Do you know the financial ratios that help you make decisions for your business?

'“Financial ratios help investors break down the enormous amount of financial data that are reported by companies. A ratio is simply a metric to help analyze the data and make useful comparisons with other companies and other reporting periods.

It's important to consider that the results from financial ratios are often interpreted differently by investors. Although financial ratio analysis provides insight into a company, individual ratios should be used in concert with other metrics and evaluated against the overall economic environment of a company. Below are some of the most common financial ratios that investors use to interpret a company's financial statements.

Financial ratios analyze specific financial line-items within a company's financial statements to provide insight as to how well the company is performing. Ratios determine profitability, a company's indebtedness, the effectiveness of management, and operational efficiency.

Profitability Ratios

Profitability ratios are a group of financial metrics that show how well a company generates earnings compared to its associated expenses.  You will get a better sense of how well a company is doing by comparing ratios of a similar period. For example, comparing the fourth quarter of this year with the same quarter from last year will get a better result.

Return on Equity

Return on equity, or ROE, is a common profitability ratio used by many investors to calculate a company's ability to generate income from shareholders' equity or investments. Companies issue shares of stock to raise capital and use the money to invest in the company. Shareholders' equity is the amount that would be returned to shareholders if a company's assets were liquidated, and all debts were paid off. The higher the return or ROE, the better the company's performance since it generated more money for each dollar of investment in the company. You might consider a good ROE one that increases steadily over time. That could indicate a company does a good job using shareholder funds to increase profits. In turn, that can increase shareholder value.

​Return on Equity=Average Shareholders’ Equity/Net Income

Operating Margin

Operating profit margin evaluates the efficiency of a company's core financial performance. Operating income is the revenue generated from a company's core business operations. Although operating margin is the profit from core operations, it doesn't include expenses such as taxes and interest on debt. As a result, operating margin provides insight as to how well a company's management is running the company since it excludes any earnings due to ancillary or exogenous events. For example, a company might sell an asset or a division and generate revenue, which would inflate earnings. Operating margin would exclude that sale. Ultimately, the operating profit is the portion of revenue that can be used to pay shareholders, creditors, and taxes.

Operating margin = operating earnings / revenue

 Liquidity Ratios

Liquidity ratios help shareholders determine how well a company handles its cash flow and short-term debts without needing to raise any extra capital from external sources, such as a debt offering.

Current Ratio

The most used liquidity ratio is the current ratio, which reflects current assets divided by current liabilities, giving shareholders an idea of the company's efficiency in using short-term assets to cover short-term liabilities.

Short-term assets would include cash and accounts receivables, which is money owed to the company by customers. Conversely, current liabilities would include inventory and accounts payables, which are short-term debts owed by the company to suppliers.

 Higher current ratios are a good indication the company manages its short-term liabilities well and generates enough cash to run its operation smoothly. The current ratio generally measures if a company can pay its debts within a 12-month period. It can also be useful in providing shareholders with an idea of the ability a company possesses to generate cash when needed.

Current ratio = current assets / current liabilities

Quick ratio (also known as the acid test)

The calculation for the quick ratio is current assets minus inventory minus prepaid expenses divided by current liabilities. The formula removes inventory because it can take time to sell and convert inventory into liquid assets. A quick ratio of less than 1 can indicate that there isn't enough in liquid assets to pay short-term liabilities. The company may have to raise capital or take other actions. On the other hand, it may be a temporary situation.

Operating cash flow ratio

The operating cash flow ratio measures the ability of a business to pay for its current liabilities from its reported operating cash flows. The best-case scenario is when the ratio reveals operating cash flows that are several multiples of the liabilities that must be settled. Conversely, a low ratio indicates that cash flows may not be sufficient to settle all obligations as they come due, which could indicate an impending solvency issue. This ratio is a good tool for lenders and creditors, especially when evaluating smaller or new borrowers.

Cash flow from operations comes from a firm’s statement of cash flows. Current liabilities are all liabilities stated on a firm’s balance sheet that are due for payment within one year. Any cash flows from ancillary activities are excluded from this calculation. If ancillary cash flows were to be included in operating cash flows, it would imply that the entity is relying on non-core activities to support its core activities.

Cash flow from operations / Current liabilities = Operating cash flow ratio

Debt Ratios

Debt ratios indicate a company’s debt situation and whether they can manage their outstanding debt as well as the debt servicing costs, such as interest. Debt includes borrowed funds from banks but also bonds issued by the company. Bonds are purchased by investors where companies receive the money from the bonds upfront. When the bonds come due–called the maturity date–the company must pay back the amount borrowed. If a company has too many bonds coming due in a specific period or time of the year, there may not be enough cash being generated to pay the investors. In other words, it's important to know that a company can pay its interest due on its debts, but also it must be able to meet its bond maturity date obligations.

Debt-to-Equity Ratio

The debt-to-equity (D/E) ratio measures how much financial leverage a company has, which is calculated by dividing total liabilities by stockholders' equity. A high debt-to-equity ratio indicates a company has vigorously funded its growth with debt. However, it's important to compare the debt-to-equity ratios of companies within the same industry. Some industries are more debt-intensive since they need to buy equipment or expensive assets such as manufacturing companies. On the other hand, other industries might have little debt, such as software or marketing companies.

D/E = total liabilities / total equity

Interest-Coverage Ratio

The interest coverage ratio measures the ease with which a company handles interest on its outstanding debt. A lower interest coverage ratio is an indication the company is heavily burdened by debt expenses.

Interest coverage = EBIT / Interest expense

EBIT stands for earnings before interest and taxes and is also referred to as operating profit.

Efficiency Ratios

Efficiency ratios show how well companies manage assets and liabilities internally. They measure the short-term performance of a company and whether it can generate income using its assets.

Inventory Turnover

The inventory or asset turnover ratio reveals the number of times a company sells and replaces its inventory in each period. The results from this ratio should be used in comparison to industry averages. Low inventory turnover ratio values indicate low sales and excessive inventory, and therefore, overstocking. High ratio values commonly indicate strong sales and good inventory management.

Inventory turnover = cost of goods sold / average inventories

Valuation Ratios

Price ratios focus specifically on a company's stock price and its perceived value in the market.

Price-to-earning (P/E)

The price/earnings (or P/E) ratio is an evaluation metric comparing the current share price of a company’s stock with its per-share earnings. Higher P/E values indicate investors expect continued future growth in earnings. However, a P/E that's too high could indicate that the stock price is too high relative to the earnings or profit being generated. Investors use the P/E ratio to evaluate whether the stock price is fairly valued, overvalued, or undervalued.

The P/E ratio is most helpful when compared to historical P/Es of the same company and companies within the same industry.

P/E = stock price / earnings per share

Trailing P/E uses a stock's historical earnings relative to its market price, while forward P/E uses earnings forecasts.

Dividend Yield

The dividend yield ratio shows the amount of dividends a company pays out yearly in relation to its share price. The dividend yield provides investors with the return on investment from dividends alone. Dividends are important because many investors, including retirees, look for investments that provide steady income. Dividend income can help offset, at least in part, losses that might occur from owning the stock. Essentially, the dividend yield ratio is a measurement of the amount of cash flow received for each dollar invested in equity.

Dividend yield = annual dividends per share / share price

Which Financial Statement Is Most Important to Shareholders?

No single financial statement is most important, since the balance sheet, income statement, and statement of cash flows all contain crucial pieces of information. Any ratios computed using fundamental analysis will draw pieces of data from places found on different statements. For instance, ROE uses information from both the income statement and balance sheet.

What Do Financial Statements Tell You?

A company's financial statements provide insights into a company's financial position, profitability, and growth potential. Taken together, financial statements allow analysts to conduct fundamental analysis to evaluate a stock's value and growth prospects. Financial statements also can signal red flags about financial instability or accounting irregularities.

Bottom Line

There is no one indicator that can adequately assess a company's financial position and potential growth. That is why financial statements are so important for shareholders and market analysts alike. These metrics (along with many others) can be calculated using the figures released by a company on its financial statements. Remember that a company cannot be properly evaluated using one ratio in isolation. So be sure to put a variety of ratios to use for more confident investment decision-making.”

Sources:

U.S. Small Business Administration. "Calculate & Analyze Your Financial Ratios: Turning Your Financial Statements into Powerful Tools," Page 3.

The Commonwealth of Massachusetts, Center for Health Information and Analysis. "Interpretation of Financial Ratios

U.S. Small Business Administration. "Calculate & Analyze Your Financial Ratios: Turning Your Financial Statements into Powerful Tools," Page 2.

Accounting Tools. "Operating Cash Flow Ratio Definition."

Accounting Tools. "Interest Coverage Ratio Definition

Financial Industry Regulatory Authority. "Six Financial Performance Metrics Every Investor Should Know

Financial Industry Regulatory Authority. "How Companies Use Their Cash: Dividends