Financial Ratios
The usage of financial ratios is helpful to get
a general idea of a company’s financial situation.
Profitability
ratio
Gross profit:
Liquidity ratios
Current ratio:
ROCE (Return on capital employed):
Gearing / leverage ratios
Debt-to-equity ratio:
Equity ratio:
Debt ratio:
Times interest earned:
Gross profit:
- a company’s revenue minus its cost
of goods sold
- a company’s residual profit after
selling a product or service and deducting the cost associated with its
production and sale
- indicates how efficiently management
uses labour and supplies in production process
- varies significantly from industry to industry
- gross profit margin = gross profit / turnover x 100
- net profit margin = net profit / turnover x 100
Liquidity ratios
Current ratio:
- shows the company’s ability to pay back its short-term liabilities with its short-term assets
- indicator of credibility and credit-worthiness
- the higher the current ratio, the more capable the company is of paying its obligations
- a ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point
- target range: 1,5 - 3,0
-
- indicator of a company’s short-term liquidity
- measures a company’s ability to meet its short-term obligations with its most liquid assets à for this reason inventories are excluded (no guarantee that we can immediately turn our inventory into cash; it takes time; you also cannot rely on the fact that you receive the book value for your inventory if it has to be sold quickly)
- target range: 0,5 – 1,0
- the higher the quick ratio, the better the company’s liquidity position (also known as the “acid test ratio")
- a quick ratio of 1.5 means that a company has $ 1.50 of liquid assets available to cover each $ 1 of current liabilities
- Quick ratio = (current assets – inventories) / current liabilities
ROCE (Return on capital employed):
- measures a company’s profitability and the efficiency with which its capital is employed
- a higher ROCE indicates a more efficient use of capital
- especially useful when comparing the performance of companies in capital-intensive sectors such as utilities and telecoms (provides a better indication of financial performance for companies with significant debt because it considers debt and other liabilities as well)
- ROCE = Earnings Before Interest and Tax (EBIT) / Capital Employed
Gearing / leverage ratios
Debt-to-equity ratio:
- measures a company’s financial leverage
- indicates what proportion of equity and debt the company is using to finance its assets
- a high ratio generally means that a company has been aggressive in financing its growth with debt
- Debt/Equity ratio
Equity ratio:
- indicates the relative proportion of equity applied to finance the assets of a company
- a higher equity ratio indicates a company’s better long-term solvency position and provides a freer access to capital at lower interest rates
- companies having a higher ratio have to pay less interest thus having more free cash on hand for future expansions, growth and dividends
- Equity Ratio = Shareholders funds / Total assets
Debt ratio:
- measures the extent of a company’s or consumer’s leverage
- can be interpreted as the proportion of a company’s assets that are financed by debt
- the higher this ratio, the more leveraged the company and the greater its financial risk
Times interest earned:
- measures a company’s ability to meet its debt obligations
- indicates how many times a company can cover its interest charges on a pretax basis
- failing to meet these obligations could force a company into bankruptcy
- Times interest earned = earnings before interest and taxes / total interest payable on bonds and other contractual debt
Source: http://www.investopedia.com/