Financial Ratios

Financial ratios measure liquidity, activity, leverage, and profitability of a company as a ratio to be able to compare it to other companies. Financial ratios can be used to find the most profitable sectors of the economy and to find the most profitable companies within those sectors. A company can also be compared to its past performance, to see if certain measures are increasing or decreasing, or not moving at all. For instance, a growing company increases revenues and usually profits, from year to year, but is the company becoming more or less profitable as it grows in size? A financial ratio, such as net profit margin, can provide the answer.

Financial ratios are often used to screen stocks by stipulating that a company’s financial ratio be a certain minimum or maximum amount, depending on the investor’s objective.

The numerators and denominators of financial ratios come primarily from either the company’s balance sheet or its income statement. Many websites that provide stock quotes also provide most of the common financial ratios, so investors rarely have to calculate it themselves, although understanding how financial ratios are calculated helps the investor to understand what they mean and their relative importance as well as understanding how they are limited.

Here is a quick overview of the most common financial ratios:

• Liquidity measures show how well a company can meet its current obligations and to pay its debt during the year or during a business cycle.
  • Working capital is what is left after subtracting current liabilities from current assets. It's not really a ratio nor can it be used by itself to compare against other companies.
  • Current ratio is equal to current assets divided by current liabilities.
• Activity ratios measure compare how well a company uses its assets to generate profits and stockholders' equity.
  • Account receivable turnover is annual sales divided by accounts receivable, which measures how well the company collects what is owed to it.
  • Inventory turnover is equal to annual sales or cost of goods sold divided by the average worth of its inventory, which shows how well a company manages its inventory.
  • Total asset turnover is equal to annual sales divided by total assets, which shows how much sales are earned for each dollar invested in assets.
• Leverage ratios compare the amount of debt to equity or earnings.
  • Debt-equity ratio is equal to long-term debt divided by stockholders' equity. This ratio measures how much debt is being used to finance operations. A high debt-equity ratio indicates significant risk for the investor, since there is great potential that the company will get into financial trouble, especially in economic downturns.
  • Times interest earned is equal to earnings before interest and taxes divided by interest expense. The ratio shows how much more earnings are compared to its interest payments. If this ratio is low, it indicates significant risk to the investor.
• Profitability ratios compare a company's profit to sales, assets, or equity.
  • Net profit margin is equal to net profit divided by total revenues. This ratio shows how much pricing power the company for its products and how well it minimizes its costs.
  • Return on assets (ROA) is equal to net profit divided by total assets. This shows the return that the company can generate for each dollar of assets.
  • Return on equity (ROE) or return on investment (ROI) is equal to net profit divided by stockholders' equity. This ratio measures the return for each dollar invested in the company.