Financial Ratios Defined

The financial ratio is an important tool to measure a number of different variables when it comes to the multitude of financial products we commonly utilize. Here are some definitions and explanations for the most popular financial ratios.

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Measuring the strength of a company can be a tough job. You can read through their financial statements, but the numbers don’t mean much unless you compare them to each other using financial ratios. There are several financial ratios that analysts use to compare one firm’s financials to another’s, more importantly you can use the ratios to help pick which company’s stocks to invest in. For each of the ratios, there’s also an industry benchmark that you can compare against to better gauge how the company is doing.

Liquidity Ratios

Liquidity ratios tell how well a company can pay off its short-term debts. Higher ratios are better because they indicate the company is better able to cover its debts, at least in the short term.

The current ratio compares the company’s current assets to its liabilities. It’s calculated as current assets / current liabilities. A higher current ratio indicates lower risk for investors. But, it can also mean the company is saving money rather than putting it back into the business. The current ratio in certain industries may be cyclical, higher in some years than in others.

The quick ratio is similar to the current ratio except that it excludes inventory from the equation. It’s calculated as (current assets – inventory)/current liabilities. Removing inventory from the equation is helpful especially when the companies sales are slowed. This equation lets you gauge whether the company could pay short-term debts without relying on product sales.

The cash ratio measures a company’s ability to repay its short-term debts using only its most liquid assets. The ratio is calculated as (cash + market securities)/current liabilities. This ratio doesn’t include inventory or accounts receivables. It’s a very conservative measure that firms don’t always use.

Financial Leverage Ratios

Financial leverage ratios are also called debt ratios. These ratios measure the company’s ability to pay its long-term debts.

The debt ratio is calculated as total debt / total assets. It shows how much debt a company has compared to its assets. Lower ratios are better since they indicate the company is using more of its own assets and less borrowed money to run the business.

The debt-to-equity ratio shows how much the company is in debt. It’s calculated as total debt / total equity.

The capitalization ratio allows you to compare the amount of equity the company is using to pay for operation costs to the amount of debt the company is using for these costs. It’s calculated as long-term debt/ (long-term debt + shareholder’s equity). Shareholder’s equity is the combination of preferred stock and common stock. The capitalization ratio can vary, even among companies in the same industry, depending on how long the company has been in business and the type of business the company does.

Cash flow to debt flow ratio shows how well a company can pay its debt with the cash it earns from operations. It’s calculated as: operating cash flow / total debt. High double-digit percentages are typically good numbers and low or negative numbers show a company has too much debt or not enough cash flow. The cash flow to debt ratio is also a better indicator of financial strength when you see how the ratio trends for that company over the course of time.

Operating Financial Ratios

These ratios show how well the company is managingand using its capital.

The asset turnover ratio shows the total ratio for every dollar of asset the company owns. It’s total revenue / average assets. Higher asset turnover ratios are better. The number is an even better indicator of company performance when compared to that of other businesses in the same industry and for the same asset period.

The receivable turnover ratio shows how many days it takes the company to collect its account receivables. It’s calculated as annual credit sales / accounts receivable.

Inventory ratio is the cost of goods sold / average inventory. It shows how long the company’s inventory is sitting on shelves or in storage before it’s sold. Higher inventory ratios show a risk of inventory loss.

The operating cycle shows (in number of days) how well a company is managing its operational capital assets. It’s calculated as Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding.

Profitability Ratios

Profitability ratios show how well the company generates profits. High gross profit margins and high returns on capital are both good metrics to show the chances a company will survive.

Gross profit margin is the amount of gross profit earned on sales. It’s calculated as (Sales – Cost of Goods Sold / Sales).

Return on assets shows how well the company’s assets are at generating profit. It’s calculated as: Net Income / Total Assets.

Return on equity is one of the most important ratios from a shareholder’s perspective. It shows the amount of profit the company has earned for each dollar of company stock. It’s calculated as Net Income / Shareholder Equity.

Return on capital employed shows whether the company is earning enough revenue and profit to effectively use its capital assets. Generally, the higher the number, the better. It’s calculated as: Net Income / Capital Employed. You won’t find Capital Income on the company’s financial statements. Instead, you’ll have to calculate it by adding average debt liabilities to average shareholder’s equity.

Market Value Ratios

Market value ratios are a good way to evaluate the value of a company’s stock.

Earnings per share lets an investor know how much they could expect to earn on one share of stock from a company. It’s calculated as (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares.

The price to earnings ratio indicates how much investors are willing to pay for a dollar of company profits. It’s equal to: Stock Price per Share / Earnings per Share. Higher numbers aren’t necessarily better because they only indicate what investors think the stock is worth.

The price to book value ratio compares the market value of a stock to its book value. It’s calculated as Stock Price per Share / Shareholder’ Equity per Share.

Price to sales ratio is similar to the price to earnings ratio except that the price to sales ratio compares the stock price to annual sales rather than company earnings. It’s calculated as Stock Price per Share / Net Sales per Share.

Dividend yield is equal to Dividends per Share / Share Price. This ratio shows how much the company pays in annual dividends compared to share price. High, stable dividend yields are typically more attractive.

Dividend payout ratio is calculated as Dividends Per Share / Earnings Per Share. An alternate way to calculate it is Dividends / Net Income. The ratio indicates the percentage of earnings that’s paid to shareholders in dividends.

You can find the information to calculate these ratios on the company’s balance sheets. Fortunately, publications like Forbes and Business Week calculate financial ratios for many publicly-traded companies. That saves you the work of having to make the calculations on your own.