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Ratio note FINANCIAL REPORTING F7
Association of Chartered Certified Accountants - ACCA (PAC150)
INTEC Education College
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The Corporate Finance Institute The Analyst Trifecta
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Financial Ratios eBook
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Table of Contents
- Financial Ratio Analysis Overview
- What is Ratio Analysis?
- Why use Ratio Analysis?
- Types of Ratios?
- Profitability Ratio
- Return on Equity
- Return on Assets
- Return on Capital Employed.............................................................................................................................................................................................
- Gross Margin Ratio
- Operating Profit Margin
- Net Profit Margin
- Leverage Ratios
- Debt-to-Equity Ratio
- Equity Ratio
- Debt Ratio
- Efficiency Ratios
- Accounts Receivable Turnover Ratio
- Accounts Receivable Days..............................................................................................................................................................................................
- Asset Turnover Ratio
- Inventory Turnover Ratio................................................................................................................................................................................................
- Inventory Turnover Days
- Liquidity Ratios
- Current Ratio
- Quick Ratio.........................................................................................................................................................................................................................
- Cash Ratio
- Defensive Interval Ratio
- Times Interest Earned Ratio
- Times Interest Earned (Cash-Basis) Ratio
- CAPEX to Operating Cash Ratio
- Operating Cash Flow Ratio.............................................................................................................................................................................................
- Pyramid of Ratios........................................................................................................................
- Multiples Valuation Ratios
- Price-to-Earnings (P/E) Ratio
- EV/EBITDA Ratio
- EV/EBIT Ratio
- EV/Revenue Ratio
- Valuation Ratios Comparison
Profitability Ratio
Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders’ equity during a specific period of time. They show how well a company utilizes its assets to produce profit and value to shareholders.
A. Return Ratios Return ratios represent the company’s ability to generate returns for its shareholders. It typically compares a return metric versus certain balance sheet items.
Return on Equity Return on Assets Return on Capital Employed
B. Margin Ratios Margin ratios represent the company’s ability to convert sales into profits at various degrees of measurement. Margin ratios typically look at certain returns when compared to the top line (revenue). Typically, it compares income statement items.
Gross Margin Ratio Operating Profit Margin Net Profit Margin
4
Return on Equity
Overview
Return on equity is a measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage (e. 10%). Alternatively, ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate (1-dividend payout ratio). There are several ROE drivers, and we will further breakdown the ratio.
Formula
Interpretation
ROE provides a simple metric for evaluating returns. By comparing a company’s ROE to the industry’s average, it is possible to pinpoint a company’s competitive advantage (or lack of competitive advantage). As it uses net income as the numerator, return on equity (ROE) looks at the firm’s bottom line to gauge overall profitability for the firm’s owners and investors.
As an investor, this is an essential ratio to look at as it ultimately determines how attractive an investment is. Return on equity is a product of asset efficiency, profitability, and financial leverage.
Return on Assets
Overview
Return on Capital Employed (ROCE) is a profitability ratio that measures how efficiently a company is using its capital to generate profits. The return on capital employed is considered one of the best profitability ratios and is commonly used by investors to determine whether a company is suitable to invest in.
Formula
Interpretation
The return on capital employed shows how much operating income is generated for each dollar invested in capital. A higher ROCE is always more favorable as it implies that more profits are generated per dollar of capital employed.
As with any other financial ratios, calculating just the ROCE of a company is not enough. Other profitability ratios such as return on assets, return on invested capital, and return on equity should be used in conjunction with ROCE to determine whether a company is truly profitable or not.
Gross Margin Ratio
Overview
The gross margin ratio, also known as the gross profit margin ratio, is a profitability ratio that compares the gross margin of a company to its revenue. It shows how much profit a company makes after paying off its cost of goods sold (COGS). The ratio indicates the percentage of each dollar of revenue that the company retains as gross profit, so naturally a high gross margin ratio is desired.
Formula
Interpretation
A low gross margin ratio does not necessarily indicate a poorly performing company. It is important to compare gross margin ratios between companies in the same industry rather than comparing them across industries.
For example, a legal service company reports a high gross margin ratio because it operates in a service industry with low production costs. In contrast, the ratio will be lower for a car manufacturing company because of high production costs.
Operating Profit Margin
Overview
Net profit margin (also known as “profit margin” or “net profit margin ratio”) is a financial ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained.
The net profit margin is equal to net profit (also known as net income) divided by total revenue, expressed as a percentage.
Formula
Interpretation
Net profit is calculated by deducting all company expenses from its total revenue. The result of the profit margin calculation is a percentage – for example, a 10% profit margin means for each $1 of revenue the company earns $0 in net profit. Revenue represents the total sales of the company in a period.
The typical profit margin ratio of each company can be different depending on which industry the company is in.
Leverage Ratios
A leverage ratio is any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. These ratios provide an indication of how the company’s assets and business operations are financed (using debt or equity).
A. Leverage Ratios Leverage ratios represent the extent to which a business is utilizing borrowed money. It also evaluates company solvency and capital structure. Having high leverage in a firm’s capital structure can be risky, but it also provides benefits.
Debt-to-Equity Ratio Equity Ratio Debt Ratio
11
Debt-to-Equity Ratio
Overview
The equity ratio is a leverage ratio that calculates the proportion of total shareholders’ equity versus total assets. The ratio determines the residual claim of shareholders on a business. It determines what portion of the business could be claimed by shareholder in a liquidation event.
Formula
Interpretation
The accounting equation can be rearranged to Equity = Assets – Liabilities. By using this as the numerator of the equity ratio, the ratio can be written as (Assets-Liabilities)/Assets. In other words, it would be the percentage of total assets after all liabilities have been subtracted.
For example, if Company XYZ has a total of $15 million in total shareholder’s equity, and total assets are equal to $50 million, then the equity ratio of this company would be equal to 0. It typically is expressed as a percentage. Therefore, it would be 30% in the above example.
Equity Ratio
Overview
The debt ratio, also known as the debt-to-asset ratio, is a leverage ratio that indicates the percentage of assets that are being financed with debt. The higher the ratio, the greater the degree of leverage and financial risk.
The debt ratio is commonly used by creditors to determine the amount of debt in a company, the ability to repay its debt, and whether additional loans will be extended to the company. On the other hand, investors use the ratio to make sure the company is solvent, have the ability to meet current and future obligations, and can generate a return on their investment.
Formula
Interpretation
The debt ratio is commonly used by analysts, investors, and creditors to determine the overall risk of a company. Companies with a higher ratio are more leveraged and hence, riskier to invest in and provide loans to. If the ratio steadily increases, it could indicate a default at some point in the future. - A ratio equal to one (=1) means that the company owns the same amount of liabilities as its assets. It indicates that the company is highly leveraged.
- A ratio greater than one (>1) means the company owns more liabilities than it does assets. It indicates that the company is extremely leveraged and highly risky to invest in or lend to.
Accounts Receivable Turnover Ratio
Overview
The accounts receivable turnover ratio, sometimes known as the debtor’s turnover ratio, measures the number of times over a specific period that a company collects its average accounts receivable.
The accounts receivable turnover ratio can also be manipulated to obtain the average number of days it takes to collect credit sales from customers, known as accounts receivable days.
Formula
Interpretation
To calculate this ratio, the following formulas are also necessary:
Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances Average Accounts Receivable = (Accounts Receivableending + Accounts Receivablebeginning)/
For example, at the end of a fiscal year, a company has credit sales of $50,000 and returns of $3,200. At December 31st, the company had accounts receivable of $6,000. At January 1st, accounts receivable was $3,000. Therefore, its accounts receivable turnover ratio for this fiscal period ( days) would be = (50,000 – 3,200) / ((6,000 + 3,000) / 2) = 10.
Analyzing this, the company collects its accounts receivables about 10 times a year. This number should be compared to industry averages to see how efficient the company is in collecting payments versus its competitors.
Accounts Receivable Days..............................................................................................................................................................................................
Overview
Accounts receivable days are the number of days on average that it takes a company to collect on credit sales from its customers. This formula is derived by using the previously mentioned accounts receivable turnover ratio.
Formula
Interpretation
To calculate this ratio, it is necessary to use the accounts receivable turnover ratio:
Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable
Using the same example, at the end of a fiscal year, a company has credit sales of $50,000 and returns of $3,200. At December 31st, the company had accounts receivable of $6,000. At January 1 st, accounts receivable was $3,000. Therefore, its accounts receivable turnover ratio for this fiscal period (365 days) would be = (50,000 – 3,200) / ((6,000 + 3,000) / 2) = 10. We can use these numbers to calculate the accounts receivable days, which would be = 365 / 10 = 35.
Analyzing this, it takes the company 35 days on average to collect its accounts receivables. As with the accounts receivable turnover ratio, this number should be compared to industry averages to see how efficient the company is in collecting payments versus its competitors.
Asset Turnover Ratio
Overview
The inventory turnover ratio measures how many times a business sells and replaces its stock of goods in a given period of time. This ratio looks at cost of goods sold relative to average inventory in the period.
This ratio indicates how efficient a business is at clearing its inventories.
Formula
Interpretation
To calculate this ratio, average inventory is calculated as:
Average Inventory = (Inventoryending + Inventorybeginning)/
For example, a company has cost of goods sold of $3 million for the fiscal year. On December 31st, the company’s inventory was $350,000. On January 1st, inventory was $260,000. Therefore, the company’s inventory turnover ratio would be = 3,000,000 / ((35,000 + 26,000) / 2) = 9. This number means that the company sold its entire stock of inventory 9 times in the fiscal year.
Additionally, like the accounts receivable turnover ratio, the inventory turnover ratio can be manipulated to give inventory turnover days – the average number of days it takes to sell an entire stock of goods.
Inventory Turnover Ratio................................................................................................................................................................................................
Overview
Inventory Turnover Days are the number of days on average it takes to sell a stock of inventory. This formula is derived using the previously mentioned inventory turnover ratio. Like the inventory turnover ratio, inventory turnover days is a measure of a business’ efficiency.
Formula
Interpretation
To calculate this ratio, the inventory turnover ratio is necessary:
Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory
Using the same example, a company has cost of goods sold of $3 million for the fiscal year. On December 31st, the company’s inventory was $350,000. On January 1st, inventory was $260,000. Therefore, the company’s inventory turnover ratio would be = 3,000,000 / ((35,000 + 26,000) / 2) = 9. This number means that the company sold its entire stock of inventory 9 times in the fiscal year. We can use these numbers to calculate the inventory turnover days, which would be = 365 / 9 = 37.
Analyzing this, it takes the company 37 days on average to sell an entire stock of inventory. As with the inventory turnover ratio, this number should be compared to industry averages to see how efficient the company is in converting inventory into sales versus its competitors.
Ratio note FINANCIAL REPORTING F7
Course: Association of Chartered Certified Accountants - ACCA (PAC150)
University: INTEC Education College
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