Financial Ratios A. Credit Analysis To determine whether a company is capable of fulfilling its short term financial obligations. 1. Liquidity The higher the liquidity ratio, the more likely the firm will be able to meet its short Ratios term obligations. Current Ratio Or Working capital ratio = Total Current Assets / Total Current Liabilities The current ratio is a liquidity ratio that measures a company’s ability to pay short-term obligations or those due within one year. Quick ratio or Acid test ratio = (Current Assets – Inventories – Prepaid expenses) / Total Current Liabilities The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. Cash ratio = (Cash + Marketable Securities) / Total Current Liabilities The cash ratio is a liquidity measure that shows a company's ability to cover its short-term obligations using only cash and cash equivalents. 2. A high ratio indicates high leverage and a high financial risk. If High following measures should be taken: Focus on profit maximization (reduce cost); repay long-term loans; retain profits rather than pay dividends; issue more shares; convert loans into equity. If Low measures: Focus on growth (Invest in revenue growth rather than profit max); convert S.T debt into L.T loans; Buy-back ordinary shares; pay increased dividends; issue debentures or preference shares. Solvency ratios Debt-to-Equity ratio (D/E Ratio or Risk ratio or Gearing ratio) = Total Liabilities (S.T and L.T) / Total Owners’ Equity Debt-to-equity (D/E) ratio compares a company’s total liabilities with its shareholder equity and can be used to assess the extent of its reliance on A current ratio that is in line with the industry average or slightly higher is generally considered acceptable. A current ratio that is lower than the industry average may indicate a higher risk of distress or default. Similarly, if a company has a very high current ratio compared with its peer group, it indicates that management may not be using its assets efficiently. As a rule of thumb the ratio of 2:1 is considered good. A result of 1 is considered to be the normal quick ratio. It indicates that the company is fully equipped with exactly enough assets to be instantly liquidated to pay off its current liabilities. A company that has a quick ratio of less than 1 may not be able to fully pay off its current liabilities in the short term, while a company having a quick ratio higher than 1 can instantly get rid of its current liabilities. A calculation greater than 1 means a company has more cash on hand than current debts, while a calculation less than 1 means a company has more short-term debt than cash. Lenders, creditors, and investors use the cash ratio to evaluate the short-term risk of a company. Among similar companies, a higher D/E ratio suggests more risk, while a particularly low one may indicate that a business is not taking advantage of debt financing to expand. Debt-to-Asset ratio Or Debt ratio = Total Liabilities (S.T and L.T) / Total Assets Equity-to-Asset ratio Or Equity ratio = Total Owner’s Equity / Total Assets Coverage ratios Times Interest Earned or Interest Cover ratio Debt Service Coverage ratio debt. The degree to which a company is using debt (relative to equity) to fund operations (leverage) The Debt to Asset Ratio, also known as the debt ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt. The higher the ratio, the greater the degree of leverage and financial risk. The percentage of assets that are being financed with equity. A ratio of less than one (<1) means the company owns more assets than liabilities and can meet its obligations by selling its assets if needed. The lower the debt to asset ratio, the less risky the company. Equity ratios that are .50 or below are considered leveraged companies; those with ratios of .50 and above are considered conservative, as they own more funding from equity than debt. 3. Cash Coverage ratio 4. Altman’s ZScore Model = Operating Income (EBIT) / Interest Expense The number of times a company is able to pay the interest expenses on its debt with its operating income. An ICR below 1.5 may signal default risk and the refusal of lenders to lend more money to the company. = Operating Income (EBIT) / Total Debt service (shortterm debt + current portion of long term debt) = Cash & Cash equivalents / Total Interest Expense A company’s ability to use its operating income to repay its current debt obligations including interest, principal, and lease payments that are due in the coming year. A DSCR calculation greater than 1.0 indicates there is barely enough operating income to cover annual debt obligations, while a calculation less than one indicates potential solvency problems. As a general rule of thumb, an ideal debt service coverage ratio is 2 or higher. = 1.2 * Working Capital / Total assets + 1.4 * Retained earnings / The cash coverage ratio is useful for determining the amount of cash available to pay for a borrower's interest expense, and is expressed as a ratio of the cash available to the amount of interest to be paid. A higher cash ratio means the company has an easier time paying off its debts. There’s no exact figure of how minimum the cash ratio should be for a company to be considered financially healthy. However, a ratio between 0.5 and 1 is generally acceptable. Since the cash ratio only adds cash and cash equivalents from assets into the equation, it provides the most conservative wisdom to the company’s liquidity. The Altman Z-score is a formula for determining whether a company, notably in the manufacturing space, is headed for bankruptcy. An Altman Z-score close to 0 suggests a company might be headed for bankruptcy, while a score closer to 3 suggests a company is in solid financial positioning. Total assets + 3.3 * EBIT/ Total assets + 0.6 * Market value of equity / Total liabilities + .999 *Total Sales / Total assets A score below 1.8 signals the company is likely headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling, or shorting, a stock if the value is closer to 1.8. In more recent years, Altman has stated a score closer to 0 rather than 1.8 indicates a company is closer to bankruptcy. B. Profitability Analysis The ability of a company to generate income (profit) and value to shareholders relative to revenue, costs, assets, and shareholders’ equity during a specific period of time. 1. Margin ratios Measure the company’s ability to convert sales into profits. Gross profit = Gross Profit A GPM of 0.36 or 36 % shows Low GPM: Higher supplier costs: margin (GPM) (Sales – that for every dollar in sales negotiate harder or look for COGS) / Sales achieved, $0.36 cents is retained alternative providers x 100 as gross profit. Selling at lower prices: acquisition of cheaper supplies or cutting labor costs may be necessary; passing on the costs to customers are possible protective measures Intense competition; Industry changes Operating profit = Operating Compare companies in the same margin (OPM) Income (EBIT) industry and same time period. / Sales x 100 Facing low OPM: Boost employee productivity or automate specific tasks; improve inventory management and reduce waste Net profit margin = Net Income Facing low NPM: Increase customer (NPM) (PAT) / Sales x base; find cheaper sources of raw 100 material; sale prices; sales reward programs 2. Return ratios Represent the company’s ability to generate returns to its investors (including shareholders). It's always best to compare the ROA Return on assets = Net income Indicates how profitable a company is in relation to its of companies within the same / Total Assets (ROA) total assets. Corporate industry because they'll share the management, analysts, and same asset base. investors can use ROA to determine how efficiently a company uses its assets to generate a profit. Return on Equity = Net income The rate of return on the money A high ROE could be a good reason to / that equity investors have put buy stock of a company. Less rely on (ROE) Shareholder’s into the business. external debt. Equity = EBIT / Total Used to assess a company's It's always a good idea to compare Return on Assets Total profitability and capital the ROCE of companies in the same Capital Current efficiency. In other words, this industry as those from differing Employed Liabilities ratio can help to understand industries usually vary. (ROCE) OR EBIT / Shareholders’ Equity + Long Term Liabilities how well a company is generating profits from its capital as it is put to use. ROCE is one of several profitability ratios financial managers, stakeholders, and potential investors may use when analyzing a company for investment. Higher ratios tend to indicate that companies are profitable. C. Activity/Efficiency Analysis A company’s ability to effectively employ its resources, such as assets, to produce income. Cash Conversion Cycle = DIO + DSO - DPO Days inventory outstanding (DIO) = [Avg. Inventory / CGS] * 365 Time to sell inventory in the market Days sales outstanding (DSO) = [Avg. accounts receivables / Time to collect cash from customers Credit sales] * 365 Days payable outstanding (DPO) = [Avg. accounts payable / CGS] Time to pay off suppliers * 365 D. Market Prospect ratios Market prospect ratios help potential investors to assess what they might receive from an investment – in terms of future dividends, earnings, or capital gains from a higher share price. Earnings per Share or EPS =[Net Income – Dividend paid EPS indicates how much money a on preferred stock / Number of company makes for each share of its equity shares outstanding] stock and is a widely used metric for estimating corporate value. A higher EPS indicates greater value because investors will pay more for a company's shares if they think the company has higher profits relative to its share price. Price to Earnings Ratio Or P/E Ratio = Current market price per share The P/E ratio helps one determine (MPS) / EPS whether a stock is overpriced or underpriced. A company's P/E can also be benchmarked against other stocks in the same industry or against the broader market. A high P/E ratio could mean that a company's stock is overvalued, or that investors are expecting high growth rates in the future. Dividend payout ratio =Total dividends paid / Net The dividend payout ratio is the Income proportion of earnings paid out as dividends to shareholders, typically expressed as a percentage. Dividend yield =Dividend per share / MPS The dividend yield, expressed as a percentage, is a financial ratio (dividend/price) that shows how much a company pays out in dividends each year relative to its stock price. It's important for investors to keep in mind that higher dividend yields do not always indicate attractive investment opportunities Earnings Yield =Earnings Per Share EPS / Current Market Price Per Share MPS because the dividend yield of a stock may be elevated as a result of a declining stock price. The earnings yield (the inverse of the P/E ratio) shows the percentage of a company's earnings per share. Earnings yield is used by many investment managers to determine optimal asset allocation and is used by investors to determine which assets seem underpriced or overpriced.
