<p>In this reading we will learn about how an analyst can use the financial reports to perform detailed financial analysis of a company.</p>



<p>A financial analyst uses many tools to perform detailed financial analysis of a company. The most widely used tools are ratio analysis, common size statement analysis, graphical analysis, and regression analysis. In this reading we will focus on calculating and interpreting financial ratios. We will learn about the important financial ratios, analysing the performance of a company using these ratios, and DuPont analysis.</p>

Study Notes for Financial Analysis Techniques

Financial Analysis Techniques

Financial analysts use many ratios while analyzing a company. Since there are many ratios, it becomes easy to categorize them under broad categories. The following table lists the categories and the key ratios within each category.
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td valign="top" width="112"><strong>Category</strong></td>
<td valign="top" width="142"><strong>Description</strong></td>
<td valign="top" width="172"><strong>Key ratios</strong></td>
</tr>
<tr>
<td valign="top" width="112">Activity ratios</td>
<td valign="top" width="142">Activity ratios measure how effectively a business uses its resources, such as receivables collection, inventory, etc. Also called efficiency ratios</td>
<td valign="top" width="172">
<ul>
 	<li>Inventory Turnover</li>
 	<li>Days of Inventory on Hand (DOH)</li>
 	<li>Receivables Turnover</li>
 	<li>Days of Sales Outstanding (DSO)</li>
 	<li>Payables Turnover</li>
 	<li>Number of Days of Payables</li>
 	<li>Working capital Turnover</li>
 	<li>Fixed Asset Turnover</li>
 	<li>Total Asset turnover</li>
</ul>
&nbsp;</td>
</tr>
<tr>
<td valign="top" width="112">Liquidity ratios</td>
<td valign="top" width="142">Liquidity ratios measure a business’s ability to meet its debt obligation in the short-term</td>
<td valign="top" width="172">
<ul>
 	<li>Current Ratio</li>
 	<li>Quick Ratio</li>
 	<li>Cash Ratio</li>
 	<li>Defensive Interval Ratio</li>
 	<li>Cash Conversion Cycle</li>
</ul>
&nbsp;</td>
</tr>
<tr>
<td valign="top" width="112">Solvency ratios</td>
<td valign="top" width="142">Solvency ratios measure a business’s ability to meet its obligations in the long-term. Also called leverage ratios.</td>
<td valign="top" width="172">Debt Ratios
<ul>
 	<li>Debt/Asset Ratio</li>
 	<li>Debt/Capital Ratio</li>
 	<li>Debt/Equity Ratio</li>
 	<li>Financial Leverage Ratio</li>
</ul>
&nbsp;

Coverage Ratios
<ul>
 	<li>Interest Coverage</li>
 	<li>Fixed Charge Coverage</li>
</ul>
&nbsp;</td>
</tr>
<tr>
<td valign="top" width="112">Profitability ratios</td>
<td valign="top" width="142">Profitability ratios measure how profitable a company is.</td>
<td valign="top" width="172">Return on Sales
<ul>
 	<li>Gross Profit Margin</li>
 	<li>Operating Profit Margin</li>
 	<li>Pretax Margin</li>
 	<li>Net Profit Margin</li>
</ul>
&nbsp;

Return on Investment
<ul>
 	<li>Operating ROA</li>
 	<li>ROA</li>
 	<li>Return on Total Capital</li>
 	<li>ROE</li>
 	<li>Return on Common Equity</li>
</ul>
&nbsp;</td>
</tr>
<tr>
<td valign="top" width="112">Valuation ratios</td>
<td valign="top" width="142">These ratios measure the value of a company.</td>
<td valign="top" width="172">
<ul>
 	<li>Price/Equity Ratio</li>
 	<li>Price/Cash Flow</li>
 	<li>Price/Sales</li>
 	<li>Price/Book Value</li>
 	<li>Earnings Per Share</li>
 	<li>Cash Flow per Share</li>
 	<li>EBITDA per Share</li>
 	<li>Dividends per Share</li>
 	<li>Dividend Payout Ratio</li>
 	<li>Retention Rate</li>
 	<li>Sustainable Growth Rate</li>
</ul>
&nbsp;</td>
</tr>
</tbody>
</table>
An analyst uses a combination of these ratios to analyze various aspects of a business. We will look at all these ratios in the following articles.

&nbsp;

Common Ratios in Financial Analysis

Inventory turnover is an important activity ratio.

Activity ratios measure how effectively a business uses its resources, such as receivables collection, inventory, etc. They are also called efficiency ratios.

Inventory turnover ratio provides a measure of how effectively a business is using its inventory.

These ratios measure how many times the company's inventory has been turned over or sold during a specified period.

For example, an inventory turnover ratio of 10 means that the inventory has been turned over 10 times in the specified period, usually a year. The Days of Inventory at Hand (DOH) specifies how many days worth of inventory the company had in hand. For example, DOH of 36 days means that the company had 36 days of inventory at hand during the period.
<h3 class="hdpline">Formulas</h3>
<div class="formula1">[latex size="3" background="#F0F0F0"]Inventory\ Turnover = \frac{Cost\ of\ Goods\ Sold\ (COGS)}{Average\ Inventory}[/latex]</div>
Cost of Goods Sold value is taken from the Income Statement and Inventory is taken from the Balance Sheet. Since the balance sheet tells the financial condition of a company at the end of the period, we take Average Inventory for the year in our calculation.
<div class="formula1">[latex size="3" background="#F0F0F0"]DOH = \frac{365\ or\ 360}{Inventory\ Turnover}[/latex]</div>
365 is the most commonly used day count convention however some analysts may prefer to use 360 days.
<h3 class="hdpline">Example</h3>
Assume that the cost of goods sold for a company for the previous year was $1,000,000 and the beginning and ending inventory for the year were 120,000 and &nbsp;80,000.
<div class="formula1">[latex size="3" background="#F0F0F0"]Inventory\ Turnover = \frac{1,000,000}{\frac{(120,000+80,000)}{2}} = 10[/latex]</div>
This means that the company turns over its entire inventory 10 times during the year.
<div class="formula1">[latex size="3" background="#F0F0F0"]DOH = \frac{365}{10}=36.5[/latex]</div>
This means that on average the company had 36.5 days of inventory at hand.

Note that if the analyst is particularly interested in how much inventory was at hand at the end of the financial year, then he will use the closing inventory for the above calculation.
<h3 class="hdpline">Analysis</h3>
As you can see the Inventory Turnover and Days of Inventory at hand are inversly related. If inventory turnover is high, the DOH will be low and vice verse.

The ratio is compared with others in the industry to measure the performance.

A high inventory turnover ratio generally means that the company is managing its inventory effectively. It can also mean that the company has shortage of inventory which could actually impact the revenues. To identify which is the correct situation, the analyst will interpret this ratio in combination with revenue growth. If revenue growth is slow, and the inventory turnover is high, it indicates a shortage of inventory.

A low inventory turnover ratio, compared to its peers, could indicate that the company is not able to sell its inventory.

Inventory Turnover and Days of Inventory on Hand (DOH)

Receivables turnover is an important activity ratio, and provides a measure of how effectively a business is managing its receivables.

The receivables turnover ratio measures the number of times the company collected its receivables during a specified period.

For example, a receivables turnover ratio of 10 means that the receivables have been collected 10 times in the specified period, usually a year. A variant of receivables turnover is Days of Sales Outstanding (DSO) or average collection period. A DSO of 30 means that on average the company had 30 days worth of sales outstanding (yet to be collected).

<strong>Formulas</strong>
<div class="formula1">
[latex size="3" background="#F0F0F0"]Receivables\ Turnover = \frac{Revenue}{Average\ Receivables}[/latex]</div>
Revenue is taken from the Income Statement and Receivables are taken from the Balance Sheet. Since the balance sheet tells the financial condition of a company at the end of the period, we take Average receivables for the year in our calculation. For revenue we are generally concerned about the credit sales. So, the analyst may have to exclude cash sales from the total sales figure.
<div class="formula1">
[latex size="3" background="#F0F0F0"]DSO = \frac{365\ or\ 360}{Receivables\ Turnover}[/latex]</div>
365 is the most commonly used day count convention however some analysts may prefer to use 360 days.

<strong>Example</strong>

Assume that the credit sales for a company for the previous year was $100,000 and the beginning and ending receivables for the year were 8,000 and &nbsp;12,000.
<div class="formula1">
[latex size="3" background="#F0F0F0"]Inventory\ Turnover = \frac{100,000}{\frac{(8,000+12,000)}{2}} = 10[/latex]</div>
This means that the company collected its receivables 10 times during the year.
<div class="formula1">
[latex size="3" background="#F0F0F0"]DSO = \frac{365}{10}=36.5[/latex]</div>
This means that on average the company had 36.5 days of sales outstanding at any time.

Note that if the analyst is particularly interested in how much receivables were outstanding at the end of the financial year, then he will use the closing receivables for the above calculation.

<strong>Analysis</strong>

These ratios are an indicator of how fast or slow the company is collecting its receivables.

The ratio is compared with others in the industry to measure the performance.

A high receivables turnover ratio (or a low DSO) generally indicates that the company has good collection. It can also mean that the company has very strict collection policy, which could actually impact the revenues.

A low receivables turnover ratio (or a high DSO), compared to its peers, could indicate that the company is unable to collect its receivables and that it has a poor collection policy/procedure.

Receivables Turnover and Days of Sales Outstanding (DSO)

Payables turnover is an important activity ratio, and provides a measure of how effectively a business is managing its payables.

The payables turnover ratio measures the number of times the company pays off all its creditors in one year.

For example, a payables turnover ratio of 10 means that the payables have been paid 10 times in one year. A variant of payables turnover is number of days of payables. Number of days of payables of 30 means that on average the company takes 30 days to pay its creditors.

<strong>Formulas</strong>
<div class="formula1">
[latex size="3" background="#F0F0F0"]Payables\ Turnover = \frac{Credit Purchases}{Average\ Payables}[/latex]</div>
Purchases are taken from the Income Statement and Payables are taken from the Balance Sheet. Since the balance sheet tells the financial condition of a company at the end of the period, we take Average payables for the year in our calculation. For purchases we are generally concerned about the credit purchases. So, the analyst may have to exclude cash purchases from the total sales figure.
<div class="formula1">
[latex size="3" background="#F0F0F0"] Days\ Payable = \frac{365\ or\ 360}{Payables\ Turnover}[/latex]</div>
365 is the most commonly used day count convention however some analysts may prefer to use 360 days.

<strong>Example</strong>

Assume that the credit purchases for a company for the previous year were $50,000 and the beginning and ending payables for the year were 8,000 and 12,000.
<div class="formula1">
[latex size="3" background="#F0F0F0"]Inventory\ Turnover = \frac{50,000}{\frac{(8,000+12,000)}{2}} = 5[/latex]</div>
This means that the company paid all its creditors 10 times during the year.
<div class="formula1">
[latex size="3" background="#F0F0F0"] Days\ Payable = \frac{365}{5}=73[/latex]</div>
This means that on average the company took 73 days to pay its creditors.

<strong>Analysis</strong>

These ratios are an indicator of how fast or slow the company is pays its creditors.

The ratio is compared with others in the industry to measure the performance.

A low payables turnover ratio (or high days payables) is in favor of the company. However, it could also mean that the company is finding it difficult to make payments.

If a company has a high payables turnover ratio, it indicates that the company has very lenient payment policy, and it is probably not taking advantage of credit facilities. It can also mean that the company is using the discounts offered by the suppliers for early payments.

Payables Turnover and Number of Days of Payables

Working capital turnover ratio reflects how effectively the company is using its working capital. Working capital turnover ratio measures how much revenue a company generates from every dollar of capital invested during a year.

<strong>Formula</strong>
<div class="formula1">
[latex size="2" background="#F0F0F0"] Working\ Capital\ Turnover = \frac{Revenue}{Average\ Working\ Capital}[/latex]</div>
<strong>Example</strong>

Assume that a company has $1.2 million in sales for the year. Its current assets were $700,000, and current liabilities were $500,000. The working capital will be $200,000 ($700,000 - $500,000).

The working capital turnover ratio will be $1,200,000/$200,000 = 6.

<strong>Interpretation</strong>

A working capital turnover ratio of 6 indicates that the company is generating $6 for every $1 of working capital.

<strong>Analysis</strong>

While analyzing a company, this ratio is compared to that of its peers, and/or its own historical records.

A high working capital turnover is considered good as it indicates that the company is generating good sales compared to the funds invested in operations, i.e., the company is very efficient.

For some companies, there may be very low working capital, in which case this ratio will be useless. Such companies will use other ratios such as Fixed Asset Turnover or Total Asset Turnover.

Working Capital Turnover Ratio

Fixed Asset and Total Asset turnover ratios reflect how effectively the company is using its assets, i.e., their ability to generate revenue from the given assets. Fixed asset turnover ratio measures how much revenue a company generates from every dollar of fixed assets. Total asset turnover ratio measures how much revenue a company generates from every dollar of the total assets.

<strong>Formulas</strong>
<div class="formula1">
[latex size="3" background="#F0F0F0"] Fixed\ Asset\ Turnover = \frac{Revenue}{Average\ Net\ Fixed\ Assets}[/latex]

[latex size="3" background="#F0F0F0"] Total\ Asset\ Turnover = \frac{Revenue}{Average\ Total\ Assets}[/latex]

</div>
Total Assets include both fixed assets and current assets.

<strong>Example</strong>

Assume that a company has $1.2 million in sales for the year. Its average current assets were $700,000, and average fixed assets were $1,000,000.

The fixed asset turnover ratio will be $1,200,000/$700,000 = 1.71

The total asset turnover ratio will be $1,200,000/($700,000 + $1,000,000) = 0.71

<strong>Interpretation</strong>

A fixed asset turnover ratio of 1.71 indicates that the company is generating $1.71 for every $1 of fixed assets. Similarly, the company is generating $0.71 for every $1 of total assets.

<strong>Analysis</strong>

A high asset turnover ratio indicates greater efficiency.

A low asset turnover ratio indicates inefficiency, or high capital-intensive nature of the business.

A low fixed asset turnover ratio could also mean that the company’s assets are new (less depreciation).

The fixed asset ratio is generally not very consistent, because even if the revenue is growing consistently, the fixed assets don’t have a smooth pattern.

The total asset turnover ratio should be interpreted in conjunction with the working capital turnover ratio. This is because the presence of current assets in the ratio can lead to misinterpretation of results.

A low total asset turnover can indicate many problems. The firm may have unsold inventory and may be finding it difficult to sell it fast enough. There could be a problem with receivables, as the firm may have a long collection period. The firm may also not be under utilizing its fixed assets. Reading this ratio along with other ratios will provide a more clear picture about the firm.

Fixed Asset and Total Asset Turnover Ratio

<p>In the previous articles we learned about the key activity ratios: <a title="Permalink to Inventory Turnover and Days of Inventory on Hand (DOH)" href="https://financetrain.com/inventory-turnover-and-days-of-inventory-on-hand-doh/">Inventory Turnover and Days of Inventory on Hand (DOH)</a>, <a title="Permalink to Receivables Turnover and Days of Sales Outstanding (DSO)" href="https://financetrain.com/receivables-turnover-and-days-of-sales-outstanding-dso/">Receivables Turnover and Days of Sales Outstanding (DSO)</a>, <a title="Permalink to Payables Turnover and Number of Days of Payables" href="https://financetrain.com/payables-turnover-and-number-of-days-of-payables/">Payables Turnover and Number of Days of Payables</a>, <a title="Permalink to Working Capital Turnover Ratio" href="https://financetrain.com/working-capital-turnover-ratio/">Working Capital Turnover Ratio</a> and <a title="Permalink to Fixed Asset and Total Asset Turnover Ratio" href="https://financetrain.com/fixed-asset-and-total-asset-turnover-ratio/">Fixed Asset and Total Asset Turnover Ratio</a>.</p>



<p>The following video from Bionic Turtle provides a summary of all the activity ratios along with examples.</p>



<figure class="wp-block-embed is-type-video is-provider-youtube wp-block-embed-youtube wp-embed-aspect-16-9 wp-has-aspect-ratio"><div class="wp-block-embed__wrapper">
https://www.youtube.com/watch?v=h3_GnJpIAMk
</div></figure>

Activity Ratios – Video Summary

Liquidity is a measure of how quickly a firm is able to convert its assets into cash. While analyzing the liquidity position of a company, an analyst uses the common liquidity ratios to measure the company’s ability to pay-off its short-term liabilities.

There are four important liquidity ratios:
<ul>
 	<li>Current Ratio</li>
 	<li>Quick Ratio</li>
 	<li>Cash Ratio</li>
 	<li>Defensive Interval Ratio</li>
</ul>
All these ratios compare the company’s short-term assets with its short-term liabilities, however, make use of short-term assets with varying levels of liquidity.

We will take a simple example to understand these ratios. Let’s say that we have the following data for a company.
<table border="1" cellspacing="0" cellpadding="0">
<tbody>
<tr>
<td colspan="2" valign="top" width="213"><strong>Current Assets</strong></td>
<td colspan="2" valign="top" width="213"><strong>Current Liabilities</strong></td>
</tr>
<tr>
<td valign="top" width="106">Cash</td>
<td valign="top" width="106">$20,000</td>
<td rowspan="4" valign="top" width="106">&nbsp;

Total Current Liabilities</td>
<td rowspan="4" valign="top" width="106">&nbsp;

$110,000</td>
</tr>
<tr>
<td valign="top" width="106">Short-term Marketable Securities</td>
<td valign="top" width="106">$20,000</td>
</tr>
<tr>
<td valign="top" width="106">Receivables</td>
<td valign="top" width="106">$60,000</td>
</tr>
<tr>
<td valign="top" width="106">Inventory</td>
<td valign="top" width="106">$40,000</td>
</tr>
<tr>
<td valign="top" width="106">Total Current Assets</td>
<td valign="top" width="106">$140,000</td>
<td valign="top" width="106">&nbsp;</td>
<td valign="top" width="106">$110,000</td>
</tr>
</tbody>
</table>
Let’s calculate the liquidity ratios using this data.

<strong>Current Ratio</strong>
<div class="formula1">
[latex size="3" background="#F0F0F0"] Current\ Ratio = \frac{Current\ Assets}{Current\ Liabilities}[/latex]</div>
The current assets include all the current assets that we expect to convert to cash in one year.

Current ratio = $140,000/$110,000 = 1.273

A high current ratio indicates that the company has good liquidity to meet its short-term obligations. If this ratio is low, this means that the company has low liquidity and is relying on its operating cash flow and loans to meet its obligations.

One problem with this ratio is that it assumes that the inventory and account receivables are liquid.

<strong>Quick Ratio</strong>

Quick ratio is the same as current ratio except that it excludes inventory from the current assets. It assumes that inventory cannot be easily converted into cash and hence is excluded from the liquid assets.
<div class="formula1">
[latex size="3" background="#F0F0F0"] Quick\ Ratio = \frac{Quick\ Assets}{Current\ Liabilities}[/latex]</div>
The quick assets include only cash and cash equivalents, short-term investments, and account receivables. It excludes inventory, and other current assets, which are not liquid such as prepaid expenses, deferred income tax, etc.

Quick ratio = $100,000/$110,000 = 0.91

This ratio is considered a superior measure to the current ratio. A high quick ratio indicates that the company has good liquidity to meet its short-term obligations.

<strong>Cash Ratio</strong>

This ratio takes an even more conservative measure to liquidity, and includes only cash, cash equivalents and short-term investments as liquid assets.
<div class="formula1">
[latex size="3" background="#F0F0F0"] Cash\ Ratio = \frac{Cash\ and\ Cash\ Equivalents}{Current\ Liabilities}[/latex]</div>
The assets include only cash and cash equivalents, and short-term investments. It excludes inventory, account receivables and any other current assets.

Cash ratio = $40,000/$110,000 = 0.36

This ratio is not commonly used, but is useful in a crisis situation. Even in a crisis situation this ratio may not be reliable because the value of marketable securities can change drastically.

<strong>Defense Interval Ratio</strong>

This ratio measures for how many days can a company pay its daily expenses only from the existing liquid assets assuming that the company does not receive any new cash flow. This ratio considers only quick assets for the purpose of existing liquid assets.
<div class="formula1">
[latex size="3" background="#F0F0F0"] Defence\ Interval\ Ratio = \frac{Quick\ Assets}{Daily\ Cash\ Expense}[/latex]</div>
Assuming that in our example the company has daily cash expenses of $2,000, the ratio will be calculated as follows:

Defense interval ratio = $100,000/$2,000 = 50 days.

This indicates that the company can continue to meet its daily cash expenses for 50 days from the existing liquid assets. A high ratio indicates that the company is quite liquid. A low ratio is a cause of concern and the analyst need to look into whether the company is expecting stronger cash inflows.

Liquidity Ratios (Current Ratio, Quick Ratio, and Others)

Cash Conversion Cycle is an important concept in liquidity analysis. The cash conversion cycle indicates the time (no. of days) it takes for the cash invested in the business to be converted back to cash. In other words it is the total time taken to sell its inventory, collect the receivables, and pay the creditors.

The Cash Conversion Cycle (also called the Net Operating Cycle) is measured as follows:
<div class="formula1">
CCC = DOH + DSO – DPO</div>
The <a href="https://financetrain.com/inventory-turnover-and-days-of-inventory-on-hand-doh/" title="Inventory Turnover and Days of Inventory on Hand (DOH)">Days of Inventory at Hand (DOH)</a> specifies how many days worth of inventory the company had in hand. For example, DOH of 15 days means that the company had 36 days of inventory at hand during the period.

DSO stands for <a href="https://financetrain.com/receivables-turnover-and-days-of-sales-outstanding-dso/" title="Receivables Turnover and Days of Sales Outstanding (DSO)">Days of Sales Outstanding</a>. A DSO of 30 means that on average the company had 30 days worth of sales outstanding (yet to be collected).

DPO stands for <a href="https://financetrain.com/payables-turnover-and-number-of-days-of-payables/" title="Payables Turnover and Number of Days of Payables">Days of Payable Outstanding</a>. Number of days of payable of 25 means that on average the company takes 25 days to pay its creditors.

Using the above figures, the CCC will be:
<div class="formula1">
CCC = 15 + 30 – 25 = 20</div>
20 days is the time between the cash outlay and the cash received.

If CCC is negative, it indicates that the company has excess cash to invest. A CC of -10 indicates that the company has excess cash to invest for 10 days.

<strong>Graphical Representation</strong>
<div><strong><img class="aligncenter size-full wp-image-5027" title="Cash Conversion Cycle" src="https://financetrain.com/wp-content/uploads/CCC.png" alt="Cash Conversion Cycle"></strong></div>
<strong>Analysis</strong>

The cash conversion cycle tells more about the <a href="https://financetrain.com/liquidity-ratios-current-ratio-quick-ratio-and-others/" title="Liquidity Ratios (Current Ratio, Quick Ratio, and Others)">liquidity position of a company</a> than the current or quick ratio.

A low CCC indicates that the company has high liquidity, and that the company will have to fund its inventory and receivables for a shorter period. While looking at the trend of CCC over a period of time, a decreasing trend is positive, as it indicates that the cash conversion cycle is shortening, i.e., it is able to convert its inputs to cash faster. A short cash conversion cycle reduces the firm’s cost.

A firm with the least amount of inventory possible, the least amount of accounts receivable and the greatest amount of accounts payable will have the shortest CCC. However, there are costs associated with each element and the firm needs to take a balanced approach so as not to hurt the business. For example, with a strict credit policy, a company can reduce its account receivables, but may end up hurting its sales. On the other hand, a liberal credit policy may help improve sales, but will result in higher level of account receivables and even bad debt.

Cash Conversion Cycle (CCC)

<p>Solvency ratios measure a business’s ability to meet its obligations in the long-term based on its overall debt level and earnings capacity. These ratios are important because failure to meet its interest obligation could put a firm into bankruptcy. They are also called leverage ratios. Solvency ratios include debt ratios and coverage ratios.</p>



<h3>Debt Asset Ratio</h3>



<p>This ratio measures what percentage of assets is financed with debt. An increase in this ratio indicates that the company is relying more on debt as a source of financing its assets. A decrease in this ratio indicates less reliance on financing.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/sr-1.png" alt="" class="wp-image-28820" width="524" height="79"/></figure></div>



<h3>Debt Equity Ratio</h3>



<p>This ratio shows the extent the company is leveraged. If the company has too much debt, any dip in business may result in the owner losing its equity or put the company in a position wherein it cannot service its debt. Alternatively, if the debt quotient is small, it probably means the company is not putting enough capital to work.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/sr-2.png" alt="" class="wp-image-28821" width="478" height="80"/></figure></div>



<p>Factors that affect this ratio are:</p>



<ul><li>Additional working capital can be put to use to increase profits.</li><li>Component of debt if it is short term or long term. This will determine the payback period.</li><li>Interest rate of the debt. Short term creditor debt is low compared to long term debt.</li><li>Level of profitability in the industry. A low margin industry cannot afford high cost debt, unlike a high profit margin industry.</li></ul>



<h3>Debt-to-Capital Ratio</h3>



<p>Debt-to-capital ratio is the ratio of total debt to total capital.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/sr-3-1024x122.png" alt="" class="wp-image-28822" width="653" height="78"/></figure></div>



<p>A high debt-to-capital ratio indicates that a high proportion of a company's capital is comprised of debt which makes it riskier for the shareholders.</p>



<h3>Financial Leverage</h3>



<p>Also called leverage ratio, this ratio measures the financial leverage of a company.</p>



<div class="wp-block-image"><figure class="aligncenter size-large is-resized"><img src="https://financetrain.com/wp-content/uploads/sr-4.png" alt="" class="wp-image-28823" width="427" height="68"/></figure></div>



<p>A higher financial leverage indicates more usage of debt, and higher risk for shareholders as well as bondholders. While analyzing this ratio, it is important to understand what kind of business the firm is in. A fairly steady company can probably take on large amounts of debt without too much risk. On the other hand for a company in a cyclical business an investor should be vary of a high leverage ratio. A financial leverage ratio of 2.1 is fairly conservative, even for a fast growing retailer. It’s when we see ratios of 4, 5 or more that companies start to get really risky.</p>



<p>However, financial firms and banks have a much larger asset base relative to equity. The average bank has a financial leverage ratio in the range of 12 to 1 or so, as compared to 2-to-1 or 3-to-1 for the average company.</p>



<h3>Interest Coverage Ratio</h3>



<p>Interest coverage ratio, also called ‘Times Interest Earned’, determines a firm’s ability to repay its debt obligations.</p>



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<p>The ratio indicates how many times the company could have paid the interest expense on its debt. The higher the ratio, the less likely that the company will run into difficulty if earnings fall unexpectedly. Companies in more volatile businesses will have a higher interest coverage ratio than stable companies. An analyst should look for the trend in the interest coverage ratio for a period of time. A falling interest coverage ratio over time indicates that the company is becoming riskier.</p>



<h3>Fixed Charge Coverage Ratio</h3>



<p>This ratio indicates the company’s ability to meet its fixed financing expenses such as interest and lease payments.</p>



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<p>This is a more useful measure for companies that lease a large part of their assets such as airline companies. The higher the ratio, the easier it is for the company to meet these obligations.</p>

Solvency Ratios

<p>Profitability ratios measure how profitable a company is.&nbsp;</p>



<h3><strong>Gross Profit Margin</strong></h3>



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<p>Gross profit margin measures gross profit as a percentage of gross revenue. This helps capture profit as a percentage of revenue, and helps assess components that affect profitability.</p>



<h3><strong>Net Profit Margin</strong></h3>



<p>When net profit or the bottom line, profit after subtracting all costs is shown as a percentage of gross sales we call it net profit margin.</p>



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<p>This margin varies from industry to industry. For example a 5-6% profit in the&nbsp;steel manufacturing industry is considered very good, but poor for the pharmaceutical industry. It also needs to be compared with the firm’s historical performance.</p>



<h3><strong>Cost per Sales Dollar</strong></h3>



<p>This helps estimate sales and marketing as a percentage of Gross Sales. This helps in cost control.</p>



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<p>We will now look at the profitability ratios that look at profits relative to the funds invested in the business (Return on Investment).</p>



<h3>Return on Assets</h3>



<p>This measure calculates the returns as a percentage of total assets. It uses net income as the numerator. This ratio tells us how much returns the company generated from the invested capital.</p>



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<p>One problem with this measure is that the denominator (total assets) contains both debt and equity. However, the numerator (net income) excludes interest. For this reason, sometimes the denominator is adjusted by adding back the interest expense net of taxes.</p>



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<h3>Operating Return on Assets (ROA)</h3>



<p>Operating ROA is calculated just like Return on Assets but uses Earnings Before Interest and Taxes (EBIT) instead on Net Income. </p>



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<p>Operating return on assets indicates the company's operating income generated per dollar invested in total assets. A higher operating RoA is preferred and while analysing this ratio, the analyst must analyse the historical performance and also compare it with the peers in the industry.&nbsp;</p>



<h3>Return on Total Capital</h3>



<p>This ratio is calculated by dividing the EBIT by the total capital that includes long-term debt, short-term debt, preferred equity and common equity. </p>



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<p>This is an important profitability measure. By including debt in the total capital, the analyst is able to assess how well the management of the company is utilizing the funds available to them. A higher ROTC is preferred and should be atleast above the firm’s average borrowing rate.&nbsp;&nbsp;&nbsp;</p>



<h3>Return on Equity (ROE)</h3>



<p>This ratio is calculated by dividing the Net Income by the Average Total Equity. The ratio tells us how much returns shareholder’s earned on their investment.</p>



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<p>This is one of the most widely used ratios by investors. However, since this ratio does not include debt, looking at just this ratio may be misleading. A company with very high debt will have a small equity base and even a small amount of net income will produce high ROE. Therefore, this ratio must be analysed together with other profitability measures.</p>



<p>This ratio is also sometimes called Return on Total Equity.</p>



<h3>Return on Common Equity</h3>



<p>This is a variation of ROE, and calculates the returns earned only by the common shareholders. We consider only the profits available to common shareholders and equity invested by common shareholders instead of all shareholders.</p>



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Profitability Ratios

<p>DuPont analysis is an approach used to analyse return on equity (ROE). Under this approach, we break down ROE into operating and financing components.</p>



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<p>The following table shows the DuPont Analysis of two fictitious companies.</p>



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<p>By breaking down the ROE, we can analyse the components that have contributed to the returns on equity. The first component net profit margin tells how much profits the company made from its revenue. The second component asset turnover tells us how effectively the company utilized its assets and the third component equity multiplier tells us about how leveraged the company is.</p>



<p>In the above example, for Alpha Corp. the RoE dropped significantly from 2012 to 2013. The dip is contributed primarily to a decrease in net profit margin. The financial leverage has remained the same while asset turnover has increased slightly.&nbsp;</p>



<p>An analyst should carefully analyse the source of increase in ROE. An increase in ROE due to net profit margin is a good sign, however, increase in ROE due to increase in leverage, especially for an already leveraged company, is a warning signal.&nbsp;</p>



<p>We can further extend the DuPont equation by breaking up net profit margin into EBIT margin, tax burden and interest burden. This is called the 5-factor DuPont analysis.</p>



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DuPont Analysis

<p>Valuation ratios associate stock price to a performance metric.</p>



<p>Some of the commonly used valuation ratios are cash flow per share, EBITDA per share, dividend per share, price to earnings ratio, price to cash flow ratio, price to sales ratio, and price to book value.</p>



<p>When looking at financial ratios, analysts should: apply their prior experience in evaluating firms and industries; consider the company’s publicly stated objectives; and determine industry norms, as the nuances of economic differences across industries can be reflected in their ratios.&nbsp;</p>



<h3>Earnings Per Share (EPS)</h3>



<p>Earnings per share (EPS) is considered to be one of the best measures to summarize the performance of a company. The EPS for a company is reported only for common stock.&nbsp;</p>



<p>A company can have simple capital structure or complex capital structure.</p>



<ul><li>A company with a&nbsp;<strong>simple capital structure</strong>&nbsp;can only have common stock, nonconvertible debt and non-convertible preferred stock. It cannot have any potentially dilutive securities (i.e., stock options, warrants, convertible&nbsp;&nbsp;bonds, and convertible preferred stock). For companies with simple capital structure, we calculate the&nbsp;<strong>Basic EPS</strong>.</li><li>A company with a&nbsp;<strong>complex capital structure</strong>&nbsp;also includes convertible securities, stock options and warrants. For these companies, we calculate both&nbsp;<strong>Basic EPS</strong>&nbsp;and&nbsp;<strong>Diluted EPS</strong>. The diluted ESP considers the impact of potentially dilutive securities.</li></ul>



<p><strong>Basic EPS</strong></p>



<p>The basic EPS is calculated as follows:</p>



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<p><strong>Diluted EPS</strong></p>



<p>Companies with complex capital structures are required to present both basic and diluted earnings per share.</p>



<p>In computing diluted EPS, the potential impact (i.e., the assumed conversion) of potentially dilutive securities is considered in addition to the weighted average shares.</p>



<p><em>The calculation of Basic EPS and Diluted EPS is explained in detail under <a href="https://financetrain.com/courses/understanding-income-statements/"><strong>Reading: Understanding Income Statement</strong>.</a></em></p>



<h3>Price to Earnings Ratio</h3>



<p>The Price to Earnings ratio&nbsp;refers to the price of the stock to profit (or net income). It is also known as multiple. Typically a stocks market capitalization to its total annual earnings will give its PE ratio.</p>



<p class="has-background" style="background-color:#fffac1"><strong>PE ratio = Price per share/ Earning per share</strong></p>



<p>Say the price of the share is $32 and its earning per share is $8, then its PE ratio would be 4. This is assuming inflation stays constant as does the time value of money. It would take 4 years for the share to pay back its purchase price. The PE ratio is used to value stocks in the same sector. Companies with stronger earnings generally attract better valuation as compared to riskier lower expected earning stocks.</p>



<h3>Price to Book Value Ratio</h3>



<p>Price to Book ratio&nbsp;measures the price of the share to the book value of the share.</p>



<p class="has-background" style="background-color:#fffac1"><strong>PB ratio= Stock Price/(Total Assets – Intangible Assets and Liabilities)</strong></p>



<p>This ratio helps assess if investors are paying too much for the stock, should the company go bankrupt tomorrow. This ratio does not value brand value or other intellectual property, on which companies are valued. In that sense this ratio has limited scope.</p>



<h3>Price to Earning Growth Ratio</h3>



<p>Price to Earning Growth ratio<strong>&nbsp;</strong>is arrived at by dividing the PE ratio by the growth on earnings per share. This ratio is preferred by investors as it factors in growth in earnings. This ratio can be used in say comparing stocks of supposedly high expected growth companies (e.g. technology) with perhaps a more traditional company (e.g. Book publishing). This will help us understand if a particular stock is overvalued.</p>



<p>Assume that the technology company has a high PE ratio of 50 and an annual expected growth of 25%. The book publishing company has a PE ratio of 20, and expected growth of 5%.</p>



<p>The PEG ratio for the technology company is 2, while that of the book publishing company stands at 4. Despite better expected rate of growth, the book publishing company seems a better bet and the technology firm overvalued.</p>



<h3>Dividend Yield</h3>



<p>Dividend Yield&nbsp;is the inverse of the PE ratio. This ratio helps understand how much cash you will get for the money you have invested in the stock. A company that has a steady and high dividend is preferred by investors. A high dividend yield could mean the company has reached its peak as far as payouts are considered or that it is undervalued. Low dividend yields mean one can expect better payouts in the future or that the stock is overvalued.</p>



<p>These ratios used together can help a beginner seek his way better through all the stocks in the market that vie for their attention.</p>



<h3>Price to Sales (P/S) Ratio</h3>



<p>Price to Sales ratio is calculated by dividing Market price per share by Sales per share.</p>



<p class="has-background" style="background-color:#fffac1"><strong> P/S = Market Price per Share / Sales per Share</strong></p>



<p>Price to Sales is a useful measure because sales can be more difficult for management to manipulate than earnings or book value. While earnings can be negative, sales are never negative. Sales can be more consistent than earnings. P/S can be useful for analyzing companies with no earnings, are cyclical, or have reached maturity. Stock return trends can be analyzed within the context of differences in P/S values.&nbsp;</p>



<p>P/S ratio also has some drawbacks. Unprofitable companies can still show sales growth. P/S ratio does not reflect cost structure. Different companies may have different revenue recognition policies.&nbsp;</p>



<h3>Price to Cash Flow Ratio</h3>



<p>Analysts may choose to value stocks based on price to cash flow ratios.</p>



<p>The cash flow applied could be: Net Income plus Non-cash Charges (which is not correct); Cash Flow from Operations; Adjusted CFO; or Free Cash Flow to Equity.</p>



<p>Cash flows are more objective than earnings. When earnings are volatile, cash flow ratios will be more stable than the P/E ratio. Stock return trends can be analyzed within the context of differences in price to cash flow values.</p>



<p>A drawback is that if Free Cash Flow to Equity is negative, then the P/FCFE metric cannot be used to value a stock. FCFE can be volatile. Cash flow approximation metrics can be misapplied by the analyst.&nbsp;</p>

Valuation Ratios

<h3>Financial Ratio Uses</h3>



<ul><li>Valuing a company’s stock.</li><li>Determining a company’s systemic risk (beta risk) exposure.</li><li>Creating a company’s credit rating.</li><li>Predict a company’s likelihood of financial distress (i.e. bankruptcy).</li><li>Preparing pro forma financial statements that provide estimates of financial statements for future periods.</li></ul>



<h3>Financial Ratio Analysis Limitations</h3>



<p>While financial ratios can provide valuable insights to analysts, they cannot be considered all knowing.&nbsp; Ratio analysis can be limited by:</p>



<ul><li>Application of different accounting methods by firms which are being compared.</li><li>Multiple firm operations; when a company has multiple business units, it can be difficult to determine the appropriate industry norms for ratio analysis.</li><li>Need to consider all ratio categories when analyzing a company, as one category of ratios may not tell the complete story.</li><li>Analyst judgment; ultimately the analyst must decide what an appropriate ratio range is for a given firm or industry.</li></ul>

Financial Ratios: Uses and Limitations

This quiz is a part of the CFA Level 1 reading 'Financial Analysis Techniques'. 

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