income, also known as operating profit, is a financial metric that represents the profit a company generates from its core business operations, excluding the impact of financing and investing activities. It is a key indicator of a company's operational efficiency and profitability.
Operating Profit Margin: The operating profit margin is a financial ratio that measures a company's operating efficiency. It represents the percentage of revenue that a company retains as operating profit after accounting for the cost of goods sold and operating expenses, excluding the impact of interest, taxes, and other non-operating items.
Profitability Ratios: Profitability ratios are a set of financial metrics that measure a company's ability to generate profits and returns relative to its revenue, operating costs, and capital investments. These ratios provide insight into the overall financial health and performance of a business, allowing for analysis of its profitability and efficiency.
Quick ratio: The quick ratio measures a company's ability to meet its short-term obligations using its most liquid assets. It is calculated as (Current Assets - Inventory) / Current Liabilities.
Quick Ratio: The quick ratio, also known as the acid-test ratio, is a liquidity ratio that measures a company's ability to pay its short-term obligations using its most liquid assets. It provides a more stringent assessment of a company's liquidity compared to the current ratio by excluding inventory from current assets, as inventory may be more difficult to convert into cash quickly.
Ratio Interpretation: Ratio interpretation is the process of analyzing and understanding the meaning behind the numerical relationship between two or more variables or quantities. It involves examining the proportional relationship between these elements to gain insights and draw conclusions about the underlying financial or operational dynamics of a business or situation.
Return on Assets (ROA): Return on Assets (ROA) is a financial ratio that measures a company's profitability by calculating the net income generated per dollar of assets. It provides insight into how efficiently a company is utilizing its assets to generate profits.
Return on Equity (ROE): Return on Equity (ROE) is a financial ratio that measures a company's profitability by calculating the amount of net income returned as a percentage of shareholders' equity. It is a key indicator of a company's efficiency and effectiveness in utilizing its equity capital to generate profits.
Shareholders' Equity: Shareholders' equity, also known as stockholders' equity, represents the residual interest in the assets of a company after deducting its liabilities. It reflects the amount that would be available to shareholders if a company's assets were liquidated and its liabilities paid off. Shareholders' equity plays a crucial role in the balance sheet, the relationship between the balance sheet and income statement, as well as in various financial ratios.
Solvency Ratios: Solvency ratios are a group of financial ratios that measure a company's ability to meet its long-term debt obligations and overall financial health. These ratios provide insight into a company's capital structure, leverage, and capacity to withstand financial challenges over an extended period.
Time-Series Analysis: Time-series analysis is a statistical method used to analyze and model data that is collected over time, with the goal of understanding the underlying patterns, trends, and relationships within the data. It is a powerful tool for forecasting, decision-making, and understanding the dynamics of various phenomena.
Total Asset Turnover Ratio: The total asset turnover ratio is a financial metric that measures a company's efficiency in using its total assets to generate sales. It is an important indicator of a firm's operating efficiency and is commonly used in the context of analyzing a company's overall performance and asset utilization.
Trend Analysis: Trend analysis is the examination of historical data to identify and evaluate patterns or trends over time. It is a fundamental tool used to understand the direction and rate of change in various financial and operational metrics, allowing for more informed decision-making and forecasting.
Working Capital: Working capital refers to the difference between a company's current assets and current liabilities, representing the liquid resources available to fund day-to-day business operations. It is a crucial metric that reflects a company's short-term financial health and liquidity position, with implications across various financial statements and analysis techniques.
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