Financial Performance Metrics –
Financial Ratios
Dr. Imran Umer
Financial Performance Metrics –
Financial Ratios
• Financial ratio analysis is the systematic use of ratios
to interpret financial statements so that the existing
strengths and weaknesses of a firm as well as its
historical performance and current financial condition
can be determined and evaluated.
For Example:
• Short-term creditors, such as banks and trade creditors,
use ratios to determine the firm’s immediate liquidity.
• Longer-term creditors such as bondholders use them
to determine its long-term solvency.
Ratio is a quantitative relation between two amounts showing the number of times one value contains or is contained within the
other.
Financial Performance Metrics –
Financial Ratios
When we calculate a ratio, all we get is a number. In order for this
number to be meaningful to us, we need to put it into some kind of
context by comparing it with another number. We can make these
comparisons through:
1) Trend analysis of a single company by comparing current ratios to
previous years. Trends can be particularly useful in analyzing a
firm’s financial condition. If ratios are becoming less favorable
over time, for example, this is an indication of trouble.
2)
Comparison with other companies in the same industry or with
industry averages after any necessary adjustments have been
made to assure that the accounting data is comparable.
3)
Comparison with management’s expectations.
Types of Financial Ratios
1. Profitability Ratio
Measures the firm’s profit in relation to its total revenue, or the amount
of net income from each dollar of sales and its return on invested assets;
2. Assets Utilization Ratio / Efficiency Ratio or Activity
Analysis
Activity ratios, which relate information on a firm's ability to manage its
current assets (accounts receivable and inventory) and current liabilities
(accounts payable) efficiently;
3. Short Term Solvency Ratios / Liquidity Ratio
Measures the ability of the firm’s cash resources to meet its short-term
cash obligations;
4. Long Term Solvency Ratios / Debt Utilization Ratio
Evaluates the firm’s ability to satisfy its longer-term debt and investment
obligations by looking at the mix of its financing sources;
Profitability Ratio
Profitability ratios allow us to measure the ability of the firm to earn an
adequate return on sales, assets and invested capital.
The higher ROA & ROE, the better, or more effectively, the company is using its
assets and capital.
Assets Utilization Ratio / Efficiency
Ratio / Activity Analysis
Under this type, ratios are used to measure the speed at which the firm is
turning over accounts receivable, inventory and long term assets to generate
sales and revenue.
a)
Accounts Receivable Turnover
It is the measure of the efficiency of a firm’s credit policy. It
estimates the number of days it takes for a dollar in sales to be
collected by the firm.
• An increase in the accounts receivable turnover ratio indicates that
receivables are being collected more rapidly. A decrease indicates
slower collections.
Collection Period = 360/Times
Assets Utilization Ratio / Efficiency
Ratio / Activity Analysis
b)
Inventory Turnover
It Indicates how quickly inventory is sold during the year.
If a company has a high inventory turnover ratio,
• It may mean the company is using good inventory management and
is not holding excessive amounts of inventories that may be
obsolete, unmarketable goods.
• However, it can also mean that the company is not holding enough
inventory and may be losing sales if prospective customers are
unable to make purchases because items are out of stock.
Assets Utilization Ratio / Efficiency
Ratio / Activity Analysis
c)
Fixed Assets Turnover
It indicates how well the investment in long term (fixed) assets is
being managed.
d)
Assets Turnover
The Asset Turnover Ratio measures the amount of sales revenue the
company is generating from the use of all of its assets. It provides a
means to measure the overall efficiency of the company’s use of all
of its investments, as represented by both short-term assets and
long-term assets.
Short Term Solvency Ratio / Liquidity
Ratio
These ratios measure firm’s ability to pay off short term obligations as they are
due.
a)
Current Ratio
A measure of short term debt paying ability. The “norm” is 2:1. A
lower ratio indicates a possible liquidity problem.
b)
Quick Ratio / Acid Test Ratio
An improved measurement of short term debt paying ability.
Note: Quick Assets = Current Assets – Inventories – Prepaid
Short Term Solvency Ratio / Liquidity
Ratio
c)
Working Capital
Indicates the cash generated by operations after allowing for cash
payment of expenses and operating liabilities.
Long Term Solvency Ratio / Debt
Utilization Ratio
It shows the overall debt position of the firm in the light of its assets base and earning power.
a)
Debt Ratio
Percentage of assets financed by creditors, and also indicates relative size of the equity position.
Note: Assets = Liabilities + Shareholders Equity
b)
•
•
Debt to Equity Ratio
The Debt to Equity ratio can serve as a screening device for the analyst when looking at capital
structure ratios. If this ratio is extremely low (for instance, 0.1:1), then there is no need to
calculate other capital structure ratios because there is no real concern with this part of the
company’s financial situation. The analyst’s time could be better spent looking at other aspects
of the company’s operations.
However, if the Debt to Equity ratio is in the neighbourhood of 2:1 or higher, it would be
important to do some extended analysis that focuses on other ratios such as profitability, as well
as the company’s future prospects.
Long Term Solvency Ratio / Debt
Utilization Ratio
c) Coverage Ratios
Coverage ratios measures the degree to which fixed payments are “covered”
by operating profits. we use earnings coverage ratios to focus on the
company’s earning power, because that will be the source of interest
payments, as well as the source for the principal repayments.
I. Times Interest Earned / Interest Coverage Ratio
Indicator of a company's ability to meet its interest payment obligations.
•
•
The Interest Coverage ratio compares the funds available to pay interest. This ratio
gives an indication of how much the company has available for the payment of its
fixed interest expense.
A high ratio is desirable. An interest coverage ratio of greater than 3.0 is excellent.
When the interest coverage ratio gets down to 1.5, a company has a heightened risk
of default, which becomes higher the further the ratio declines below 1.5.
Other Important Ratios
a)
Earnings Per Share (EPS)
EPS is essentially the measure of the amount of income that each share of common stock would have
earned if the profit of the company had been “paid” (distributed) to all of the common shares
outstanding.
b)
Price Earnings Ratio (P/E)
The P/E ratio gives an indication of what shareholders are paying for continuing Earnings Per Share.
Investors view it as an indication of what the market considers to be the firm’s future earning power.
• The P/E ratio is greatly influenced by where a company is in its cycle. A company in a growth stage
will usually have a high P/E ratio because of the market’s expectations of future profits (which
makes the market price higher) despite the fact that at the current time, profits may be low.
• Companies with low growth generally have lower P/E ratios.
• This ratio is meaningless when a company is experiencing losses (the P/E would be negative
because earnings are negative)
Other Important Ratios
c)
Dividend Payout Ratio
The dividend payout ratio measures the proportion of earnings paid out as dividends to common
stockholders.
Generally, a new company or a company that is growing will have a low or no dividend payout,
because it is retaining earnings in the company to finance its growth.
Thank You