A Background on Financial Ratio Analysis
Financial ratio analysis has been used to assess business performance for around a hundred years.
Fundamental analysis, of which financial ratio analysis is but one sub-set, looks at a business’s financial statements, management, health and position in the competitive landscape to determine a fair market valuation.
Liquidity Ratios
Liquidity ratios indicate whether a business can pay off short-term debt obligations (debts due to be paid within one year) as they fall due. Generally, a higher value is desired as this indicates greater capacity to meet debt obligations.
The current ration measures a business’s ability to repay short-term liabilities such as accounts payable and current debt using short-term assets such as cash, inventory and receivables. Another way to look at it would be the value of a business’s current assets that will be converted to cash over the next twelve months compared to the value of liabilities that will mature over the same period. The Current ratio is useful as it shows whether a business has adequate resources to repay short-term debt or if it will experience cash flow problems in the near term.
Formula:
Current Ratio = Current assets
Current liabilities
Example
Current Ratio = $2,000,000
1,000,000
Current Ratio = 2
Profit before Depreciation and Amortisation to Current Liabilities (PDACL)
Profit before depreciation and amortisation to current liabilities is defined as net operating profit before tax plus non-cash charges in relation to short-term debt obligations. This is a powerful ratio because it depicts a business’s margin of safety to meet short-term commitments using cash flow generated from trading operations.
Lower risk businesses exhibit a higher margin of safety, whereas higher risk businesses exhibit a lower margin of safety. Should the business need to call on resources to meet short-term debt obligations, a lower margin of safety may be an issue.
Formula:
PDACL = Profit before depreciation and amortisation
Current liabilities
Example
PDACL = $340,000
$1,000,000
PDACL = 0.34
Operating Cash Flow to Current Liabilities (OCFCL)
Operating cash flow to current liabilities pertains to the cash generated from the operations of a business (revenues less all operating expenses, plus depreciation), in relation to short-term debt obligations. Operating cash flow is a more accurate measure of a business’s profitability than net income because it only deducts actual cash expenses and therefore demonstrates the strength of a business’ operations.
Consistently negative operating cash flow implies a business is going backwards in relation to the cost of conduct ordinary operations.
A positive operating cash flow is vital to support ongoing operations. The OCFCL ratio is significant because it shows the ability of a company to meet short-term debt obligations form internally generated cash flow.
The higher the value of the OCFCL ratio the lower the level of risk. A high value indicates that the business generates sufficient cash from its operations to cover short-term liabilities. Conversely, a lower value for OCFCL denotes higher risk.
Formula:
OCFCL = Operating Cash Flow
Current Liabilities
Example
OCFCL = $90,000
$250,000
OCFCL = 0.36
Cash Balance to Total Liabilities (CBTL)
This ratio shows a business’s cash balance in relation to its total liabilities. Cash is the most liquid assets a business has. A negative cash balance (caused by overdrafts) raises a warning signal and failure to address such an issue will likely result in liquidity problems.
Lower risk firms tend to have a higher value CBTL because they have more cash that can be used to pay suppliers, banks or any other party that has provided the business with a product or service. Higher risk businesses typically have a lower value CBTL which means the business’s ability to meet its debt obligations is significantly hampered.
Formula
CBTL = Cash balance
Total Liabilities
Example
CBTL = $560,000
$1,600,000
Leverage Ratios
Leverage ratios, also known as gearing ratios, measure the extent to which a business utilizes debt to finance growth. Leverage ratios can provide an indication of a business’s long-term solvency. Although debt is usually a cheaper form of financing than equity, debt carries risks and investors need to be aware of the extent of this risk.
Debt to Equity Ratio (De Ratio)
The debt to equity ratio provides an indication of a business’s capital structure and whether the business is more reliant on borrowings (debt) or shareholder capital (equity) to fund assets and activities.
Note, debt is not necessarily a bad thing. Debt can be positive, provided it is used for productive purposes such as purchasing assets and improving processes to increase net profits.
Acceptable debt to equity ratios may also vary across industries. Generally, businesses that are capital intensive tend to have higher ratios because of the requirement to invest more heavily in fixed assets.
The DE Ratio example shown below indicates that for every $1 of shareholder ownership in the business, the business owes $1.14 to creditors. A higher ratio generally indicates greater risk. Greater debt can result in volatile earnings due to additional vulnerability to business downturns.
But as with all other ratios, the DE Ratio will be more meaningful when compared over a period of time.
Formula
De Ratio = Total debt
Shareholder’s equity
Example
DE Ratio = $1,600,000
$1,400,000
DE Ratio = 1.14
Total Liabilities to Total Tangible Assets (TLTAI)
This ratio provides the relationship between a business’s liabilities and tangible assets. Tangible assets are defined as physical assets, such as property, cash, inventory and receivables. This classification excludes intangible assets, i.e. those assets that cannot be physically touched like goodwill, franchise, patent or trademark, or the value of a brand.
The use of tangible assets, compared to total assets, is more conservative as it only considers those assets that can be easily valued and, therefore, easily liquidated to cover liabilities.
The higher the value of the TLTAI ratio the higher the level of risk. In this case, the business is exposed to a high level of risk because it has $1.60 in liabilities for every $1 in tangible assets.
Formula
TLTAI = Total liabilities
Total Tangible Assets
Example
TLTAI = $400,000
$250,000
TLTAI = 1.60
Interest Cover Ratio
A business interest cover ratio measures its ability to meet interest expenses on debt using profits. Generally, a ratio of greater than two is regarded as a healthy position to cover interest.
Formula
Interest Cover = Net profit before tax + Interest
Interest
Example
Step 1
Interest cover = $20,000 + $10,000
$10,000
Step 2
Interest cover = $30,000
$10,000
Interest cover = 3
In this case, an interest cover ratio of three is considered good. It may be interpreted that the business is able to cover its interest expense three times over using earnings.
Profitable Ratios
Profitable ratios measure a business’s performance and provide an indication of its ability to generate profits. As profits are used to fund business development and pay dividends to shareholders, a business’s profitability and how efficient it is at generating profits is an important consideration for shareholders.
Earnings per Share (EPS)
A business’s earnings per share (EPS) ratio allows us to measure earnings in relation to every share on issue. This is done by dividing the business’s net income by the average weighted number of shares on issue.
Formula
EPS = Net income attributable to common shareholders
Total shares outstanding*
*adjusted for changes in capital during the period
Example
EPS = $200,000
$125,000
EPS = $1.60
Gross Profitability Ratios
Gross profit margin tells us what percentage of sales revenue would remain after deducting the cost of goods sold. This is important as it helps to determine whether the business would still have enough funds to cover operating expenses such as employee benefits, lease payments, advertising, and so forth.
The gross profit margin of a business may also be viewed as a measurement of production efficiency. A business with a gross profit margin higher than that of its competitors, or the industry average, is deemed to be more efficient and is therefore, all things being equal, preferred.
Formula
Gross Profit Margin = Sales – Cost of goods sold x 100
Sales
Example
Gross Profit Margin = $1,000,000 – $600,000 x 100
$1,000,000
Gross Profit Margin = 40%
Net Profit Margin
Net profit margin meanwhile indicates what percentage of sales would remain after all costs have been taken into account. This is best compared with other entities in the same industry and analysed over time, considering that variations from year to year may be due to abnormal conditions.
To explain this further, a declining net profit margin ratio may indicate a margin squeeze possibly due to increased competition or rising costs.
Formula
Net profit margin = Net income x 100
Sales
Example
Net profit margin = $250,000 x 100
$1,250,000
Net profit margin = 20%
Return on Assets (ROA)
Return on assets, commonly referred to as ROA, is a measurement of management performance. ROA indicates how well a company uses its assets to generate income. A higher ROA denotes a higher level of management performance.
Formula
ROA = Net income x 100
Average total assets
Example
ROA = $250,000 x 100
$2,000,000
ROA = 12.5%
In this example, the business generates a 12.5% return on its assets. This may again be compared against other companies in the same industry and observed over a period of time.
Return on Equity (ROE)
Return on equity, referred to as ROE, is another measurement of management performance. ROE gives an indication of how well a business has used the capital from its shareholders to generate profits. Similar to the ROA ratio, a higher ROE denotes a higher level of management performance.
Formula
ROE = Net income x 100
Average shareholders’ equity
Example
ROA = $200,000 x 100
$900,000
ROA = 22.22%
In this example, the business generates a 22.22% return on its shareholder’s equity. This may be compared to other companies in the same industry and observed over a period of time.
Valuation Ratios
Valuation ratios to determine whether the current share price of a business is high or low in relation to its true value. Valuation ratios help share investors assess if a business is cheap or expensive relative to earnings, growth prospect and dividend distributions.
Price to Earnings Ratio (PE)
The price to earnings ratio (PE) shows the number of times the share price covers the earnings per share over a 12-month period. It is measured by taking a business’s current share price and dividing this by earnings per share (EPS).
PE may also be interpreted as how much an investor pays for every $1 dollar the company earns. PE is one of the most widely used ratios for assessing a business’s value.
Formula
PE = Share price
Earnings per share
Example
PE = $10,000
$0.40
PE = 15.625