Financial analysts commonly use financial ratios to evaluate the investment worthiness of a company’s equity or debt. Ratio analysis is commonly done in comparison to other companies of similar industry.
When analyzing financial ratios, the analyst should consider the values in the context of the business cycle, trends, and industry or competitor standards.
5 Ratio Categories
Activity ratios measure the efficiency in which management runs the company.
Measure the company’s capacity to meet its short-term financial commitments.
Liquidity Ratio Examples: quick ratio (also called acid test ratio), cash ratio, defensive interval ratio, and cash conversion cycle.
Solvency ratios measure the company’s capacity to fulfill long-term financial commitments.
Solvency Ratio Examples: Debt to assets ratio (also called total debt ratio), debt to capital ratio, debt to equity ratio, financial leverage ratio, interest coverage ratio (also called times interest earned ratio), and fixed financial charge ratio.
Measure the company’s management effectiveness in driving earnings from sales and/or assets.
Profitability Ratio Examples: gross margin, operating margin, pre-tax margin, net profit margin, operating return on assets, return on assets, return on total capital, return on equity.
ROE note: CFAI emphasizes that candidates understand the DuPont model for ROE, which provides insights into the different levers driving a firm’s profitability.
- DuPont Traditional ROE = (Net Inc. / Net Revenue) * (Net Revenue / Avg. Total Assets) * (Avg. Total Assets / Avg. Shareholders Equity)
- DuPont Extended ROE = (Net Inc. / Earnings Before Tax) * (EBT / EBIT) * (EBIT / Net Revenue) * (Net Revenue / Avg. Total Assets) * (Avg. Total Assets / Avg. Shareholders Equity)
- DuPont Extended ROE = tax burden * interest burden * EBIT margin * Asset Turnover * Financial Leverage.
Valuation ratios associate stock price to a performance metric.
Valuation Ratio Examples: cash flow per share, EBITDA per share, dividend per share, price to earnings ratio, price to cash flow ratio, price to sales ratio, price to book value.
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.
Financial Ratio Uses
- Valuing a company’s stock.
- Determining a company’s systemic risk (beta risk) exposure.
- Creating a company’s credit rating.
- Predict a company’s likelihood of financial distress (i.e. bankruptcy).
Financial Ratio Analysis Limitations
While financial ratios can provide valuable insights to analysts, they cannot be considered all knowing. Ratio analysis can be limited by:
- Application of different accounting methods by firms which are being compared.
- Multiple firm operations; when a company has multiple business units, it can be difficult to determine the appropriate industry norms for ratio analysis.
- Need to consider all ratio categories when analyzing a company, as one category of ratios may not tell the complete story.
- Analyst judgment; ultimately the analyst must decide what an appropriate ratio range is for a given firm or industry.