Financial Ratios

Last updated on May 3, 2023

Financial Ratios are metrics to help investor judge a company. These are guidelines to investment decisions. We will highlight ratios the are generally good but each company and industry should be judge by its environment. Make sure you look at industry averages. There are many sites that can help with the industry averages. Again, each company and industry needs to be viewed based on its environment.

Liquidity Ratios- How liquid is the business?”

1. Current Ratio = Current Assets/Current Liabilities.
   • The ideal ratio is 1.  A ratio of 2, the company will have trouble with the liabilities.
2. Quick Ratio = (Current Assets-Inventory)/Current Liabilities.
   • This is the liquidity ratio or quick assets.

Turnover Ratios-

1. Inventory Turnover Ratio = Cost of goods/Average Inventory
   • Turnover ratio is dependent on the industry.  Ideally it should be between 5-10 but certain companies have longer turnover ratios.  Airplanes and housing are two of them.  It tells us how long it takes to sell inventory of a product.  
2. Receivables Turnover Ratio= Net Credit Sales / Average Accounts Receivable
   • The receivables turnover ratio tells us how effectively a company is handling collections.  The higher the ratio the better. It tells you how many days clients take to pay. 
3. Capital Turnover Ratio= Net Sales (Cost of Goods Sold) / Shareholder’s Equity
   • This shows how efficiently the company is turning over sales against working capital.
4. Asset Turnover Ratio = Net Sales / Net Tangible Assets
   • How efficient is the company turning over sales from its assets.
5. Net Working Capital Ratio = Net Sales / Net Working Capital
   • This shows if the company can pay current liabilities with current assets.
6. Cash Conversion Cycle = Receivable Days + Inventory Days – Payable Days
   • How long does it take a convert cash to profits.

Operating Profitability Ratios

1. Earnings Margin = Net Income / Turnover * 100
   • This is a measure of profitability.  It measures how much of each dollar in revenue is profit.
2. Return on Investment (ROI)= Profit Before Interest and Tax / Total Capital Employed
   • This is the return of profits on capital. 
3. Return on Equity = Profit After Taxation – Preference Dividends / Ordinary Shareholder’s Fund * 100
   • This is the return of profits on net assets.  It is a good judge on how the company is doing. 
4. Earnings Per Share = Earnings After Taxation – Preference Dividends / Number of Ordinary Shares
   • This is return per share.  It is the most used ratio on most sites.  Expectations of increased (EPS) will typically cause the stock price to move.

Business Risk Ratios

1. Operating Leverage = % Change in EBIT / % Change in Sales
   • This shows the ability to increase income based on increasing sales.
2. Financial leverage = % Change in Net Income / % Change in EBIT
   • This shows the increase in income by borrowing money.
3. Total Leverage = % Change in Net Profit / % Change in Sales

Financial Risk Ratios

1. Debt-Equity Ratio = Long Term Debts / Shareholder’s Fund
   • Indicates how much debt is being used to finance its assets
2. Interest Coverage Ratio = EBITDA / Interest Expense
   • Indicates if the company can pay interest on outstanding debt.
3. Debt Service Coverage Ratio = Operating Income / Debt Service
   • Indicates the current income to pay current debt.

Stability Ratios

1. Fixed Asset Turnover Ratio = Net Assets / Fixed Assets
   • This indicates the how the efficient the assets are being used.
2. Proprietary Ratio = Shareholder Fund / Total Tangible Assets
   • This indicates the capitalization of assets used.

Coverage Financial Ratio

1. Fixed Interest Cover = Net Profit Before Interest and Tax / Interest Charge
   • Measures the ability to cover fixes charges such as interest and leases.

Efficiency Ratios

1. Capacity Ratio Formula = Actual Hour Worked / Budgeted Hour * 100
   • Measures capacity of production
2. Activity Ratio = Standard Hours for Actual Production / Budgeted Standard Hour * 100
   • Measures planned capacity production.
3. Efficiency Ratio = Standard Hours for Actual Production / Actual Hour Worked * 100
   • Measure actual capacity.

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