Understanding Key Financial Ratios for Business Analysis
Profitability Ratios: How Successfully is the Business Using its Resources to Generate Profit?
Return on Capital Employed (ROCE)
· Measures a company’s profitability and the efficiency with which its capital is employed (Investopedia).
· A higher ROCE indicates more efficient use of capital. ROCE should be higher than the company’s capital cost; otherwise, it indicates that the company is not employing its capital effectively and is not generating shareholder value (Investopedia).
· ROCE considers debt and other liabilities (Investopedia). This provides a better indication of financial performance (Investopedia) for companies with significant debt.
Operating Profit Margin (Net Profit Margin)
· Gives the business owner a lot of important information about the firm’s profitability, particularly with regard to cost control. It shows how much cash is thrown off after most of the expenses are met.
· High operating profit means that the company has good cost control and/or that sales are increasing faster than costs, which is the best situation for the company.
Gross Profit Margin
· Expresses the gross profit as a percentage of the sales revenue. Gives a good indication of financial health. Without an adequate gross margin, a company will be unable to pay its operating and other expenses and build for the future. Gross profit is the amount remaining (if positive) after the cost of sales has been deducted from trading revenue (before day-to-day running costs are deducted).
Efficiency Ratios: How Efficient are the Resources Being Used?
Average Inventories Turnover Period
· Measures the average period for which inventories are being held. Shows how many times a company’s inventory is sold and replaced over time.
· This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying.
· High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.
Liquidity Ratios: Will the Companies Be Able to Make Payments When Necessary?
Current Ratio
The current ratio is a liquidity ratio (Investopedia) that measures a company’s ability to pay short-term (Investopedia) and long-term (Investopedia) obligations. To gauge this ability, the current ratio considers the total assets of a company (both liquid (Investopedia) and illiquid (Investopedia)) relative to that company’s total liabilities (Investopedia).
A ratio under 1 = liabilities are greater than its assets and suggests that the company in question would be unable to pay off its obligations if they came due at that point.
A ratio over 3 = does not necessarily indicate that a company is in a state of financial well-being either. Depending on how the company’s assets are allocated (Investopedia), a high current ratio may suggest that that company is not using its current assets efficiently, is not securing financing well, or is not managing its working capital well.
Acid Test or Quick Ratio
The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its immediate liabilities. Commonly known as the quick ratio (Investopedia), this metric is more robust than the current ratio (Investopedia), also known as the working capital ratio (Investopedia), since it ignores illiquid assets (Investopedia) such as inventory (Investopedia).
Companies with an acid-test ratio of less than 1 do not have the liquid assets (Investopedia) to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that current assets are highly dependent on inventory.
Gearing Ratios: Does the Business Rely on Borrowing?
Gearing Ratio
A general term describing a financial ratio that compares some form of owner’s equity (Investopedia) (or capital) to borrowed funds. Gearing (Investopedia) is a measure of financial leverage (Investopedia), demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds.
The higher a company’s degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry.
Interest Cover Ratio
The interest coverage ratio measures how many times over a company could pay its current interest payment with its available earnings (Investopedia).
It measures the margin of safety a company has for paying interest during a given period, which a company needs to survive future (and perhaps unforeseeable) financial hardship should it arise. A company’s ability to meet its interest obligations is an aspect of a company’s solvency (Investopedia), and is thus a very important factor in the return (Investopedia) for shareholders (Investopedia).
Investment Ratios: Help the Shareholders Understand How the Company Operates
Dividend Per Share
The total of declared dividends for each share of stock issued. Dividends are essentially profit-sharing mechanisms allowing the distribution of company profits to the shareholders who actually own the company.
Earnings Per Share
The portion of a company’s profit allocated to each outstanding share of common stock (Investopedia). Earnings per share serves as an indicator of a company’s profitability (Investopedia).
Is generally considered to be the single most important variable in determining a share’s price. It is also a major component used to calculate the price-to-earnings valuation ratio (Investopedia).
Price to Earnings Ratio
The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price (Investopedia) relative to its per-share earnings (Investopedia).