The balance sheet and income statement are fundamental to any business. They could be thought of as a "report card" on the performance of the business for the period. But what do they really tell you, other than the bottom line result? Once the financial statements have been prepared for your own business, how can you use them and learn from them to help you manage your business? Or, if you are considering making an investment in a company’s stock, how can you use its financial statements to help you decide whether it might be a good investment? One of the tools you can use is ratio analysis.
Ratio analysis as an evaluation tool
Obviously there are many different aspects and factors involved in evaluating a business, including management capability, innovations in products and technology, shifts in market demands, and general economic conditions, among others. But one of the advantages of using financial statements is that they provide you with objective, concrete data with which to perform analysis. Ratio analysis by itself is just one tool you can use in evaluating your own business, or a potential investment opportunity. For example, comparisons of balance sheets and income statements from one period to another can be very effective in detecting changes, trends and shifts. Calculating ratios based on the current period balance sheet and income statement can be very useful, and when combined with a comparative analysis from period to period, it becomes a very dynamic way of gauging performance.
How you use the insights you gain from your analytical work will of course depend on your purpose in reading the financial statements. If you are looking at a company in which you already have an investment, or in which you are thinking about investing, you may use the results of your analysis to either buy or sell, or to increase or decrease your holdings of that stock. If you are looking at your own company, you can use your analysis to see where your business is strong, and where it could use some adjustments or improvements. This will help you make financial decisions about your business operations.
Types of ratios
Some of the different types of ratios that can be calculated from data in the financial statements and used to evaluate a business include:
Liquidity ratios
Solvency ratios
Activity ratios
Profitability ratios
Liquidity ratios
Liquidity ratios measure a business’s ability to cover its obligations, without having to borrow or invest more money in the business. The idea is that there should be sufficient cash and assets that can be readily converted into cash to cover liabilities as they come due.
One of the most common liquidity ratios is:
Current Ratio = Current Assets / Current Liabilities
Current assets basically include cash, short-term investments and marketable securities, accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts payable to vendors and employees, and installments on notes or loans that are due within one year. This ratio could also be seen as a measure of working capital – the difference between current assets and current liabilities. A company with a lot of working capital will be in a better position to expand and improve its operations. On the contrary, a company with negative working capital does not have sufficient resources to meet its current obligations, and therefore is not in a position to take advantage of opportunities for growth.
Another stringent test of liquidity is the:
Acid-test Ratio = Current Assets minus Inventories / Current Liabilities
Inventory is a current asset that may or may not be quickly converted into cash. This depends on the rate at which inventory is being turned over. By excluding inventory, the acid-test ratio only considers that part of current assets that can be readily converted into cash. This ratio, also called the Quick Ratio, tells how much of the business's short-term debt can be met by using the company's liquid assets at short notice.
A ratio that shows how many times inventory is turned over, or sold during the period is:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
A high turnover ratio is a sign that products are being produced and sold quickly during the period. A ratio of 1.0, for example, would mean that at any given time you have enough inventory on hand to cover sales for the entire period. The higher this ratio, the more quickly inventory is being turned over and producing assets that are more liquid -- accounts receivable and then cash.
If you want an even clearer idea of exactly how much ready cash is on hand to cover current liabilities, you can use the:
Cash ratio = Cash + Marketable securities / Current Liabilities
The cash ratio measures the extent to which a business could quickly cover short-term liabilities, and therefore is of particular interest to short-term creditors. A ratio of 1.0 would indicate that all current liabilities would be covered at any average point in time by cash and marketable securities that could be readily sold and converted to cash. A ratio of less than 1.0 would mean that other assets, such as accounts receivable or inventory, would have to be converted to cash to cover short-term obligations. A ratio of greater than 1.0 means that there is more than enough cash on hand.
Solvency Ratios
Solvency ratios are measures to assess a company’s ability to meet its long-term obligations and thereby remain solvent and avoid bankruptcy. Two general, overall solvency ratios include:
Solvency Ratio = Total Assets / Total Liabilities
and
Solvency Ratio = Net Worth (Total Capital or Equity) / Total Liabilities
These ratios basically tell whether a company owns more than it owes. The higher the ratio, the more solvent the company.
Another ratio that can tell how much a company relies on debt to finance its assets is:
Debt Ratio = Total Debt / Total Assets
Traditionally, both short-term and long-term debts and assets are used in determining this ratio. In general, the lower a company’s reliance on debt to finance its assets, the less risky the company.
The debt to equity ratio is a measure of a company’s leverage – how much financing it has in the form of debt as compared with how much it has invested in the business.
Debt-equity Ratio = Total Liabilities / Total Owners’ Equity, or
Debt-equity Ratio = Long-Term Liabilities / Total Owners’ Equity
In assessing solvency, it is also important to take into consideration the breakdown of a company’s liabilities. Not all liabilities are debt in the form of bank loans or notes payable, for example. There are also accounts payable to vendors, salaries and wages payable, taxes payable, and accrued liabilities, among others. One of the measures of what debt constitutes in terms of total liabilities is:
Indebtedness Ratio = Total Debts / Total Liabilities
In general, a company that is heavy on debt may be better leveraged, but is also less solvent.
The debt repayment terms are another consideration. Short-term debt, payable within one year, may pose a greater burden on cash flow and eventual solvency than long-term debt, which is due beyond one year. A ratio used to quantify this is:
Short-term Debt Ratio or Quality of Debt = Short-term Debt / Total Debt
A lower value for this ratio would indicate less concern for installments coming due within a year.
There are other ratios intended to assess a company’s capacity to cover its debt repayments and financing costs. One of these ratios measures how interest expense is being covered by the net income the company is generating:
Interest expense coverage = Net income before interest and taxes / Interest expense
This ratio is also called Number of Times Interest Earned, and represents how many times the net income generated by the company, without considering interest and taxes, covers the total interest charge. The higher the ratio the more solvent the company.
Another similar ratio often used to measure a company’s capacity to cover its fixed charges is:
Ratio of Earnings to Fixed Charges = Earnings before income tax and fixed charges / Interest expense (including capitalized interest) and amortization of bond discount and issue costs
Capitalized interest is the amount of interest on a loan to finance a project or acquisition of fixed assets, that has been capitalized and included as part of the cost of the project or asset on the balance sheet. You will probably need to see the notes to the financial statements to find this figure.
Activity Ratios
Many useful gauges of operations can be calculated from data reported in the financial statements. For example, you can determine the average number of days it takes to collect on customer accounts, the average number of days to pay vendors, and how much of the operation is effectively being financed with payment terms extended by vendors.
Accounts Receivable Turnover = Total Credit Sales / Average Accounts Receivable
This tells you the average duration of accounts receivable for credit sales to customers. This in turn can be expressed in terms of the collection period, as follows:
Average Collection Period = Days in Year / Accounts Receivable Turnover
or
Days to Collect = Trade Accounts Receivable / Credit Sales x 365
A similar calculation can be made on the liabilities side, with accounts payable to vendors:
Days to Pay = Trade Accounts Payable / Purchases x 365
To determine how much of a company’s accounts receivable and inventory are effectively being financed by the credit extended to the company by its vendors:
Financing of Trade Accounts Receivable in terms of Trade Accounts Payable = Trade Accounts Payable / Trade Accounts Receivable
Financing of Inventory in terms of Trade Accounts Payable = Trade Accounts Payable / Inventory
Effectively managing the credit extended by vendors can help a company’s cash flow and therefore its liquidity and solvency.
From data reported on the income statement, various relationships can be calculated between different expenses and revenues, or a certain type of expense as a percentage of total expenses.
Labor Cost Percentage = Payroll and Related Expenses / Total Revenue or Total Expenses
Interest Expense Percentage = Interest Expense / Total Revenue or Total Expenses
These types of ratios or percentages can be calculated for any item on the income statement. Which accounts are more important will depend on the nature of the business. For example, some operations are more labor intensive and some are more capital intensive. In a labor intensive operation, the percentage that employee-related expenses, including wages, salaries and benefits, represent in terms of total operating expense is relevant. In a capital intensive operation, repairs and maintenance may take on more importance.
Profitability Ratios
One of the most common profitability ratios is the profit margin. This can be expressed as the gross profit margin or net profit margin, and it can be expressed by company, by sector, by product, or by individual unit. The information reported on the income statement will enable you to determine the overall profit margin. If additional breakdowns are provided, more detailed margins can be calculated.
Gross Profit Margin = Gross Income / Total Revenue
Net Profit Margin = Net Income / Total Revenue
Other commonly used ratios are returns, expressed as return on investment or equity, return on assets, and return on capital employed. These ratios measure a company’s ability to use its capital, or its assets, to generate additional value.
Return on Investment (ROI) or Return on Owners’ Equity = Net Income / Average Owners’ Equity
Return on Assets (ROA) = Net Income / Average Total Assets
Return on Capital Employed (ROCE) = Net Income Before Interest and Tax / Capital Employed (Total Assets minus Current Liabilities)
When evaluating investment opportunities, profits are often measured per share:
Earnings per Share = Net Profit After Tax and Dividends / Ordinary Shareholders' Equity
Another commonly used ratio to show the yield on an investment is:
Dividend Yield Ratio = Dividends per Share / Market Value per Share
And, to measure how the price of an investment correlates with the earnings on that investment, you can use the:
Price to Earnings Ratio = Market Value per Share / After-Tax Earnings per Share
Summary
The bottom line on the income statement is not the only important figure on the financial statements, and may not even be the most important. There is another whole dimension of valuable information that can be obtained from the data reported in the financial statements. Ratio analysis is one of many tools that can be used to evaluate a company’s performance, its current status, and its evolution over time. And if you are the owner of the business, this type of analysis can help you make the right decisions to improve your operations and make your business stronger and more successful.
