Financial ratio analysis is one quantitative tool that business managers use to gather valuable insights into a business firm's profitability, solvency, efficiency, liquidity, coverage, and market value. Ratio analysis provides this information to business managers by analyzing the data contained in the firm's balance sheet, income statement, and statement of cash flows. The information gathered from financial ratio analysis is invaluable to managers who have to make financial decisions for the business and to external parties, like investors, so that they may evaluate the financial health of the business.
What Is Financial Ratio Analysis?
Financial ratios are useful tools that help business managers and investors analyze and compare financial relationships between the accounts on the firm's financial statements. They are one tool that makes financial analysis possible across a firm's history, an industry, or a business sector.
Financial ratio analysis uses the data gathered from the calculation of the ratios to make decisions about improving a firm's profitability, solvency, and liquidity.
Types of Financial Ratios
There are six categories of financial ratios that business managers normally use in their analysis. Within these six categories are 15 financial ratios that help a business manager and outside investors analyze the financial health of the firm. Financial ratios are only valuable if there is a basis of comparison for them. Each ratio should be compared to past time periods of data for the business. They can also be compared to data for other companies in the industry.
It's important to note that financial ratios are only meaningful in comparison to other ratios for different time periods within the firm. They can also be used for comparison to the same ratios in other industries, for other similar firms, or for the business sector.
The liquidity ratios answer the question of whether a business firm can meet its current debt obligations with its current assets. There are three major liquidity ratios that business managers look at:
- Working capital ratio: This ratio is also called the current ratio (current assets - current liabilities). These figures are taken off the firm's balance sheet. It measures whether the business can pay its short-term debt obligations with its current assets.
- Quick ratio: This ratio is also called the acid test ratio (current assets - inventory/current liabilities). These figures come from the balance sheet. The quick ratio measures whether the firm can meet its short-term debt obligations without selling any inventory.
- Cash ratio: This liquidity ratio (cash + cash equivalents/current liabilities) gives a financial manager a more conservative view of the firm's liquidity since it uses only cash and cash equivalents, such as short-term marketable securities, in the numerator. It indicates the ability of the firm to pay off all its current liabilities without liquidating any other assets.
Efficiency ratios, also called asset management ratios or activity ratios, are used to determine how efficiently the business firm is using its assets to generate sales and maximize profit or shareholder wealth. They measure how efficient the firm's operations are internally and in the short term. The four most commonly used efficiency ratios calculated from information from the balance sheet and income statement are:
- Inventory turnover ratio: This ratio (sales/inventory) measures how quickly inventory is sold and restocked or turned over each year. The inventory turnover ratio allows the financial manager to determine if the firm is stocking out of inventory or holding obsolete inventory.
- Days sales outstanding: Also called the average collection period (accounts receivable/average sales per day), this ratio allows financial managers to evaluate the efficiency with which the firm is collecting its outstanding credit accounts.
- Fixed assets turnover ratio: This ratio (sales/net fixed assets) focuses on the firm's plant, property, and equipment, or its fixed assets, and assesses how efficiently the firm uses those assets.
- Total assets turnover ratio: The total assets turnover ratio (sales/total assets) rolls the evidence of the firm's efficient use of its asset base into one ratio. It allows the financial manager to analyze how efficiently the asset base is at generating sales and profitability.
A business firm's solvency, or debt management, ratios allow the financial manager to appraise the position of the business firm with regard to the debt financing, or financial leverage, that they use to finance their operations. The solvency ratios gauge how much debt financing the firm uses as compared to either its retained earnings or equity financing. There are two major solvency ratios:
- Total debt ratio: The total debt ratio (total liabilities/total assets) measures the percentage of funds for the firm's operations obtained by a combination of current liabilities plus its long-term debt.
- Debt-to-equity ratio: This ratio (total liabilities/total assets - total liabilities) is most important if the business is publicly traded. The information from this ratio is essentially the same as from the total debt ratio, but it presents the information in a form that investors can more readily utilize when analyzing the business.
The coverage ratios measure the extent to which a business firm can cover its debt obligations and meet the associated costs. Those obligations include interest expenses, lease payments, and, sometimes, dividend payments. These ratios work with the solvency ratios to give a financial manager a full picture of the firm's debt position. Here are the two major coverage ratios:
- Times interest earned ratio: This ratio (earnings before interest and taxes (EBIT)/interest expense) measures how well a business can service its total debt or cover its interest payments on debt.
- Debt service coverage ratio: The DSCR (net operating income/total debt service charges) is a valuable summary ratio that allows the firm to get an idea of how well the firm can cover all of its debt service obligations.
Profitability ratios are the summary ratios for the business firm. When profitability ratios are calculated, they sum up the effects of liquidity management, asset management, and debt management on the firm. The four most common and important profitability ratios are:
- Net profit margin: This ratio (net income/sales) shows the profit per dollar of sales for the business firm.
- Return on total assets (ROA): The ROA ratio (net income/sales) indicates how efficiently every dollar of total assets generates profit.
- Basic earning power (BEP): BEP (EBIT/total assets) is similar to the ROA ratio because it measures the efficiency of assets in generating sales. However, the BEP ratio makes the measurement free of the influence of taxes and debt.
- Return on equity (ROE): This ratio (net income/common equity) indicates how much money shareholders make on their investment in the business firm. The ROE ratio is most important for publicly traded firms.
Market Value Ratios
Market Value Ratios are usually calculated for publicly held firms and are not widely used for very small businesses. Some small businesses are, however, traded publicly. There are three primary market value ratios:
- Price/earnings ratio (P/E): The P/E ratio (stock price per share/earnings per share) shows how much investors are willing to pay for the stock of the business firm per dollar of profits.
- Price/cash flow ratio: A business firm's value is dependent on its free cash flows. The price/cash flow ratio (stock price/cash flow per share) assesses how well the business generates cash flow.
- Market/book ratio: This ratio (stock price/book value per share) gives the financial manager another indicator of how investors view the value of the business firm.
How Does Financial Ratio Analysis Work?
Financial ratio analysis is used to extract information from the firm's financial statements that can't be evaluated simply from examining those statements.
In order to perform financial ratio analysis, a financial manager gathers together the firm's balance sheet, income statement, and statement of cash flows, along with stock price information if the firm is publicly traded. Usually, this information is downloaded to a spreadsheet program.
Small businesses can set up their spreadsheet to automatically calculate each of the 15 financial ratios.
Ratios are generally calculated for either a quarter or a year. Ratios then should be gathered for other companies in the same industry. Comparisons should be made. It is only after comparing the financial ratios to other time periods and to the companies' ratios in the industry that a financial manager can draw conclusions about the firm performance. Financial managers can paint a good picture of firm performance based on these calculations and comparisons.
One ratio calculation doesn't offer much information on its own. For example, if a firm's debt-to-asset ratio for one time period is 50%, that doesn't tell a useful story unless management compares it to previous periods, especially if the debt-to-asset ratio was much lower or higher historically. In this scenario, the debt-to-asset ratio shows that 50% of the firm's assets are financed by debt. The financial manager or an investor wouldn't know if that is good or bad unless he compares it to the same ratio from previous company history or to the firm's competitors.
Performing an accurate financial ratio analysis and comparison helps companies gain insight into their financial position so that they can make necessary financial adjustments to enhance their financial performance.
There are other financial analysis techniques that financial managers can use to add to the insights gained through financial ratio analysis such as common size analysis and a more in-depth analysis of the statement of cash flows.
Who Uses Financial Ratio Analysis?
There are several stakeholders who might need to use financial ratio analysis:
- Financial managers: Financial managers must have the information that financial ratio analysis imparts about the performance of the various financial functions of the business firm. Ratio analysis is a valuable and powerful financial analysis tool.
- Competitors: Other business firms find the information about the other firms in their industry important for their own competitive strategy.
- Investors: For either publicly traded firms or firms financed by venture capital, potential investors need the financial information gleaned from ratio analysis to determine whether or not they want to invest in the business.
Pros and Cons of the Use of Financial Ratios
|Pros and Cons of Financial Ratio Analysis|
|Helpful in setting goals for high
|Large, multidivisional firms can only use it on a divisional basis.|
|Useful for smaller firms with a narrow focus or divisions of large firms||In times of high inflation, financial data is distorted and not useful for ratio analysis.|
|Useful to analyze firm performance across periods of time||Firms can cheat and window dress their financial statements.|
|Useful to compare firms on a cross-sectional or industry analysis||Not useful for seasonal or cyclical firms due to time distortion|
- Helpful in setting goals for high performance: Through financial ratio analysis, financial and business managers can determine acceptable financial performance for the business firm. The firm can see what is a realistic performance by viewing its own performance across time and aspire to better performance by looking at the industry leader's financial data.
- Useful for small firms with a narrow focus or divisions of large firms: Large, multidivisional firms don't find financial ratio analysis useful for the firm as a whole. Since ratios are only useful when compared to industry or firm financial data, smaller firms with one line of business or the divisions of larger firms find ratio analysis useful.
- Useful to analyze a firm performance across periods of time: Time-series or trend financial ratio analysis lets firms evaluate financial performance across periods of time such as a quarter or a fiscal year.
- Useful to compare firms on a cross-sectional or industry basis: Comparing a firm's financial performance to a group of similar firms within an industry allows the financial manager to see where the firm stands competitively.
- Not useful for large, multidivisional firms: Since ratio analysis is only useful on a comparative basis, divisions of large firms can use this financial analysis technique, but it is not useful for a multidivisional company as a whole.
- Problems if there is inflation: If the business firm is operating in an inflationary environment, financial data will be distorted from one time period to another and ratio analysis will not be useful
- Window dressing: Firms can cheat and window dress their financial statements. Window dressing is the act of making financial statements look stronger but manipulating data.
- Seasonal and cyclical firms: If business firms have seasonal or cyclical sales, financial ratio analysis using time-series data would yield distorted results since sales vary widely between time periods.
- Financial ratio analysis assesses the performance of the firm's financial functions of liquidity, asset management, solvency, and profitability.
- Financial ratio analysis is a powerful tool of financial analysis that can give the business firm a complete picture of its financial performance on both a trend and an industry basis.
- The information gleaned from a firm's financial statements by ratio analysis is useful for financial managers, competitors, and outside investors.
- Financial ratio analysis is only useful if data is compared over several time periods or to other companies in the industry.