Financial Ratios

What they mean

In assessing the significance of various financial data, managers often use ratio analysis, the process of determining and evaluating financial ratios. A financial ratio indicates a relationship between a company's activities, for example, the ratio between the company's current assets and current liabilities or between its accounts receivable and its annual sales. The basic source for these ratios is the company's financial statements that contain figures on assets, liabilities, profits, and losses. Ratios are only meaningful when compared with other information. Since they are often compared with industry data, ratios help managers understand their company's performance relative to that of competitors and are often used to trace performance over time. Ratio analysis can reveal much about a company and its operations. However, there are several points to keep in mind about ratios.

First, a ratio is just one number divided by another. Financial ratios are only " flags" indicating areas of strength or weakness. One or even several ratios might be misleading, but when combined with other knowledge of a company's management and economic circumstances, ratio analysis can tell much about a corporation.

Second, there is no single correct value for a ratio. The observation that the value of a particular ratio is too high, too low, or just right depends on the perspective of the analyst and on the company's competitive strategy.

Third, a financial ratio is meaningful only when it is compared with some standard, such as an industry trend, ratio trend, a ratio trend for the specific company being analyzed, or a stated management objective.

Types of analysis

Another type of ratio analysis, cross-sectional analysis, compares the ratios of two or more companies in similar lines of business. One of the most popular forms of cross-sectional analysis compares a company's ratios to industry averages. These averages are developed by statistical services and trade associations and are updated annually.

Financial ratios can also give mixed signals about a company's financial health and can vary significantly among companies, industries, and over time. Other factors should also be considered such as a company's products, management, competitors and vision for the future.

Types of Ratios

The price to earnings (P/E) ratio is calculated by dividing the current market price per share by current earnings per share. It represents a multiplier applied to current earnings to determine the value of a share of the stock in the market. The price-earnings ratio is influenced by the earnings and sales growth of the company, the risk (or volatility in performance), the debt-equity structure of the company, the dividend policy, the quality of management, and a number of other factors. A company's P/E ratio should be compared to those of other companies in the same industry.

Other ratios useful in analyzing a company's balance sheet and income statement:

Liquidity

Liquidity ratios help analyze a company's ability to meet short-term financial obligations.

Example Ratios	Formula	Measures
Current Ratio	total current assets	Ability to pay current debts
Current Ratio	total current liabilities	Ability to pay current debts
Quick ratio/Acid-test ratio	total current assets minus inventory	Ability to convert current assets to cash for the purpose of meeting current liabilities. Called the acid-test -- is a crucial test of the firm's liquidity
Quick ratio/Acid-test ratio	total current liabilities
Working capital	total current assets - current liabilities	Cash flow

Profitability

Profitability ratios help analyze management's ability to control expenses and earn profits through the use of company's resources.

Example Ratios	Formula	Measures
Net profit margin	net profit	Measures percentage of each sales dollar remaining after all expenses
	net sales
Return of equity (ROE)	earnings	Rate of return that owners receive on their investment.
	shareholders equity
Return on investment (ROI)	net profits	Overall effectiveness to generate profits from total investment in assets.
	total assets
Gross Profit Margin	sales - costs of goods sold	Profitability of a company's sales after the cost of sales has been deducted.
	sales

Asset management (efficiency)

Asset Management ratios help analyze how quickly a company's resources can be converted to cash or sales.

Example Ratios	Formula	Measures
Inventory turnover	cost of goods sold	The speed with which inventory moves through the company and is turned into sales.
	inventory
Fixed asset turnover	sales	Extent to which company is utilizing existing property, plant, and equipment to generate sales.
	fixed assets
total asset turnover	sales	How effectively company uses its total resources to generate sales.
	total assets
Average collection period	accounts receivable	Serves as a basis for determining how rapidly a company's credit accounts are being collected.
	average daily credit sales

Debt Management (leverage)

Debt Management ratios help analyze the degree and effect of a company's use of borrowed funds (debt) to finance its operations.

Example Ratios	Formula	Measures
Debt ratio	total debt	The extent to which the total assets of the firm have been financed using borrowed funds.
	total assets
Debt to equity ratio	total debt	The portion of the funds obtained by the companies that came from debt vs. stockholders investments.
	total stockholder's equity
Times interest earned	earning before interest and taxes	The ability to the companies to meet is interest obligations should profits decline.
	total interest charges
Fixed charge coverage	profits before taxes & interest + lease payments	Company's ability to meet all costs long-term fixed costs should profits decline.
	total interest charges + lease obligations

In assessing the significance of various financial data, managers often engage in ratio analysis, the process of determining and evaluating financial ratios. A financial ratio is a relationship that indicates something about a company's activities, such as the ratio between the company's current assets and current liabilities or between its accounts receivable and its annual sales. The basic source for these ratios is the company's financial statements that contain figures on assets, liabilities, profits, and losses. Financial and operating ratios allow one to focus on various areas of business management, to compare results against industry averages, and to the gage the financial health of an investment prospect. Ratios are intended to show relationships between dollars, numbers, and percentages taken from balance sheets and/or income statements.

Ratio analysis can reveal much about a company and its operations. However, there are several points to keep in mind about ratios. First, a ratio is just one number divided by another. Financial ratios are only "flags" indicating areas of strength or weakness. One or even several ratios might be misleading, but when combined with other knowledge of a company's management and economic circumstances, ratio analysis can tell much about a corporation. Second, there is no single correct value for a ratio. The observation that the value of a particular ratio is too high, too low, or just right depends on the perspective of the analyst and on the company's competitive strategy. Third, a financial ratio is meaningful only when it is compared with some standard, such as an industry trend, ratio trend, a ratio trend for the specific company being analyzed, or a stated management objective. Financial and operating ratios allow one to focus on various areas of business management, to compare results against industry averages, and to the gage the financial health of an investment prospect. Ratios are intended to show relationships between dollars, numbers, and percentages taken from balance sheets and/or income statements.

Market share is the ratio of sales of a brand to the total sales of that product-type in a defined area (county, continent, etc.). Market share can also be defined as the ratio of sales of a company's entire product line to the total sales of all related companies. Market share is usually presented as a percentage, although sometimes a raw number of sales or units is provided. If the total raw number is also provided, you can calculate the market share percentage by dividing the brand's number by the total number, and multiplying the result by 100. Market share data is sometimes hard to find.

Some corporate annual reports provide the market share of a company's products (this is particular likely if the company is proud of its market share). Look in the introductory material (the glossy, promotional section) or the management's discussion (a section most annual reports include).

In trend analysis, ratios are compared over time, typically years. Year-to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with three to five years of ratios. The second type of ratio analysis, cross-sectional analysis, compares the ratios of two or more companies in similar lines of business. One of the most popular forms of cross-sectional analysis compares a company's ratios to industry averages. These averages are developed by statistical services and trade associations and are updated annually. Some of these sources will be covered later in this guide.

There are many different ratios and models used today to analyze companies. The most common is the price earnings (P/E) ratio. It is published daily with the transactions of the New York Stock Exchange, American Stock Exchange, and NASDAQ. These quotations show not only the most recent price but also the highest and lowest price paid for the stock during the previous fifty-two weeks, the annual dividend, the dividend yield, the price/earnings ratio, the day's trading volume, high and low prices for the day, the changes from the previous day's closing price. The price to earnings (P/E) ratio is calculated by dividing the current market price per share by current earnings per share. It represents a multiplier applied to current earnings to determine the value of a share of the stock in the market. The price-earnings ratio is influenced by the earnings and sales growth of the company, the risk (or volatility in performance), the debt-equity structure of the company, the dividend policy, the quality of management, and a number of other factors. A company's P/E ratio should be compared to those of other companies in the same industry.

Balance Sheet Ratio Analysis

The following is a listing of some of the ratios to be aware of in analyzing a company's balance sheet and income statement. These ratios fall into four categories - liquidity, profitability, asset management (efficiency), and debt management (leverage).

Liquidity, leverage, profitability, and management ratios allow the business owner to identify trends in a business and to compare its progress with the performance of others through data published by various sources. The owner may thus determine the business's relative strengths and weaknesses.

How to find information on industries

The United States Government is currently in transition between two systems of classifying American industry. The older Standard Industrial Classification Manual lists government SIC codes - 4 digit numbers used to identify industries. The new system, North American Industry Classification System (NAICS codes) provides common industry definitions for Canada, Mexico, and the United States. This system will be phased in and eventually replacethe SIC code. A comparison of the two systems can be found at census.gov.

Where to find standard financial ratios

The following is an annotated list of the "standard" sources of industry ratios. In the introduction of each of these sources, there is a description of how the data for the ratios was obtained and a definition for each ratio is also given.

Troy. Leo. Almanac of Business and Industrial Financial Ratios. Englewood Cliffs, NJ: Prentice Hall. Annual. REF HF 5681 .R25 T7 Cardinal Stritch University Library keeps the most current three years of the Almanac.

Information in this publication is compiled from the tax returns, C and S, filed with the U.S. Internal Revenue Service. It covers approximately 4.7 million active corporate federal income tax returns, including those owned by foreign persons. It provides comparative financial data and benchmarks for 192 industry groups based on IRS corporate tax return data. Ratios are provided for both balance sheet and income statement tables. Income data includes selected expense items as a percentage of sales. The publication profiles corporate performance in two analytical tables for each industry. Table I reports operating and financial information for all corporations, those with and without net income. Table II provides the same information as Table I, but only for corporations with net income. It provides 50 performance indicators for each industry. At the end of each industry section, performance indicators for the last ten years are shown. Data are grouped into 16 categories by size of assets in each industry. Norms in actual dollars for revenue and capital factors such as net receivables, inventories, and total assets are given. It also gives average operating costs in percent of net sales for: cost of operations, pensions and benefits, compensation officers, wages and salaries, taxes and more.

RMA Annual Statement Studies. . Philadelphia, PA: RMA AnnualREF HF 5681 .B2 R58 Cardinal Stritch University Library keeps the most current three years of Annual Statement Studies.

The Risk Management Association (RMA) is a not-for-profit professional association serving the financial services industry. The RMA Annual Statement Studies is compiled from more than 190,000 statements of commercial bank borrowers and prospects. These financial statements come directly to RMA from member institutions, which get their data straight from the customer. Most customers are, according to the RMA, small and medium size businesses. The data is presented by SIC (Standard Industrial Classification Code), with more recent volumes providing access via the North American Industry Classification System (NAICS). The Annual Statement Studies have been published for more than 80 years, making timeline analysis possible.

Financial statements on each industry are shown in common size, and are accompanied by widely used ratios. In general the data for a particular industry appear on both the right and left hand pages. The heading Current Data Sorted By Assets is on the far left. The center section of the double page contains the Comparative Historical Data, with the All Sizes column for the current year shown under the heading 4/1/xx-3/31/xx. Comparable data from past editions of the Annual Statement Studies also appears in this section. To the far right is the display Current Data Sorted by Sales. The information shown at the top of each page includes the identity of the industry group; its Standard Industrial Classification (SIC) or North American Industrial Classification System (NAICS) number; a breakdown by size categories of the types of financial statements reported; the number of statements in each category; the dates of the statements used; and the size categories. For instance, (16 4/1/98-9/30/99) means that 16 statements with fiscal dates between April 1, 1998 and September 30, 1999, make up parts of the sample. More than 600 industries at the four-digit SIC level and at the six-digit NAICS level are covered.

RMA reports three values for each ratio: the upper quartile, median, and lower quartile. For any given ratio, these figures are calculated by first computing the value of the ratio for each financial statement in the sample. These values are then arrayed -- "listed" -- in order from the strongest to the weakest. The array of values is then divided into four asset categories of equal size. The upper quartile is that point at which 1/4 of the array of ratios falls between the strongest ratio and the upper quartile point. The media is the middle value and the lower quartile is that point at which 3/4's of the array falls between the strongest ratio and the lower quartile point. By reporting three values for each ratio, the researcher is able to compare a particular company with the "average" (median) company, as well as with the "typical" companies in the top and bottom halves of the sample.

First time users of the Annual Statement Studies should check the definitions and explanations for ratios provided in the preface. There is also a subject index of industries, an index by SIC/NAICS number, and a bibliography of other sources of financial ratios.

RMA data should be regarded only as general guidelines and not as absolute industry norms. Other considerations that can result in variations among different companies engaged in the same general line of business are different labor markets; geographical location; different accounting methods; quality of products handled; sources and methods of financing; and terms of sale.

Industry Norms and Key Business Ratios. Murray Hill, NJ: Dun & Bradstreet Credit Services. Annual.

This publication is produced from business credit reports and financial statements for more than 400,000 companies. It covers 800 industry groups organized in broad categories. Similar to the Annual Statement Studies, three values for the ratios are calculated: upper quartile, median, and lower quartile. The data are not grouped by size of company and no historical information is provided. Reports are given for 14 key ratios for each industry that indicate solvency, efficiency, and profitability.

Other Sources

If you want to construct your own ratios for corporations, you can find the financial data in a variety of sources. Some of these sources also provide computed financial ratios for companies.

American Stock Exchange: A comprehensive resource for investors and issuers seeking the unique market environment offered at the American Stock Exchange.
Annual Reports: Most publicly held companies publish an annual report containing income statement and balance sheet data, along with other financial information. With the advent of the Internet many companies now post their annual report on their homepage.
Census of Manufacturers: The purpose of this census is to provide periodic and comprehensive statistics about manufacturing establishments, activities, and production. The United States Code, Title 13, requires this census and provides for mandatory responses.
Census of Service Industries: "The Service Annual Survey provides estimates of revenue and other measures for most traditional service industries. The United States Code, Title 13, authorizes this survey and provides for mandatory responses."
Chicago Stock Exchange: The Chicago Stock Exchange provides a vital element of competition to the marketplace.
10K Reports: Publicly owned companies are required to file a 10K report with the Securities and Exchange Commission (SEC) each year. These reports contain income statement and balance sheet data, plus a wide range of other relevant information dealing with the company's past and current performance and expected future prospects. 10K reports can be found at the SEC web site
Trade Journals: These are publications devoted to the needs of a particular industry. Trade journals provide a wide range of current information about the industries they cover. They also publish detailed information on industry trends and industry statistics, some of which are difficult to find elsewhere.
Standard and Poor's NetAdvantage (Online database. Name and barcode number required to access the database).: One of the key resources in this database is the industry surveys. Standard and Poor's Industry Surveys contain data covering all major domestic industries. Each survey includes recent developments, industry basics, and company data. Each survey begins with an examination of the current environment of that particular industry.This is followed by a profile of the industry and trends for the industry. Statistical tables and charts accompany textual material and provide informative background material. The section of importance is the "Comparative Company Analysis." Here the growth in sales and earnings of leading companies in the industry and listed. This allows the tracking of profit margins, dividends, price-earnings ratios, and data for each company over a number of years.
Value Line: The Value Line Investment Survey is a comprehensive source of information and advice on approximately 1,700 stocks, more than 90 industries, the stock market, and the economy. The Value Line Investment Survey's main section, "Ratings & Reports," presents full-page, individual stock reports (encapsulating the company's past performance, current status, and outlook) and industry reviews. The "Summary & Index" provides a key to locating the latest quarterly and supplementary reports and cites the most recent data on each of the stocks followed. Finally, "Selection & Opinion," a feature section, gives Value Line's views on the economy and the stock market and on stocks of special interest. It also provides model portfolios for investors with various objectives and a number of economic and stock-market statistics.

Value Line Sample Entry

Nasdaq: NASDAQ is the largest U.S. electronic stock market. With approximately 3,300 companies, it lists more companies and, on average, trades more shares per day than any other U.S. market.
New York Stock Exchange: As of December 31, 2005, the NYSE was home to approximately 2,672 world-class issuers, which includes operating companies, closed-end funds and exchange traded funds.
Stock Exchanges Worldwide: Stock Exchanges Worldwide Links is a list of world's major stock exchanges and other exchange resources.

Finding

Browsing

Guides