Financial statement ratios

Financial statement ratios

Ratios are tools used to evaluate a company’s financial statements. Here are some of the more commonly used ratios.

Working capital ratio
Current assets ÷ current liabilities.
Illustration: Current assets of $2,500,000 ÷ current liabilities of $1,250,000 = 2.
This is also called the current ratio. Its purpose is to determine how the business can handle its daily operations. A number greater than one is good, with the greater the number the better. Less than one indicates an “insolvent” company and one that needs to be watched closely. The current assets include assets likely to be converted into cash within the next year while current liabilities are due to be paid within the next year.

Debt to equity
Total debt ÷ stockholders’ equity or capital.
I prefer the long term debt to equity ratio. See next ratio.

Long term debt to equity
Long term debt ÷ stockholders’ equity.
Illustration: LTD of $9,000,000 ÷ S/H equity of $6,000,000 = 1.5.
The purpose is to determine how leveraged the company is. The greater the long term debt in relation to equity, the more leveraged the company is, the more sensitive to interest rate increases it is, and the more sensitive it is to situations that could cause a temporary or permanent inability to make principal payments timely. Long term debt holders usually have covenants that place restrictions on the company causing adherence to certain controls or measures that are triggered when they are violated. Long term debt includes all debt except the current liabilities. If perchance the current liabilities exceed the current assets, this will be evident in the working capital ratio. A similar ratio is total debt to equity which I do not think is as effective of a measure since the total debt includes current liabilities with no offset for current assets and this makes the ratio harder to use as a tool. I previously posted a blog explaining leverage on Nov 11, 2014. [Included below]

Receivables turnover or days to collect
365 ÷ (Net sales revenue ÷ average net receivables).
Illustration: 365 ÷($12,000,000 ÷3,000,000) = 91 days.
Note: To determine average net receivables divide the beginning and ending receivables by 2.
This indicates how many days sales are tied up in receivables giving an indication about how fast sales are converted into cash. The longer the period, the greater the possibility that cash will be tight necessitating a slowdown of vendor payments or the need for additional capital or borrowing.

Return on assets
Net profit ÷ average of total assets.
Illustration: $1,000,000 profit ÷$12,000,000 average total assets = 8.33%.
This indicates how well the company is doing utilizing its assets. I think a better ratio is return on equity. The reason I do not use this is that the company could have recently borrowed $5,000,000 and it could be invested in short term marketable securities until utilized. This would increase its total assets by that $5,000,000 distorting the return on assets percentage.

Return on equity
Net profit ÷ average stockholders’ equity.
Illustration: $1,000,000 profit ÷ $2,500,000 S/H equity = 40%.
This appears to be a better measure of resource utilization. A further ratio could be return on market value or market cap. This is more appropriate for a public company with a readily ascertainable market value. If this is applied to a private company using a market cap formula for its valuation it can provide interesting insights. For instance , a private company earning $1,000,000 applying a 15% market cap percentage or return on investment percentage can indicate a company value of $6,700,000. Another way of looking at this is where there is an industry standard such as a percentage or multiple sales is to use that value as the denominator instead of S/H equity. Still another way would be to adjust S/H by the unstated values of certain assets the company has. Note that for a public company, the return on market cap is 1 ÷ the P/E ratio. For instance if the P/E is 20 the return on market value is 5%. There are other variations on this ratio especially where there is considerable debt and high interest expenses, but that is not for now where the purpose is to provide basic ratios.

Return on sales or net profit margin
Net profit ÷ net sales.
Ill.: $1,000,000 ÷$12,000,000 = 8.33%.
This shows how much ends up on bottom line. A note about using these ratios. When working with public companies they usually work. With private companies additional thought needs to be applied. For instance is the net profit before or after income taxes? If the entity is an S corporation, partnership or LLC it would not pay income taxes but the owners would be paying it personally on their individual tax returns. Also, the controlling owners could be taking higher than normal compensation or excessive fringe benefits making comparisons with other companies not feasible. It could also make comparisons between years of the same company inappropriate since these amounts could vary greatly from one year to the next.

Earnings before interest and taxes or EBIT
Net profit + interest + taxes added back.
This is a method to normalize earnings and make operational comparisons more consistent by adding back interest and taxes. Interest is a function of borrowing which is usually necessitated by a shortage of capital. A fully capitalized company would not have to borrow for capital purpose and make interest payments; or if it did borrow it would be to level out short term cash flow needs, or possibly to fund equipment or real estate. Adding back interest eliminates this bias. As said earlier, some entities do not pay tax and some could pay significantly different state and local taxes depending upon their location. This is another normalization feature.

EBITDA (Earnings before interest, taxes, depreciation and amortization)
Net profit + interest + taxes + depreciation + amortization.
This is a variation on EBIT that I do not use and feel is greatly misused because while it adds back the depreciation and amortization that was deducted to arrive at net income, it takes no account of normal recurring fixed asset additions which are usual for companies with equipment. This is an example of something that is used that is not understood but where the user feels it makes them a “player” or places them in a “knowledgeable” position. Bull duty! I posted a blog on this on Nov 13, 2014. [Included below]

Gross profit margin
1 – (Cost of sales ÷ net sales).
Illustration: 1- ($8,000,000 cost of sales ÷ $12,000,000 sales) = 33.3%.
This indicates the percentage of each sale that is left over after subtracting the direct costs of what was sold. The greater the margin the better. Companies with high margins have greater dollars available from sales to be used for overhead and fixed and operating expenses and available profits.

Inventory turnover
365 ÷ (Cost of sales ÷ average inventory).
Illustration: 365 ÷($8,000,000 ÷1,600,000) = 73 days.
This shows that the average inventory is 73 days of sales. A higher number indicates inventory being held for longer periods while a lower number shows a faster turnover. The longer the inventory is held, the greater the risk of not selling it and of inventory becoming stale, obsolete or damaged.

There are myriad others, but these are some of the more popular ratios. Ratios can be categorized into types such as for liquidity, performance, and capital structure, but there are not that many shown here and I did not think it mattered here to categorize them. The purpose of ratios is to provide a quick look at certain big picture or essential items. All ratios are better used when they can be compared with previous periods to determine trends. The more periods the better able to detect developing trends. For more serious analysis I prefer to have as many as five periods for comparison. In many cases it is not as much the ratio that matters as the change and trend.