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, other sectors, and other times. 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, with more detailed information in the following articles:

• 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 = current assets – current liabilities. It's not really a ratio nor can it be used by itself to compare against other companies, but it does show how well a company can meet current liabilities and how much money is left over to run the business.
  • Current ratio = current assets / current liabilities. Shows the margin of safety that the company has in paying for current liabilities.
• Activity ratios compare how well a company uses its assets to generate profits and stockholders' equity.
  • Account receivable turnover = annual sales / accounts receivable, which measures how well the company collects what is owed to it.
  • Inventory turnover = annual sales or cost of goods sold / the average worth of its inventory, which shows how well a company manages its inventory.
  • Total asset turnover = annual sales / 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 = long-term debt / 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, because of a greater potential that the company will get into financial trouble, especially in economic downturns.
  • Times interest earned = earnings before interest and taxes (EBIT) / interest expense. This ratio shows how much earnings exceed its interest payments. A low ratio indicates a greater risk of credit default.
• Profitability ratios compare a company's profit to sales, assets, or equity.
  • Net profit margin = net profit / total revenues. This ratio shows how much pricing power the company has for its products and how well it minimizes its costs.
  • Return on assets (ROA) = net profit / 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) = net profit / stockholders' equity. This ratio measures the return for each dollar invested in the company.

Financial ratios may not be as useful for finding the best investments as they once were. This is because many, if not most, securities are purchased as part of an index fund, through exchange traded funds or mutual funds. Fund managers buy and sell shares of stock based on whether they are part of the index they are tracking and how they are tracking that index. For instance, if a fund is based on market capitalization of an index, then fund managers tracking that index will buy more of that stock as it increases in price relative to other stocks in the index, regardless of worsening financial ratios. This partly explains why the most popular stocks often have undesirable financial ratios and why many fund managers, such as Warren Buffett, miss out on the best stocks, because they are unwilling to buy stocks with undesirable financial ratios. Likewise, if a stock is removed from an index, then fund managers tracking that index will sell that stock, regardless of financial ratios. Being part of an index amplifies stock price changes that becomes somewhat dependent on how well the index does. Because most people invest by buying exchange-traded funds or mutual funds, how well a security will do will depend on what, and on how many, indexes it composes. When a security is added to an index or when the security increases in price significantly, then it will benefit more being part of an index that it would if it were not part of an index. A security removed from an index because of declining financials will drop faster than if it never composed an index.

By William C. Spaulding