Ratio Analysis

The Three Different Financial Statements

The Income Statement

The income statement, also known as the profit and loss statement, is a financial statement broken down into 3 sections:

• Revenue: money earned throughout the period
• Expenses: expenses accumulated throughout the period
• Income: After subtracting expenses from revenue, it provides income, which is known as net profit for the period.

The Balance Sheet

The balance sheet is broken down into 3 sections:

• Assets: Items of value the business owns. Assets can include cash, machinery and receivables. Assets are ordered on the balance sheet according to their level of liquidity, from the most liquid at the top, to the least liquid at the bottom. ‘Current assets’ are expected to be converted into cash within a year, non-current assets are not expected to be converted into cash within a year. This applies for current and non-current liabilities as well.
• Liabilities: financial debts or obligations of a business, which must be settled or repaid.
• Equity: the company’s residual value after subtracting total liabilities from total assets. It represents the company’s total worth, and what amount would be left if the company sold all of their assets and paid off all of their liabilities.

The Cash Flow Statement

The cash flow statement is broken down into 3 sections:

• Cash flow from operations: cash flows from day-to-day activities
• Cash flows from investing activities: cash flows for buying and selling assets
• Cash flow from financing activities: cash flows for funding the business, concerning creditors or shareholders.

Part 1: Profitability Ratios

(1) Profit Margin

The profit margin compares the company’s total net profit with its total revenue or sales. It is expressed as a percentage, and is used to indicate how much profit a company can retain after taking their revenue or sales into consideration.

Where to locate these key variables: Net income can be found on the income statement, and revenue and sales can also be found on the income statement.

Profit margin = 22% Means: 22% of sales or revenue ends up as profit.

• If the profit margin is increasing over time, either (1) expenses have fallen, or (2) the business is selling products at a higher price without a relative increase in costs.
• If profit margin is decreasing over time, either (1) expenses have increased, or (2) the business is selling products at a lower price.

(2) Gross Profit Margin

The gross profit margin measures how much of every dollar of revenue is left over after paying for cost of goods sold (COGS). This ratio tells investors how much money is left over from revenues or sales after paying for the materials (COGS) needed to produce the company’s goods and/or services.

Where to locate these key variables: Revenue can be found on the income statement, and cost of goods sold can also be found on the income statement.

Gross Profit Margin = 35% Means: 35% of sales revenue is left over to pay expenses. 65% of sales revenue was consumed by the cost of sales, such as purchasing and manufacturing inventory.

There are 2 reasons for improving gross profit margin, (1) sales or revenue is increasing in respect to the cost of goods sold (COGS), or (2) the cost of goods sold (COGS) falls in respect to sales or revenue.

(3) Return On Assets

Return on assets (ROA) compares the net profit a company generates with their total assets. It is expressed as a percentage, and it is calculated by dividing the company’s net income with their total assets. The return on assets ratio indicates how efficient the management team are at earning net profit through the use of the company’s assets.

Where to locate these key variables: Net income can be found on the income statement, and total assets can be found on the balance sheet.

Return on Assets = 18% means: For every dollar ($1) worth of assets in the business, 18 cents (18c) is generated as a return.

• An increasing return on assets means (1) profitability has increased in respect to asset usage, or (2) assets are being used without the required capital to maintain or replenish their levels.
• A declining return on assets means (1) assets have increased without a relative increase in profitability, or (2) assets are not performing as well, or (3) new large assets fail to meet profitability expectations.

(4) Return On Equity

Return on equity (ROE) reveals the amount of profit a company has generated relative its shareholders equity. It is expressed as a percentage, and is calculated by comparing the company’s net income to its shareholders equity. Return on equity indicates how efficient the company are at earning net profit on its shareholder equity.

Where to locate these key variables: Net income can be found on the income statement, and total shareholder equity can be found on the balance sheet.

Return on Equity = 18% means: For every dollar ($1) of shareholder equity, the business is returning 18 cents (18c) of profit.

In theory, if a business can produce a return on equity ratio which is higher than its cost of capital, then value is being created.

Part 2: Liquidity Ratios

(5) Current Ratio

The current ratio shows how well a company can pay off their short-term obligations (liabilities) by using their current assets. It is calculated by comparing the company’s current assets with their current liabilities. Current assets should convert into cash within a year, and current liabilities should be reconciled within a year.

Where to find these key variables: Current assets can be found on the balance sheet, and current liabilities can also be found on the balance sheet.

Current ratio = 1.82 Means: Current Assets can be used 1.82 times to repay the current liabilities.

• The higher the current ratio, the easier it becomes for a business to service its short-term obligations with their current assets.
• A current ratio over 2 is considered safe.
• A current ratio less than 1 is considered risky, since there are not enough liquid assets (current assets) to cover current liabilities which may require the sale of non-current assets, to cover current obligations and prevent insolvency.

(6) Acid-Test Ratio

The acid-test ratio compares the company’s highly liquid assets with their current liabilities. It is calculated by subtracting inventory from the company’s current assets, then dividing that figure with the company’s current liabilities.

Where to find these key variables: All of the above variables used for this ratio can be found on the balance sheet.

Acid Test Ratio = 1.45 Means: Liquid assets can be used 1.45 times to cover current liabilities.

• The higher the acid-test ratio, the better a business is able to service short-term obligations (current liabilities) with highly liquid assets.
• A high acid-test ratio means the management team do not need to restructure their business to meet their short-term obligations, for example by selling a non-current asset.

(7) Cash Ratio

The cash ratio is used to compare the company’s cash and cash equivalents with the total value of their current liabilities. It reflects the company’s ability to pay off their short-term obligations by using their most liquid asset (cash). The difference between the cash ratio and current ratio is that the cash ratio does not take inventory or accounts receivable into consideration.

Where to find these key variables: Current liabilities can be found on the balance sheet, and cash and cash equivalents can also be found on the balance sheet.

Cash Ratio = 1.12 Means: The most liquid asset (cash) can be used 1.12 times to cover current liabilities.

• The cash ratio changes most frequently compared to other liquidity ratios.
• The higher the cash ratio, the better a business is able to service short-term obligations with it’s most liquid asset (cash).
• A falling cash ratio generally means higher uncertainty with meeting short-term obligations, and it may require restructuring such as converting non-current assets into more liquid assets (cash) to meet short-term debts.

Part 3: Leverage Ratios

(8) Debt Ratio

The debt ratio demonstrates the companies total debt compared to its total amount of assets. The debt ratio is expressed as a percentage, and it measures the amount of debt a company holds in comparison to the total amount of assets.

Where to find these key variables: Debt (also known as borrowings) can be found on the balance sheet, and total assets can also be found on the balance sheet.

Debt Ratio = 65% Means: For every ($1) dollar of assets, there is 65 cents of debt, or 65% of assets are financed with debt.

• The debt ratio is widely used as an indicator of investment risk.
• A falling debt ratio may signal business success, for example increasing sales volume can increase the value of the company’s assets.
• If the debt ratio goes above 100%, then theoretically the business is unable to pay off its debts through the liquidation of its assets.

(9) Debt To Equity Ratio

The debt to equity ratio compares the company’s total liabilities with their shareholder equity. It helps investors understand the company’s level of financial leverage, relative to their total equity.

Where to locate key variables: Total liabilities can be found on the balance sheet, and shareholder equity can also be found on the balance sheet.

Debt to Equity = 20% Means: For every dollar ($1) of Company X equity, there are 20 cents (20c) of liabilities. Alternatively, the proportion of assets funded by debt is 20% the level of equity.

• Leverage (debt) can be useful for achieving faster business growth than what would otherwise be possible.
• The debt to equity ratio can measure the risk of an investment, the higher the ratio, the greater the investment risk.

(10) Times Interest Earned Ratio

Also known as the interest coverage ratio, it measures how many times the company’s earnings can cover their current interest obligations. It uses earnings before interest and tax (EBIT) for its earnings metric.

Where to locate these key variables: EBIT can be found on the income statement, and interest expense can also be found on the income statement.

Times Interest Earned Ratio = 5.6 Means: The company’s EBIT can pay its interest expense 5.6 times.

• The times interest earned ratio shows the company’s ability to service its debt obligations.
• A decreasing times interest earned ratio indicates either (1) less earnings from operations, or (2) Taking on more debt without a corresponding increase in earnings.

Part 4: Efficiency Ratios

(11) Inventory Turnover

The inventory turnover ratio reveals the number of times a company has sold and replaced its inventory during a specified period. It shows how quickly a company can sell all of its inventory, which demonstrates the strength of company sales and/or the operational efficiency of the company.

Where to locate these key variables: Cost of goods sold (COGS) can be found on the income statement, and inventory can be found on the balance statement.

Inventory turnover = 8.9 Means: The business has stocked inventory, and then sold all of this inventory 8.9 times.

• An increase in inventory turnover is positive, this means (1) sales of goods are increasing, or (2) inventory purchases on behalf of the business are becoming more efficient with matching the demand from the market.
• A decrease of inventory turnover is negative, this means (1) sales of goods are decreasing, or (2) inventory purchases on behalf of the business are becoming less efficient with matching the demand from the market.

(12) Accounts Receivable Turnover

The accounts receivable turnover ratio is similar to the inventory turnover ratio. The accounts receivable turnover ratio shows the company’s ability to convert its accounts receivable into cash.

Where to find these key variables: Total revenue or sales can be found on the income statement, and accounts receivable can be found on the balance sheet.

Accounts Receivable Turnover = 6.5 Means: Over specified time period, the business turned its accounts receivable into cash 6.5 times.

• An increase in accounts receivable turnover may indicate, (1) an increase in performance of internal collection teams claiming accounts receivable payments, (2) a positive change in credit and collections policy on behalf of the business, and (3) the business being able to service accounts payable better.
• A decrease in accounts receivable turnover is caused by the opposite to the above.

(13) Days Sales In Receivables

Days sales in receivables shows how many days on average it will take to turn accounts receivable into cash.

Where to find these key variables: Accounts receivable can be found on the balance sheet, sales or revenue can be found on the income statement.

Days Sales In Receivables = 35 Means: On average, it takes 35 days to turn your accounts receivable into cash, or it takes 35 days to collect the credit sales.

• An increase in days sales in receivables may indicate, (1) an increase in performance of internal collection teams claiming accounts receivable payments, (2) a positive change in credit and collections policy on behalf of the business, (3) the business being able to service accounts payable better.
• A decrease in days sales in receivables is caused by the opposite to the above.

Part 5: Valuation Ratios

(14) Earnings Per Share (EPS)

Earnings per share (EPS) shows the proportion of company profit allocated to each (one share of) common stock. It highlights the level of profitability the company is able to achieve on a per share basis.

Where to find these key variables: Net Income can be found on the income statement, and shares outstanding can be found in the notes section of the balance sheet.

EPS = 58 cents (0.58c) Means: For every common share, there is 58 cents of net profit for each share.

• An increase in earnings per share (EPS) could signal (1) uptrend of growth in the wider economy, (2) skillful management and efficient internal decisions securing superior earnings and profitability, or (3) increasing the amount of leverage which may inflate growth and profit.
• A decrease in earnings per share (EPS) can be caused by the opposite to the above.

(15) Price/Earnings (P/E) Ratio

The price to earnings ‘PE’ ratio is a popular valuation ratio that compares the company’s earnings per share with its current share price. It shows investors the dollar amount they have to pay, to receive exposure to one dollar of that company’s earnings. This ratio can reveal how expensive or cheap exposure to a company’s profit is.

Where to find these key variables: Price per share can be found by finding the latest share price of the company, and earnings per share (EPS) can be found on the income statement.

P/E Ratio = 7.4 Means: The stock price of a business is 7.4 times its EPS, or that it will take 7.4 years of net profits to match its value.

(16) Dividend Yield

The dividend yield compares the company’s dividend per share (DPS) with its current share price. Dividends per share (DPS) is the amount of dividends allocated to one piece of common stock (Similar to EPS). The dividend yield is expressed as a percentage, and it reveals the amount of dividends paid out to shareholders.

Dividend Yield = 5.4% Means: Through the purchase of a company’s common stock, an investor receives a 5.4% annual return in dividends.

• The dividend yield may change due to (1) stock price fluctuations, (2) profit changes, or (3) payout ratio changes while profits and stock price remain constant.
• A company may reduce dividends, this is because (1) the company does not have enough spare cash available to distribute to its shareholders, or (2) management or shareholders believe that reinvesting the cash will generate greater growth and return on equity for the company.

(17) Payout Ratio

The payout ratio reveals the total amount of net income paid out to shareholders in the form of dividends. It shows investors the proportion of company net profit paid out to shareholders as dividend payments, and it reveals the proportion of net profit retained for reinvestment in the company. The ‘retention’ ratio (1 – payout ratio) measures the amount of profit that is retained and reinvested in the business.

Where to find these key variables: Dividends can be found on the cash flow statement, and net income can be found on the income statement.

Payout Ratio = 25% Means: 25% of earnings were paid out to shareholders in the form of dividends. 75% of earnings were retained in the business to achieve greater future growth.

Dividend policy is up to management, so they must weigh the benefits of handing cash back to shareholders against the benefits of retaining the cash to achieve business growth.