Intro to
ratios

Ratios
are essential to making sense out of financial numbers. For example, assume
that a hypothetical XYZ company sells for $100 per share. Is that a high price or a low price? There’s no way to answer without more
information. Investors typically will
compare the share price to the company earnings per share, to get a “P/E
ratio.” If XYZ earned $1 per share,
that’s a P/E of 100, and many investors would consider that pretty expensive. But if XYZ earned $20 per share, that pushes
the P/E down to 5, which would be remarkably cheap. Historically, most large-capitalization
companies have had P/E ratios in the teens.

For analysis of a company’s
financial health, instead of its stock price, financial analysts use other
ratios. These are derived using numbers
made available through each company’s financial statements. The ratios need to
be reviewed over time, in order to determine trends in financial health, and
they should be compared to other companies in the same industry.

**Activity ratios**

*Inventory turnover, the cost of
goods sold divided by average inventory value. *High turnover rate is usually a
good sign, but it may indicate that the inventory is too lean and the firm is
unable to meet demand.

*Receivables
turnover, the net revenue divided by the average accounts receivable. *Again,
a high receivables ratio is healthy, but it might mean that the company’s
credit terms are too tight, so it is missing out on sales.

*Payables
turnover, the total purchases divided by average payables. * A low payables rate suggests that the company
is having trouble paying its bills, or it might just mean it is taking
advantage of generous supplier credit terms.

*Asset
turnover, the net revenue divided by average total assets. *Low asset turnover suggests inefficiency
or the presence of a capital-intensive environment.

**Liquidity ratios**

*Current ratio, current assets
divided by current liabilities. *A
high current ratio suggests that bills can be paid promptly; there is no risk
of a cash squeeze.

*Quick
ratio, cash and short-term marketable securities plus accounts receivable
divided by liabilities. *This ratio excludes inventory being held for sale,
which may be a substantial portion of a company’s assets.

* Cash
ratio, drop the accounts receivable from the quick ratio.*
This is the most conservative liquidity ratio.

**Solvency ratios**

*Debt-to-assets, total liabilities
divided by total assets.* A high number indicates more leverage, which
can increase reward as well as risk.

* Debt
to capital, total debt divided by total debt plus shareholder’s equity. *A high ratio here again shows
leverage, which may restrict growth opportunities.

* Debt
to equity, total debt divided by total shareholder’s equity. *A ratio of 1.0 shows an equal
amount of debt and equity. High debt
levels can make weathering economic storms problematic.

*Interest
coverage ratio, earnings before interest and taxes divided by interest
payments. *This ratio is more important during economic downturns.

**Profitability ratios**

*Gross profit margin, gross income
divided by net revenue.*
This figure varies widely among industries.

*Operating
profit margin, operating income divided by revenue.* Operating expenses include those items that
can’t be attributed to a single product.

*Net
profit margin, the net income divided by the net revenue.* This is where sales are turned into earnings
for the shareholders.

*Return
on equity, the net income divided by the total shareholder’s equity.* This measure takes into account the amount of
debt that the firm is using to finance its operations.

As you can see, when you get into
it, financial analysis is complicated.
If you’d rather not do it alone, turn to our investment professionals
for help.

(October 2012)

© 2012 M.A. Co.
All rights reserved.