Ratio Analysis
This material needs more development.
Financial ratios are relatively simple calculations (X divided by Y) of figures taken from a corporations financial documents (balance sheet, income statement, cash flows) that provide a clue to the strength of the company.
This document is a quick overview of some of the more common ratios (many more exist - accountants apparently have a lot of spare time and get excited by adding and dividing various things to see what happens), with later commentary on their use.
In general, analysis by the numbers is lacking (more)
Liquidity Ratios
These ratios measure the degree to which a company has liquid assets, which can be used to expand operations. It is argued that 'too little" liquidity means a company is unable to move quickly to react to market changes, but "too much" means the company's cash reserves are lying fallow and not being put to use to generate profit.
Current Ratio
Divide current assets by current liabilities to come up with this ratio. "Current Assets" include cash, cash equivalents, securities, receivables, and inventory. "Current Liabilities" and includes liabilities listed as various things in the balance sheet - generally the top lines that include accounts payable and other things that will be due in the near term.
The important thing is that it's a positive number (the company doesn't' have more debts than it has assets to pay them in the short run)
Basically one can derive working capital by subtracting CL from CA to arrive at a dollar amount. However, it must be converted to a ratio to be compared with other companies, or over time.
Quick Ratio
Same as the current ratio, only more restrictive: use cash equivalents, short term investments, and accounts receivable (eliminating inventory and long-term investments) and dividing that sum by current liabilities.
This is thought to be a clearer picture of a company's liquidity, as inventory cannot often be liquidated quickly to generate capital to pay current debts.
Cash Ratio
Even more restrictive, this uses cash, cash equivalents and sort-term investments (eliminating accounts receivable), and dividing that by current liabilities.
This is even more strict, in that this measures the company's liquidity without counting on selling its inventory or even collecting the debts other owe them.
Profitability Ratios
These ratios attempt to measure how well a company performs in terms of generating profit, based on the resources it utilizes in making that profit.
Profit Margins
These are fairly straightforward, but there are four variations: gross profit margin, operating profit margin, pretax profit margin, and net profit margin. Each of these divides the profit by net revenue to come up with a suggestion of what percentage of the company's sales are turned into cash. By computing each of the four, you can see where cash is being frittered away along the path.
Effective Tax Rate (ETR)
Divide the tax expense by the pretax income to determine the company's tax rate. The need for this ratio is not immediately apparent, but it would stand to reason that a company may benefit in the short run from sale of assets at a loss, which would decrease its tax debt, making it seem more profitable than it really is, based on its actual operating profit.
Return on Assets
Divide the net income by the average total assets - this should return a positive percentage that indicates the gross return that the company is earning on its assets.
Return on Equity
Divide the net income by the average shareholder's equity - this should return a positive percentage that indicates the gross return that the company is earning the amount of money that investors have contributed to it.
Return on Capital Employed
Divide the net income by the total liabilities and equity. Seems to me that this should be the same as ROA, provided the balance sheet balances.
Leverage Ratios
Indicate the degree to which debt is being used in a company's financial structure. A company that takes of a lot of debt, without being able to generate a profit on borrowed funds, is headed for the graveyard.
Debt Ratio
Calculate this ratio by dividing total liabilities by total assets. It should be a positive number (so long as a company has more assets than liabilities), and indicates the degree to which the company has financed its operations with debt rather than equity.
Debt to Equity Ratio
Divide liabilities by stockholder's equity. This seems to be another way of looking at the same thing (what proportion of the capital in use is financed by equities versus debt).
Operational Ratios
These ratios show how well the company produces a profit from its resources.
Fixed-Asset Turnover
Divide total revenue by the long-term assets (property, plant, and equipment) to determine how well a company is earning money based on the value of its fixed assets.
Revenue per Employee
Divide total revenue by number of employees to determine how effective the company is in terms of its use of human resources
Operating Cycle
Uses a few ratios that determine how quickly inventory is sold and invoices are collected.
Cash Flow Ratio
Divide free cash flow by total revenue to determine what percentage of sales are turned into actual cash (as opposed to receivables, or spend on expenses)
Investment Valuation Ratios
These ratios measure the performance of the stock, which takes into effect a number of factors that are not directly controlled by the management of a a company, but that nonetheless are used to gauge its performance in the market as an investment.
Price-to-Book
Divide the current price by the book value (equity per share). Typically, a stock sells for more than its book value, and this measures that relationship.
Price-to-Earnings
Divide price by the earnings per share. This, likewise, indicates that a stock sells for a multiple of the amount it earns each year.
Price-to-Sales
Divides price by the net revenue per share. Ditto.
Divided Payout Ratios
Divide dividends paid (per share) to earnings per share to determine the amount of profit that is passed on to customers as dividends rather than retained in the company (to become capital gains).
Use of Ratios
In investment planning (rather than business management), these ratios are used to gauge the performance of a company in various ways.
- The ratios themselves have meaning (high is good, low is bad, or vice versa), especially when compared with benchmarks.
- Some ratios can be used in comparison to others (if one seems high, another may explain it)
- Ratios can be tracked over time (a company may be seen as improving or declining due to the changes)
- Ratios can be compared to other firms in the same industry (to suggest that a company will outperform its peers).
Uselessness of Ratios
Even sources that advocate the use of ratio analysis concede that the approach is, to some degree, highly subjective (in the choice of ratios, benchmarks, and interpretation) and not terribly indicative of anything in specific, nor due they provide reliable guidance as to the future performance of a firm (they are, by definition, measurements of past states).
Also, ratios are a "snapshot in time", which is based upon historical information (the past is not necessarily an indicator of the future) and as such, may be skewed. A retail company make take on debt to build inventory prior to a season of sales; or a research company undertakes expenses for years to build a factory that won't generate revenue until it's been completed.
Also, considering that it is not uncommon for a corporation to operate several businesses, strength in some may be undermined by weakness in others (and conversely, weakness in some may be hidden by the strength of others).
Neither has it been consistently shown that a firm can become successful or rescue itself from ruin by merely obsessing over these numbers and jiggering their capital structure in an attempt to improve its ratios to appease or appeal to investors. An executive or board may set a financial goal (to improve fixed asset turnover) and engage in activities (or merely accounting sleight-of-hand) to improve the number without improving the business, and quite often doing harm to its future profitability.
That's not to say that ratio analysis is entirely useless, merely that its uses are limited to that of a measurement rather than a control, and can be used to identify areas where strength or weakness might exist. From an investment perspective, they can give a person a vague notion of a company's current situation, and how that situation has changed over time.