Before you read any further, I must tell you, the financial ratios in the article are mostly for non-financial companies. In the beginning, I will review a little about what financial ratios are and why they are useful in analyzing financial statements.
In the next section, you will find various financial ratios. I divided it into several subheadings: activity, liquidity, solvency, profitability, cash flow, valuation, and credit ratios. In the last section, I will review how we should use these financial ratios.
What are financial ratios?
Financial ratio is a comparison between two or more accounts in the financial statements. It is useful in measuring various aspects of a company’s finances, including operating efficiency, profitability, liquidity, and solvency. Calculating it is relatively easy because you are only comparing certain accounts in the financial statements with other accounts; however, it must be meaningful to explain the financial performance and condition of the company.
Guide to Understanding and Analyzing Financial Statements
How to analyze financial statements?
Financial statement analysis basically transforms accounting data into useful information. So, with it, you can provide insight into the company’s current finances, make forecasts and make economic decisions. Thus, basing a decision based on a financial analysis makes more sense than basing it on a hunch or guess.
These analyzes attempt to explain important relationships between numbers in financial statements, often through financial ratios. Thus, it helps us interpret the numbers and yields better insight into its financial performance and condition.
Three ways to analyze financial statements:
- Horizontal analysis
- Vertical analysis
- Financial ratio
Horizontal analysis examines how an account’s numbers change over time. It identifies their historical performance and helps to forecast their future value.
- You can observe their dollar value, whether it is increasing or decreasing. These are usually somewhat more complicated to interpret.
- Alternatively, you can divide them by their number in the base year, expressed as a percentage. It helps you to assess how the numbers have changed in recent years.
- Alternatively, you can also calculate their percentage change. You can judge how much an account has increased or decreased from year to year.
Vertical analysis compares financial statement accounts with specific accounts in the same financial statement section, such as total assets or income. Also known as common-size analysis.
- Vertical common-size income statement expresses all income statement items as a percentage of revenue. It is useful in identifying profit margins and cost trends.
Vertical common-size income statement = (Income statement account / Revenue) * 100%
- Vertical common‐size balance sheets express each item on the balance sheet as a percentage of total assets. You divide the various accounts across assets, liabilities, and equity by the total assets.
Vertical common-size balance sheet = (Balance sheet account / Total assets) *100%
Financial ratios compare accounts in financial statements with other accounts, similar to vertical analysis. However, the two are somewhat different because financial ratios may compare accounts across sections of financial statements, such as net income on the income statement with total debt on the balance sheet. In other words, they don’t just involve accounts in the same section of the financial statements.
Calculating the ratio is easy because it only requires simple arithmetic operations. However, interpreting them is not as simple as when you calculate them. They should be meaningful for describing the company’s current financial performance and condition, evaluating the past, and making forecasts. To draw conclusions, you look at individual financial ratios and see the relationship between them and consider the company’s operational data.
Why are financial ratios important?
Financial ratios are an essential tool when you analyze company finances. They help to evaluate the performance and financial health of a company. In addition, it is useful in identifying trends in the company’s financial management and providing warning signs, depending on the ratios and business aspects you are examining.
Financial ratios give you insight into business aspects such as:
- Working capital
Profitability is related to how successfully the company generates profits. It is usually measured by their ability to convert revenue into profit or provide a return on the resources used to generate profit.
- Profitability margin measures how profitable a company makes money, measured by its ability to convert revenue into profit. Gross profit, operating profit margin, and net profit margin are examples.
- Returns compare the profit generated with the resources used. You can use several ratios to measure it, including return on assets (ROA), return on equity (ROE), and return on investment (ROI).
Working capital represents net cash available from day-to-day operations. We calculate it by subtracting current assets from current liabilities.
- Working capital = Current assets – Current liabilities
It measures a company’s ability to make payments in the next 12 months. Positive working capital indicates a healthy company. It has sufficient current assets to cover short-term bills. Conversely, if it is negative, the company may be experiencing cash flow problems.
Liquidity indicates the company’s ability to pay its short-term liabilities. The company uses its cash to meet obligations. Cash is the most liquid because companies can use it anytime and for anything. The next relatively liquid assets are cash equivalents.
If it is not sufficient, the company must convert some current assets such as accounts receivable and inventory into cash. Compared to cash, they are less liquid because they cannot be converted quickly into cash with little or no loss of value.
- For example, the company needs time to collect accounts receivable. Some customers may not pay on time, or even they can’t pay.
- Likewise, companies need to convert inventories into final output before they are sold. Sales may not immediately generate cash inflows because some are owed by customers.
Solvency is about how capable the company is of meeting its long-term obligations. If unable to pay their bills, the company is insolvent. Creditors may file for bankruptcy in court to force the company to liquidate its assets to pay off debts.
What are financial ratios usually used?
The activity ratio measures how effective a company is in managing its resources (assets) and carrying out day-to-day operations, such as managing inventory, collecting receivables, and managing accounts payable. Also called the asset utilization ratio or efficiency ratio.
- Inventory turnover
- Days of inventory on hand (DOH)
- Accounts receivable turnover
- Days sales outstanding (DSO)
- Accounts payable turnover
- Days payable outstanding (DPO)
- Working capital turnover
- Fixed asset turnover
- Total asset turnover
Inventory turnover measures how well companies manage their inventory. We calculate it by dividing the cost of goods sold (COGS) by the average inventory. Both items can be found on the income statement and balance sheet.
- Inventory Turnover = COGS / Average inventory
High inventory turnover is preferred because management is effective in managing inventory. On the other hand, it may indicate a problem if it is too low due to stockpiling of goods in the warehouse, possibly resulting from weak sales.
- But, a high ratio may also indicate insufficient inventory. As a result, sales are less than optimal due to strong market demand.
So, you need to look at the company’s sales trends to explore whether the high ratio is due to high sales or insufficient inventory.
Days of inventory on hand
Days of inventory on hand measure how many days, on average, a company converts its inventory into sales. We calculate it with the following formula:
- Days of inventory on hand (DOH) = 365 / Inventory turnover
Because it is inversely proportional to inventory turnover, a low DOH is preferred, indicating the company is faster in generating sales from available inventory.
Accounts receivable turnover
Accounts receivable turnover describes the company’s effectiveness in managing credit sales. The revenue account is on the income statement. Meanwhile, trade receivables are on the balance sheet in the current assets section. Accounts receivable arise when the company has delivered goods to customers but has not received payment until the reporting period.
We calculate the accounts receivable turnover using the following formula:
- Accounts receivable turnover = Revenue / Average accounts receivable
Higher accounts receivable turnover is more desirable, indicating effective credit management, which may be due to improved credit policies and collection.
- But, high turnover may also be due to too strict credit terms or policies. It could hurt future sales. Customers may choose competitors because they offer more lenient credit terms.
Conversely, if it is too low, it indicates the company is having difficulty collecting customer payments. Or, it’s because of the company’s lenient credit policy, making consumers more likely to pay late when receivables are due.
Day sales outstanding
Day sales outstanding (DSO) shows you how many days a company collects payments from customers. We calculate it by the following formula:
- DSO = 365 / Accounts receivable turnover
A lower DSO ratio indicates the company takes fewer days to collect receivables; therefore, it is preferable. Meanwhile, a higher DSO indicates the company needs more days to collect money from customers.
Accounts payable turnover
Accounts payable turnover shows the number of times the company pays suppliers in a year. In addition, it can describe how well the company utilizes the credit facilities offered by the supplier.
Accounts payable is the opposite of trade receivable. The company has received goods from suppliers but has not paid for them until the end of the reporting date. The longer the company pays, the longer the cash is held in the company.
We calculate accounts payable turnover with the following formula:
- Accounts payable turnover = Purchases / Average accounts payable
You can find accounts payable under current liabilities. Meanwhile, for purchases, you can calculate it with the following formula:
- Purchases = Ending inventory + Cost of goods sold – Beginning inventory
Lower accounts payable turnover is more desirable because the company pays suppliers longer and can use the money for other purposes before handing it over to suppliers.
Conversely, if it is higher, the company spends money faster. It could be due to the company’s inability to maximize existing credit facilities or due to the supplier’s strict credit policies. Alternatively, the company may pay early to get a discount.
Days payable outstanding
Days payable outstanding shows how many days, on average, the company pays its trade payables. Its formula is:
- Days payable outstanding (DPO) = 365 / Accounts payable turnover
A higher DPO indicates the company is taking longer to pay its suppliers. Say, DPO equals 90 means, on average, the company takes 90 days to pay its suppliers.
Working capital turnover
Working capital turnover ratio shows how well a company uses its working capital to generate sales. We calculate it by dividing revenue by the average working capital.
- Working capital turnover = Revenue / Average working capital
A higher ratio is preferred because the company is effective in using its working capital to generate revenue. On the other hand, a turnover ratio that is too low indicates an ineffective use of working capital.
Fixed asset turnover
Fixed asset turnover is equal to revenue divided by fixed assets. It measures how effectively companies use their fixed assets in relation to the revenue generated. You can find fixed asset numbers in non-current assets, which may be presented as property, plant, and equipment (PP&E). Meanwhile, revenue is on the income statement.
- Fixed asset turnover = Revenue / Average fixed assets
A higher ratio is preferred, indicating a more effective use of fixed assets.
Total asset turnover
The asset turnover ratio highlights how capable the company is of generating revenue from the resources it has. We calculate it by the following formula:
- Total asset turnover = Revenue / Average total assets
The higher the ratio, the better, indicating the company is effectively using short-term and long-term assets.
The liquidity ratio measures how able the company is to meet its short-term obligations. Companies must have sufficient cash balances to pay bills and pay off loans. The liquidity ratio shows you information such as:
- How much cash and near-cash assets does the company have today?
- How much will the company get if it converts current asset items?
- How long does it take for the company to convert money into inventory and eventually into sales and cash in?
We then compare them with total short-term liabilities or daily cash disbursements for the first and second points.
Furthermore, we can measure liquidity through the following ratios:
- Current ratio
- Quick ratio
- Cash ratio
- Defensive interval ratio
- Cash conversion cycle
Current ratio shows how well the company’s current assets cover current liabilities. It is the loosest liquidity ratio because it includes less liquid items (such as inventory) and, possibly, items with no cash inflows but only inflows of economic benefits (such as prepaid expenses). Also known as the working capital ratio.
The current ratio formula is:
- Current ratio = Current assets / Current liabilities
A current ratio equal to 1 is usually the limit, which means current assets equal current liabilities. A lower ratio may indicate a potential problem.
Quick ratio only takes into account the more liquid items. Hence, it is more conservative compared to the current ratio. It includes only cash and cash equivalents, short-term investments (marketable securities), and accounts receivable. We exclude inventories and prepaid expenses. Also known as the acid-test ratio.
We calculate the quick ratio with the formula below:
- Quick ratio = (Cash and cash equivalents + Short-term investment + Accounts receivable) / Current liabilities
Like the current ratio, a higher quick ratio indicates better liquidity. As a result, companies should not have problems with liquidity. Conversely, a too-low ratio indicates a poor ability to meet short-term liabilities.
Cash ratio is the strictest liquidity ratio. It shows how capable the current cash and near-cash balances are of covering current liabilities. It is usually used to measure a company’s liquidity position in the event of an unexpected crisis.
The ratio only uses cash and cash equivalents as the numerator. As is the case with the quick ratio and current ratio, a higher cash ratio indicates better liquidity.
- Cash ratio = Cash and cash equivalents / Current liabilities
Defensive interval ratio
Defensive interval ratio measures how able the company is to cover daily expenses using the most liquid assets. We calculate it by the following formula:
- Defensive interval ratio = (Cash + Short-term investments + Accounts receivable) / Daily cash outlays
A higher ratio means a better ability to pay daily expenses and bills without relying on external financing (e.g., borrowing from a bank).
Cash conversion cycle
The cash conversion cycle shows us how long it takes to convert cash into inventory, sell products, pay suppliers to collect cash from customers.
Cash conversion cycle = DOH + DSO – DPO
- Days sales outstanding (DSO) – the average number of days the company collects payments from customers.
- Days of inventory on hand (DOH) – the average number of days a company converts inventory into sales.
- Days payable outstanding (DPO) – how many days on average a company pays its suppliers.
Shorter cycles mean the company raises money more quickly, and therefore, is preferred. As a result, the company has better liquidity. Conversely, longer cycles indicate poorer liquidity.
Solvency ratio measures how able the company is to pay its long-term debts and obligations. Do they have sufficient capacity and resources to pay? It is usually measured by how heavily leveraged they are and whether they generate sufficient cash to regularly pay interest.
Leverage level tells you how much a company owes on its balance sheet, which affects its financial risk. Higher leverage increases financial risk. It can lead to bankruptcy if severe because the company is insolvent. In addition, creditors may file for bankruptcy with the courts because the company cannot pay its obligations.
Examples of solvency ratios are:
- Debt-to-assets ratio
- Debt-to-capital ratio
- Debt-to-equity ratio
- Interest coverage ratio
Debt-to-asset ratio is equal to total debt divided by total assets. It shows how much the company uses debt to finance assets. You can find total debt and total assets on the balance sheet. As a note, the total debt only includes interest-bearing debt, both short-term and long-term.
- Debt-to-asset ratio = Total debt / Total assets
A high ratio indicates high financial leverage because the company relies on debt rather than equity. That implies a higher financial risk and a weaker solvency position.
Debt-to-capital ratio is calculated by dividing total debt by total capital. It shows how much companies rely on debt capital to finance long-term growth. Total capital equals total equity plus total debt.
- Debt-to-capital ratio = Total debt / Total capital
- Debt-to-capital ratio = Total debt / (Total debt + Total equity)
A lower ratio indicates a lower financial leverage level, indicating a lower financial risk. On the other hand, higher total debt increases the company’s financial risk because the company has to pay more interest and, at maturity, greater principal.
- So why should companies increase debt if it increases their financial risk?
Debt is relatively cheaper than equity because interest expense is tax-deductible. Therefore, the company may increase debt to achieve an optimal capital structure and minimize the cost of capital.
Debt-to-equity ratio measures the company’s debt level. It shows the extent to which debt is used in financing the business.
- Debt-to-equity ratio (DER) = Total debt / Total equity
DER equal to one means the company uses equity and debt in equal proportions. A higher DER indicates a higher financial risk.
Financial leverage ratio
Financial leverage ratio is a measure of the company’s financial leverage. We sometimes also call it a financial leverage multiplier. To calculate it, you divide total assets by total equity.
- Financial leverage ratio = Total assets / Total equity
Interest coverage ratio
Interest coverage ratio gauges the company’s ability to meet interest payments on any debt they have. You can calculate it by dividing earnings before interest and tax (EBIT) by interest expense.
- Interest coverage ratio = EBIT / Interest expense
A higher ratio is preferable, showing the company has a better ability to pay interest. Meanwhile, a ratio close to or less than 1 signals serious difficulties in paying interest.
In another variation, you can use EBITDA, which is EBIT, after adjusting for depreciation and amortization. EBITDA is more reflective of the amount of money a company makes from its operations than EBIT because it is adjusted for non-cash items.
Fixed-charge coverage ratio
The fixed-charge coverage ratio measures a company’s ability to meet its fixed financial costs: interest payments and lease payments. Both are fixed costs because the company has to pay for them, regardless of whether it makes money or not. We calculate it by calculating it with the formula below:
- Fixed-charge coverage ratio = (EBIT + Lease payments) / (Interest payments + Lease payments)
A higher ratio is preferred. The company generates enough money from operating activities to pay interest and rent.
Profitability ratios gauge how well the company generates profits in running the business. They fall into two categories: profitability margins and return ratios.
Profitability margin measures how much a company earns on each dollar of revenue. We calculate the profitability margin by dividing various profit measures by revenue. Examples are:
- Gross profit margin
- Operating profit margin
- EBITDA margin
- Net profit margin
Meanwhile, the return ratio shows how much profit the company generates for each resource used, including assets, equity, and invested capital. They include:
- Return on equity (ROE)
- Return on assets (ROA)
- Return on investment (ROI)
Gross profit margin
Gross profit margin tells the percentage of revenue left after the company pays the cost of goods sold (COGS). We calculate it by dividing gross profit divided by revenue. Gross profit equals revenue minus COGS.
- Gross profit margin = Gross profit / Revenue
- Gross profit margin = (Revenue – COGS) / Revenue
A higher gross profit margin is preferable, indicating the company is earning more money to pay for other expenses such as selling, general and administrative expenses.
Gross profit margin also depends on the company’s competitive strategy. For example, companies with a differentiation strategy have higher margins because they can sell at a premium. Meanwhile, the cost leadership strategy has lower margins due to set prices on the industry average rather than a premium price.
Operating profit margin
Operating profit margin is equal to operating profit divided by revenue. It measures how much a company makes a profit from its core business. In addition, it considers direct and indirect costs such as selling, general and administrative expenses, which are fixed costs. Sometimes also known as EBIT margin.
- Operating profit margin = Operating profit / Revenue
- Operating profit margin = (Gross profit – Operating expenses) / Revenue
Higher margins are more desirable because the company has more left over to pay interest and taxes. If the percentage increase is higher than the gross profit margin, the company successfully controls operating costs.
EBITDA margin divides EBITDA by revenue. EBITDA is a proxy for cash profits generated by the company during the reporting period. So, if we divide by revenue, it shows how successfully the company converts each revenue into cash profit.
- EBITDA margin = EBITDA / Revenue
Pretax profit margin
Pretax profit margin is equal to pretax profit divided by revenue, expressed as a percent. It measures how much the company profits before paying some of it for taxes.
- Pretax profit margin = Pretax profit / Revenue
Net profit margin
Net profit margin equals net profit divided by revenue. It measures how much is left after the company has paid all expenses, including interest expenses and taxes. Also known as net income margin.
- Net profit margin = Net profit / Revenue
A higher net profit margin is preferable.
Return on assets
Return on assets (ROA) is equal to net profit divided by total assets, expressed as a percent. It gauges how capable a company is of using its assets to make a profit. It is different from the asset turnover ratio, which measures how effectively the company’s assets generate revenue, although they sound similar.
Usually, the calculation uses a two-period average of total assets instead of one period to minimize variations in asset values due to seasonal factors. Higher ROA is preferred.
- ROA = Net profit / Average total assets
Another variation is adjusted ROA. As the numerator, it uses net profit before interest expense is paid.
- Adjusted ROA = Net profit x Interest expense (1 – Tax rate) / Average total assets
Return on investment
Return on investment (ROI) measures how much profit is made on each money invested. We calculate it by dividing the EBIT earned by the total investment.
- ROI = EBIT / Average total investment
Interest expense represents the return to creditors. Since we measure the return on invested capital – equity capital plus debt capital – we use EBIT instead of net income. EBIT is a measure of profit before deducting interest and taxes.
Return on equity
Return on equity (ROE) measures the profit earned for each equity capital invested in the company. We calculate it by dividing net profit by total equity.
- ROE = Net profit / Average total equity
A higher ratio is preferred because it indicates a higher return.
Return on common equity
Return on common equity (ROCE) is another measure of ROE but applies to common equity capital. To calculate it, we first subtract net income by the preferred dividend. Then, divide the result by the total assets. Also known as return on shareholders’ equity.
- ROCE = (Net income – Preferred dividend) / Average common equity
DuPont analysis decomposes return on equity (ROE) into several financial ratios. It helps you understand why a company’s ROE is going down (up) and why it’s higher or lower than competitors.
DuPont decomposition is divided into three:
- Two-step DuPont decomposition
- Three-step DuPont decomposition
- Five-step DuPont decomposition
Two-stage DuPont decomposition
Under the two-stage decomposition, we break down ROE into two financial ratios, namely ROA and leverage ratio.
- ROE = ROA x Leverage ratio
- ROA = Net profit / Total assets
- Leverage ratio = Total assets / Total equity
From the above formula, ROE increases because of:
- Higher ROA. The company effectively manages and uses its resources to generate profits.
- Higher leverage ratio. The leverage ratio rises if the company uses more debt capital. Higher debt requires the company to pay more interest, which is tax-deductible.
Note: increasing debt results in a higher ROE only if the borrowing costs are lower than the marginal return. Conversely, if borrowing costs are higher, taking on more debt will depress ROA and ROE.
Three-stage DuPont decomposition
The three-stage decomposition breaks down ROE into three other financial ratios: net profit margin, asset turnover ratio, and leverage ratio.
- ROE = Net profit margin x Asset turnover ratio x Financial leverage ratio
- Net profit margin = Net profit / Revenue
- Asset turnover ratio = Revenue / Total assets
- Leverage ratio = Total assets / Total equity
Net profit margin tells you how well the company can convert a dollar of revenue into net income. The asset turnover ratio gauges how effectively a company uses its assets to generate sales. Meanwhile, the leverage ratio measures the company’s dependence on debt in its capital composition.
Five-stage DuPont decomposition
The five-stage decomposition expresses the ROE as:
- ROE = Tax burden x Interest burden x EBIT margin x Asset turnover x Financial leverage ratio
- Tax burden = Net profit / EBT
- Interest burden = EBT / EBIT
- EBIT margin = EBIT / Revenue
- Asset turnover = Revenue / Total assets
- Financial leverage ratio = Total assets / Total equity
Tax burden takes into account the impact of taxes on company profits. It is calculated by dividing net income by earnings before tax (EBT) – also known as pretax profit. A higher tax burden increases net income because the average tax rate decreases. That ultimately increases ROE.
- The lower tax rates may be due to the government’s new legislation policy. Or, the company generates more revenue in some countries with lower taxes.
Interest burden measures the effect of interest expense on ROE. Higher interest expense reduces net income, lowers ROE. It is equal to 1 if the company has no debt.
EBIT margin measures how profitable a company’s operations are. Higher margins mean the company can convert revenue into more profit.
Cash ratios compare an item on the cash statement, usually cash from operations (CFO), with several other items in the financial statement. CFO replaces the profit measure and provides more accurate insights because it represents the amount of money a company makes from day-to-day operations.
Cash flow to revenue = CFO / Revenue
- It measures the success of the company in converting revenue within a year into cash. A higher ratio is more desirable because more money is collected from each dollar of revenue.
Cash return on assets = CFO / Average total assets
- It measures how much the company can make money from the resources (assets) it currently has. A higher ratio is preferable because the company can better use its assets by making more money.
Cash to capital expenditure = CFO / Capital expenditure
- It shows how much money generated from operations can be used for capital expenditures. A higher ratio is better, indicating more sufficient funds are available for capital investment.
Cash flow to net income = CFO / Net income
- It shows how well the money generated reflects the recorded profit. The company may book high profits, but it is cash-poor because it is heavily owed by customers.
- It is also used to evaluate the quality of the company’s earnings, whether management practices earnings manipulation or not. A ratio close to one indicates that it is less likely to happen.
Cash flow per share = (CFO – Preferred dividends) / Number of common shares outstanding
- Similar to earnings per share (EPS), but it is measured by the amount of money generated, not recorded a profit. A higher ratio indicates more money is available to common stockholders.
Operating cash flow ratio = CFO / Current liabilities
- It tells you the company’s ability to cover its current liabilities with the money it generates from its operations. If it is less than one, it indicates the company is not making enough money to pay its short-term bills.
Debt coverage = CFO / Total debt
- It measures how much money generated can be used to pay off the company’s debts. A high ratio indicates a low leverage level, indicating a better ability to pay.
Cash interest coverage = (CFO + Interest paid + Taxes paid) / Interest paid
- It shows you the company’s ability to pay interest on debt using cash from operations. A higher ratio is preferred.
Dividend payment = CFO / Dividend paid
- It measures a company’s ability to pay dividends with cash from operations. A higher ratio is more desirable. Ideally, the company has some money left over after it has been partially distributed as dividends.
Valuation ratios measure how fair a company’s market value is compared to its financial soundness. Specifically, it puts a company’s performance and financial condition into the context of the company’s stock price. Thus, it is an essential tool for evaluating investment potential.
Valuation ratios compare accounts in financial statements such as cash flow, revenue, and profit with a company’s stock price. Commonly used ratios are:
- Price-to-earnings ratio
- Price-to-book value ratio
- Price-to-sales ratio
- Price-to-cash-flow ratio
Here, I also present useful ratios for valuing company shares, such as dividend payout ratio, retention rate, and sustainable growth rate.
Price-to-earnings ratio (P/E ratio) divides the market price of a company’s stock by earnings per share. We divide net income for the last 12 months by the number of common shares outstanding to calculate earnings per share.
- P/E ratio = Share price / Earnings per share
A high P/E ratio indicates investors are willing to pay a high price for each company’s net income. They expect the company to report higher earnings growth in the future and thus bid its stock at a higher price.
Contrarily, a low P/E ratio may indicate investors are not too sure about the company’s prospects. They do not believe the company will generate higher profits. Thus, they have no reason to buy shares at a higher price.
- Or the market is undervaluing the company’s stock. If that’s true, the company’s stock is a good choice because of the potential to rise in the future.
Which P/E ratio is good?
- It depends on the company’s performance, both financial and business.
- It also depends on the industry where the company operates. Some industries have higher average P/E ratios than others.
Earning yield is equal to earnings per share (EPS) divided by share price. Or, we can calculate it by dividing 1 by the P/E ratio.
- Earning yield = 1 ÷ P/E ratio
- Earning yield = EPS / Share price
You can see from the formula above, earning yield is inversely proportional to the P/E ratio. So, if it is high, the company’s stock is relatively cheap. Conversely, if it is low, the company’s stock is too expensive.
PEG ratio or P/E growth ratio is useful for determining whether a company’s P/E ratio is too high or too low. We calculate it by dividing the forward P/E ratio by the growth in EPS, usually the average over the next five years.
- PEG ratio = Forward P/E Ratio ÷ EPS growth
The higher the PEG ratio, the more expensive a stock is.
The price-to-book ratio (P/B ratio) relates the market price of a company’s stock to its book value. To calculate it, we divide the price per share by the book value per share.
- Its book value – also known as shareholders’ equity – represents what would be left to shareholders if its assets are liquidated and distributed to creditors and shareholders.
Investors use the P/B ratio to determine whether a stock is worth buying or not. Also known as the price to book value (PBV).
- P/B ratio = Price per share / Book value per share
- P/B ratio = Market capitalization / Book value
Suppose the P/B ratio is more than one. In that case, it indicates the company’s stock price is trading at a premium above its book value.
- The company’s market value may be high because it has significant intangible assets such as strong brand equity, patents, market share, and other competitive advantages, which are not reflected in the book value in the financial statements.
- Or companies continue to earn higher ROEs compared to their peers. Thus, the market likes and trades the company’s shares at a premium.
Price-to-sales ratio (P/S ratio) is equal to the price per share divided by sales per share. Sales per share equal earnings for the last 12 months divided by the number of shares outstanding. It shows how much investors paid for the stock compared to the sales the company made per share.
- P/S ratio = Share price / Sales per share
A higher ratio means the market is willing to pay more for the company’s stock, indicating an expectation of future price increases.
Conversely, a lower ratio may be because investors are pessimistic about the company’s future sales prospects and are only willing to buy shares at a lower price.
- Alternatively, it could also indicate that the company’s stock is an attractive investment alternative because it may be undervalued by the market.
Price-to-cash-flow ratio (P/CF ratio) is an alternative to the P/CF ratio. However, it uses a realistic measure rather than the P/E ratio. It relates the company’s price to how much the company generates from operations by using cash from operations (CFO) as a divisor, not net income.
- Net income still contains non-cash items such as depreciation and amortization. So, it doesn’t show how much money was made.
The CFO excludes such items. To calculate it, we add back non-cash items such as depreciation and amortization to net income. Then, we adjust the results with changes in working capital. As a result, CFO describes the exact number of money earned from daily activities.
- P/CF ratio = Price per share / CFO per share
Like the P/E ratio, a higher P/C ratio indicates the market expects the company to make more money in the future.
Earnings per share
Earnings per share (EPS) represents the net income available to common stockholders. To calculate, we divide net income by the weighted average number of common shares outstanding during the year. If the company owns preferred stock, you must subtract the net income by the preferred dividend.
- EPS = (Net income – Preferred dividend) / Weighted average number of ordinary shares outstanding
The formula above is the basic EPS. However, suppose the company has diluted securities. In that case, we must adjust the divisors to take them into account, i.e., what EPS would be if they were converted into common stock. In this case, we calculate the diluted EPS.
- Diluted EPS = (Net income – Preferred dividend) / (Weighted average number of ordinary shares outstanding + New ordinary shares issued on conversion)
Although there is no ideal standard, higher EPS is considered better because it makes more profit available to its shareholders.
Dividend per share
Dividends per share are equal to cash dividends, adjusted for preferred dividends, divided by the number of shares outstanding. Thus, it shows the dollars earned by common stockholders for each share they own.
- Dividend per share = (Cash dividend – Preferred dividend) / Number of ordinary shares outstanding
An increased dividend per share is favored by investors, signaling management’s positive expectations for its future earnings. Management believes the increase in profit can be maintained, thus paying higher dividends from year to year.
Dividend payout ratio
Dividend payout ratio is equal to cash dividends divided by net income. Thus, it shows the proportion of profit returned to shareholders.
- Dividend payout ratio = Dividends / Net income
As a note, the above ratio is only for dividends and net income to common stockholders.
A high ratio shows you the company is distributing most of its net income as dividends. Less leftover for retained earnings and equity.
- Suppose shareholders expect the company to maintain an equal payout ratio in the future. It is challenging for the company to raise equity capital because it is difficult to cut dividends without disappointing shareholders.
Retention ratio shows how much net profit the company retains as capital to develop the business. We calculate it by dividing retained earnings by net income. Or it equals 1 minus the dividend payout ratio.
- Retention ratio = Retained earnings / Net income
- Retention ratio = (Net income – Dividend) / Net income
- Retention ratio = 1 – Dividend payout ratio
A higher ratio indicates companies retain more net income as internal capital (equity). As a result, less is distributed as dividends.
Sustainable growth rate
Sustainable growth rate shows the growth rate of dividends (and profits) that can be maintained by the company from time to time.
- Sustainable growth rate = Retention rate × ROE
It represents the company’s maximum growth rate over the long term, assuming no additional funding – neither equity nor debt – is raised.
Credit analysis evaluates a borrower’s credit risk profile and creditworthiness, usually to establish a credit rating.
- Creditworthiness indicates the borrower’s ability and willingness to fulfill its contractual obligations in the future.
- Credit analysis is usually done internally for the bank before accepting or rejecting the debtor’s loan application.
- Meanwhile, for the issuance of debt securities such as bonds, credit analysis is carried out by rating agencies. The agency assigns a credit rating to reflect the creditworthiness of the issuer.
Credit rating is an indicator to represent the credit quality and creditworthiness of the issuer of debt securities.
- The highest rating is AAA, indicating the best creditworthiness. Meanwhile, the lowest is D, where the debt issuer defaults.
- We refer to ratings of BBB- to AAA as investment grades.
- Ratings below BBB- we refer to as non-investment, junk, or speculative grades. Such bonds are called junk bonds, speculative bonds, or high-yield bonds.
Credit risk refers to the risk resulting from a borrower’s failure to make promised payments on time. Or, for financial instruments such as bonds, it also arises from changes in the bonds’ value based on changes in the default risk.
- Business risk is the risk in realizing future profits and cash flows from factors other than financial leverage. It is related to the company’s operating activities. Influencing factors include market position, revenue diversification, market cycles, and competitive dynamics.
- Financial risk is uncertainty about future outcomes involving financial losses or gains. To analyze how risky a company’s finances are, we can examine its capital structure, interest coverage ratio, cash flow ratio, and profitability ratio.
FFO to debt
Funds from operations (FFO) measures the ability to generate recurring cash flows, which are smoother than cash from operations (CFO). It represents cash flows available to the company before working capital, capital expenditures, and discretionary items such as dividends and acquisitions.
- FFO to debt (%) = FFO / Total debt
A higher FFO ratio is preferable, indicating the company is making more money to pay its debts.
Debt to EBITDA
EBITDA is a measure of profitability, which is often used to indicate the money a company makes. It is usually used as a starting point for cash flow analysis.
- Debt to EBITDA (x) = Total debt / EBITDA
So, debt to EBITDA(x) shows how many times the company’s total debt is compared to the money generated. A lower ratio is preferable because the company generates more money in proportion to its total debt.
FFO to cash interest
Broadly speaking, FFO to cash interest shows how many times the money generated is compared to the interest payments. Cash interest includes only cash interest payments, excluding non-cash interest paid on, for example, payment-in-kind instruments.
- FFO to Cash interest (x) = FFO / Cash Interest
A higher ratio is preferable because the company generates more to pay off the interest on its debt.
EBITDA to interest
EBITDA to interest measures how easily a company can pay interest on the debt. It uses EBITDA as a proxy for how much money a company makes.
- EBITDA to interest (x) = EBITDA / Interest payment
A higher ratio is preferred because it indicates a better ability to pay interest. However, the ideal ratio varies between industries.
The alternative is EBIT to interest expense. We calculate it by dividing EBIT by interest expense.
- EBIT to interest expense = EBIT / Interest expense
Like EBITDA to interest, a higher EBIT to interest expense indicates better financial health. Conversely, if it is less than one, the company may be in poor financial health.
CFO to debt
CFO to debt measures the proportion of money generated from operations compared to the company’s total debt. CFO is different from FFO, where CFO does not take into account capital expenditures. Instead, it is pure cash generated from operations.
- CFO to debt (%) = CFO / Total debt
A higher CFO to debt is preferred because the company generates more money to pay off debt.
FOCF to debt
Free operating cash flow (FOCF) is CFO after deducting capital expenditures. It is also known as free cash flow (FCF). FOCF measures the cash generated from core operations after the company pays for routine expenses such as working capital and capital expenditures.
- FOCF to debt (%) = FOCF / Total debt
A positive FOCF indicates the company has cash remaining after paying its expenses, which can be used to pay off debt. And a higher ratio is preferred.
There are various ratios between industries; often, they are specific and only relevant to the related industry, not to other industries, especially in the financial sector. For example, you will probably find ratios such as the capital adequacy ratio and net interest margin in the banking industry. In insurance, risk-based capital (RBC) is another example.
Here, I will not cover all industry-specific ratios but will only present some of them.
Capital adequacy ratio
The capital adequacy ratio (CAR) measures a bank’s ability to absorb losses. It is calculated by dividing the bank’s capital by risk-weighted assets.
- Capital adequacy ratio = (Tier 1 capital + Tier 2 capital) / Risk-weighted assets
A high capital adequacy ratio is desirable. Banks have sufficient capital to absorb losses, especially loan risk.
Regulators usually set a minimum standard for this ratio. If banks fail to comply, they must increase their capital, for example, by issuing new shares.
Net interest margin
- Net interest margin (NIM) measures how profitable the main banking activities are. We calculate it by dividing the net interest income divided by the average earning assets (loan outstanding). Net interest income is equal to interest income minus interest expense.
- Net interest margin = Net interest income / Loan outstanding
- Net interest margin = (Interest income – Interest expense) / Loan outstanding
A higher ratio is more desirable from the bank’s perspective. It shows:
- They can charge higher loan interest, or
- They can lower the cost of funds, so the interest expense goes down.
Risk-Based Capital (RBC)
Risk-Based Capital (RBC) measures the minimum capital required to support insurance business operations, taking into account its size and risk profile. Capital provides a cushion for insurance companies against bankruptcy and to absorb risk.
RBC limits the amount of risk an insurance company can take. When taking more risks, they must have higher capital.
Revenue per employee
Revenue per employee measures how much money is made per employee. We calculate it by dividing the total revenue by the total employees currently employed by the company.
- Revenue per employee = Revenue / Total employee
A higher ratio indicates greater productivity as each employee generates more revenue.
How to use financial ratios?
Above, I have presented various ratios to analyze financial statements; the next question is how to use them?
Financial ratios provide deep insight if we use them comparatively: comparing them over time and against other companies.
- Historical trend. If you observe historical trends, it gives you insight into whether a ratio is improving or deteriorating. For example, the profitability ratio improves, in general, if it rises over time.
- Compared to peers. Comparing the same ratio with competitors or industry averages helps you make a more objective opinion.
We find it difficult to determine the ideal value for a ratio because it usually depends on its industry. So the only way is to compare it to the industry average.
- For example, suppose a company’s profitability ratio is higher than the industry average. In that case, it indicates the company is better at making a profit.
- In other cases, you may see the company’s profitability ratio go up. But, that’s lower than their peers in the industry. Would you rate a company as successful in making a profit?
- If industry averages don’t exist, you can use companies as a comparison, where they have relatively similar business models and financial structures.