# Ratio Analysis

We would be performing ratio analysis by analyzing the three important categories of ratios.

• Profitability Ratio
• Efficiency Ratio
• Leverage Ratio

# Profitability Ratios

## Return on Equity (ROE)

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders' equity generates.

So a return on 1 means that every dollar of common stockholders' equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.

ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company.

Significance

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor's point of view—not the company. In other words, this ratio calculates how much money is made based on the investors' investment in the company, not the company's investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors' funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies' ratios in the industry. Since every industry has different levels of investors and income, ROE can't be used to compare companies outside of their industries very effectively.

Many investors also choose to calculate the return on equity at the beginning of a period and the end of a period to see the change in return. This helps track a company's progress and ability to maintain a positive earnings trend.

Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales. This ratio measures how profitable a company sells its inventory or merchandise. In other words, the gross profit ratio is essentially the percentage markup on merchandise from its cost. This is the pure profit from the sale of inventory that can go to paying operating expenses.

Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different. Gross margin ratio only considers the cost of goods sold in its calculation because it measures the profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.

Significance

Gross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their inventory at a higher profit percentage.

High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can get a big purchase discount when they buy their inventory from the manufacturer or wholesaler, their gross margin will be higher because their costs are down.

The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.

A company with a high gross margin ratios mean that the company will have more money to pay operating expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also measures the percentage of sales that can be used to help fund other parts of the business

## Operating Profit Margin

The operating margin ratio, also known as the operating profit margin, is a profitability ratio that measures what percentage of total revenues is made up by operating income. In other words, the operating margin ratio demonstrates how much revenues are left over after all the variable or operating costs have been paid. Conversely, this ratio shows what proportion of revenues is available to cover non-operating costs like interest expense.

This ratio is important to both creditors and investors because it helps show how strong and profitable a company's operations are. For instance, a company that receives 30 percent of its revenue from its operations means that it is running its operations smoothly and this income supports the company. It also means this company depends on the income from operations. If operations start to decline, the company will have to find a new way to generate income.

Conversely, a company that only converts 3 percent of its revenue to operating income can be questionable to investors and creditors. The auto industry made a switch like this in the 1990's. GM was making more money on financing cars than actually building and selling the cars themselves. Obviously, this did not turn out very well for them. GM is a prime example of why this ratio is important.

Significance

The operating profit margin ratio is a key indicator for investors and creditors to see how businesses are supporting their operations. If companies can make enough money from their operations to support the business, the company is usually considered more stable. On the other hand, if a company requires both operating and non-operating income to cover the operation expenses, it shows that the business' operating activities are not sustainable.

A higher operating margin is more favorable compared with a lower ratio because this shows that the company is making enough money from its ongoing operations to pay for its variable costs as well as its fixed costs.

For instance, a company with an operating margin ratio of 20 percent means that for every dollar of income, only 20 cents remains after the operating expenses have been paid. This also means that only 20 cents is left over to cover the non-operating expenses.

The EBITDA margin takes the basic profitability formula and turns it into a financial ratio that can be used to compare all different sized companies across and industry. The EBITDA margin formula divides the basic earnings before interest, taxes, depreciation, and amortization equation by the total revenues of the company-- thus, calculating the earnings left over after all operating expenses (excluding interest, taxes, dep, and amort) are paid as a percentage of total revenue. Using this formula a large company like Apple could be compared to a new start up in Silicon Valley.

Significance

The basic earnings formula can also be used to compute the enterprise multiple of a company. The EBITDA multiple ratio is calculated by dividing the enterprise value by the earnings before ITDA to measure how low or high a company is valued compared with it metrics. For instance a high ratio would indicate a company might be currently overvalued based on its earnings.

## Return on Asset

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net income produced by total assets during a period by comparing net income to the average total assets. In other words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce profits during a period.

Since company assets' sole purpose is to generate revenues and produce profits, this ratio helps both management and investors see how well the company can convert its investments in assets into profits. You can look at ROA as a return on investment for the company since capital assets are often the biggest investment for most companies. In this case, the company invests money into capital assets and the return is measured in profits.

In short, this ratio measures how profitable a company's assets are.

Significance

The return on assets ratio measures how effectively a company can earn a return on its investment in assets. In other words, ROA shows how efficiently a company can convert the money used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring the assets in the return calculation by adding back interest expense in the formula.

It only makes sense that a higher ratio is more favorable to investors because it shows that the company is more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as different industries use assets differently. For instance, construction companies use large, expensive equipment while software companies use computers and servers.

The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.

Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit margin formula would indicate the expenses are too high and the management needs to budget and cut expenses.

The return on sales ratio is often used by internal management to set performance goals for the future.

Significance

The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.

This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.

Since most of the time generating additional revenues is much more difficult than cutting expenses, managers generally tend to reduce spending budgets to improve their profit ratio.

Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.

## Price Earnings P/E ratio

The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market prospect ratio that calculates the market value of a stock relative to its earnings by comparing the market price per share by the earnings per share. In other words, the price earnings ratio shows what the market is willing to pay for a stock based on its current earnings.

Investors often use this ratio to evaluate what a stock's fair market value should be by predicting future earnings per share. Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future.

Obviously, fair market value of a stock is based on more than just predicted future earnings. Investor speculation and demand also help increase a share's price over time.

The PE ratio helps investors analyze how much they should pay for a stock based on its current earnings. This is why the price to earnings ratio is often called a price multiple or earnings multiple. Investors use this ratio to decide what multiple of earnings a share is worth. In other words, how many times earnings they are willing to pay.

Significance

The price to earnings ratio indicates the expected price of a share based on its earnings. As a company's earnings per share being to rise, so does their market value per share. A company with a high P/E ratio usually indicated positive future performance and investors are willing to pay more for this company's shares.

A company with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could prove to be a poor investment.

In general a higher ratio means that investors anticipate higher performance and growth in the future. It also means that companies with losses have poor PE ratios.

An important thing to remember is that this ratio is only useful in comparing like companies in the same industry. Since this ratio is based on the earnings per share calculation, management can easily manipulate it with specific accounting techniques.

# Efficiency Ratios

## Inventory Turnover

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is "turned" or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A company with \$1,000 of average inventory and sales of \$10,000 effectively sold its 10 times over.

This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can't sell these greater amounts of inventory, it will incur storage costs and other holding costs.

The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That's why the purchasing and sales departments must be in tune with each other.

Significance

Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn. This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company's inventory is. Think about it. Inventory is one of the biggest assets a retailer reports on its balance sheet. If this inventory can't be sold, it is worthless to the company. This measurement shows how easily a company can turn its inventory into cash.

Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this inventory will be easy to sell.

Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic car industry.

Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year.

A turn refers to each time a company collects its average receivables. If a company had \$20,000 of average receivables during the year and collected \$40,000 of receivables during the year, the company would have turned its accounts receivable twice because it collected twice the amount of average receivables.

This ratio shows how efficient a company is at collecting its credit sales from customers. Some companies collect their receivables from customers in 90 days while other take up to 6 months to collect from customers.

In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are more liquid the faster they can covert their receivables into cash

Significance

Since the receivables turnover ratio measures a business' ability to efficiently collect its receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year. In other words, this company is collecting is money from customers every six months.

Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from customers sooner, it will be able to use that cash to pay bills and other obligations sooner.

Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A company with a higher ratio shows that credit sales are more likely to be collected than a company with a lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is important.

## No of days sales in inventory

The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory, measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last.

This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash flows. Both investors and creditors want to know how valuable a company's inventory is. Older, more obsolete inventory is always worth less than current, fresh inventory. The days sales in inventory shows how fast the company is moving its inventory. In other words, it shows how fresh the inventory is.

This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company can convert its inventory into cash sooner. In other words, the inventory is extremely liquid.

Along the same line, more liquid inventory means the company's cash flows will be better.

Significance

The days sales in inventory is a key component in a company's inventory management. Inventory is a expensive for a company to keep, maintain, and store. Companies also have to be worried about protecting inventory from theft and obsolescence.

Management wants to make sure its inventory moves as fast as possible to minimize these costs and to increase cash flows. Remember the longer the inventory sits on the shelves, the longer the company's cash can't be used for other operations.

Management strives to only buy enough inventories to sell within the next 90 days. If inventory sits longer than that, it can start costing the company extra money.

It only makes sense that lower days inventory outstanding is more favorable than higher ratios.

A comparison of the receivables to the sales activity of a business is called the accounts receivable collection period or days sales outstanding. This comparison is used to evaluate how long customers are taking to pay a company. A low figure is considered best, since it means that a business is locking up less of its funds in accounts receivable, and so can use the funds for other purposes. Also, when receivables remain unpaid for a reduced period of time, there is less risk of payment default by customers.

Significance

Days sales outstanding is most useful when compared to the standard number of days that customers are allowed before payment is due. Thus, a DSO figure of 40 days might initially appear excellent, until you realize that the standard payment terms are only five days. DSO can also be compared to the industry standard, or to the average DSO for the top performers in the industry, to judge collection performance.

A combination of prudent credit granting and robust collections activity is indicated when the DSO figure is only a few days longer than the standard payment terms. From a management perspective, it is easiest to spot collection problems at a gross level by tracking DSO on a trend line, and watching for a sudden spike in the measurement in comparison to what was reported in prior periods.

## Operating Cycle

Operating cycle is the number of days a company takes in realizing its inventories in cash. It equals the time taken in selling inventories plus the time taken in recovering cash from trade receivables. It is called operating cycle because this process of producing/purchasing inventories, selling them, recovering cash from customers, using that cash to purchase/produce inventories and so on is repeated as long as the company is in operations.

Operating cycle is a measure of the operating efficiency and working capital management of a company. A short operating cycle is good as it tells that the company's cash is tied up for a shorter period.

Another useful measure used to assess the operating efficiency of a company is the cash cycle (also called the cash conversion cycle).

Significance

The operating cycle has importance in classifying current assets and current liabilities. While most manufacturers have operating cycles of several months, a few industries require very long processing times. This could result in an operating cycle that is longer than one year. To accommodate those industries, the accountants' definitions of current assets and current liabilities include the following phrase: ...within one year or within the operating cycle, whichever is longer.

The fixed asset turnover ratio is an efficiency ratio that measures a companies return on their investment in property, plant, and equipment by comparing net sales with fixed assets. In other words, it calculates how efficiently a company is a producing sales with its machines and equipment.

Investors and creditors use this formula to understand how well the company is utilizing their equipment to generate sales. This concept is important to investors because they want to be able to measure an approximate return on their investment. This is particularly true in the manufacturing industry where companies have large and expensive equipment purchases. Creditors, on the other hand, want to make sure that the company can produce enough revenues from a new piece of equipment to pay back the loan they used to purchase it.

Management typically doesn’t use this calculation that much because they have insider information about sales figures, equipment purchases, and other details that aren’t readily available to external users. They measure the return on their purchases using more detailed and specific information.

Significance

A high turn over indicates that assets are being utilized efficiently and large amount of sales are generated using a small amount of assets. It could also mean that the company has sold off its equipment and started to outsource its operations. Outsourcing would maintain the same amount of sales and decrease the investment in equipment at the same time.

A low turn over, on the other hand, indicates that the company isn’t using its assets to their fullest extent. This could be due to a variety of factors. For example, they might be producing products that no one wants to buy. Also, they might have overestimated the demand for their product and over invested in machines to produce the products. It might also be low because of manufacturing problems like a bottleneck in the value chain that held up production during the year and resulted in fewer than anticipated sales.

Keep in mind that a high or low ratio doesn’t always have a direct correlation with performance.

# Leverage Ratios

## Current Ratio

The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.

This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having to sell off long-term, revenue generating assets.

Significance

The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current liabilities.

A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make current debt payments.

If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company isn't making enough from operations to support activities. In other words, the company is losing money. Sometimes this is the result of poor collections of accounts receivable.

The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current debt, its cash flow will suffer.

Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company's ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.

This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders.

This helps investors and creditors analysis the overall debt burden on the company as well as the firm's ability to pay off the debt in future, uncertain economic times.

Significance

The debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets. As with many solvency ratios, a lower ratios is more favorable than a higher ratio.

A lower debt ratio usually implies a more stable business with the potential of longevity because a company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but .5 is reasonable ratio.

A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities. Or said a different way, this company's liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company's assets and the shareholders own the remainder of the assets.

A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm. Once its assets are sold off, the business no longer can operate.

The debt ratio is a fundamental solvency ratio because creditors are always concerned about being repaid. When companies borrow more money, their ratio increases creditors will no longer loan them money. Companies with higher debt ratios are better off looking to equity financing to grow their operations

## Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

Significance

Each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar.

A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets.

A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments.

Creditors view a higher debt to equity ratio as risky because it shows that the investors haven't funded the operations as much as creditors have. In other words, investors don't have as much skin in the game as the creditors do. This could mean that investors don't want to fund the business operations because the company isn't performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing.

The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future.

In some respects the times interest ratio is considered a solvency ratio because it measures a firm's ability to make interest and debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company can't make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.

Significance

The times interest ratio is stated in numbers as opposed to a percentage. The ratio indicates how many times a company could pay the interest with its before tax income, so obviously the larger ratios are considered more favorable than smaller ratios.

In other words, a ratio of 4 means that a company makes enough income to pay for its total interest expense 4 times over. Said another way, this company's income is 4 times higher than its interest expense for the year.

As you can see, creditors would favor a company with a much higher times interest ratio because it shows the company can afford to pay its interest payments when they come due. Higher ratios are less risky while lower ratios indicate credit risk.