Financial Statement Analysis Ratios

Financial ratios quantify many aspects of a business and are an integral part of financial statement analysis. To compare the company’s performance, position and stability we have used several ratios. According to the financial aspects of the business we have categorize the ratios as below.

1. Profitability Ratios - measure the firm's use of its assets and control of its expenses to generate an acceptable rate of return.

2. Return on investment - performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

3. Liquidity Ratios - measure the availability of cash to pay debt.

4. Efficiency Ratios - used to analyze how well a company uses its assets and liabilities internally.

5. Gearing Ratios - measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.

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Gross Profit Rate

Gross margin, Gross profit margin or Gross Profit Rate is the difference between the sales and the production costs excluding overhead, payroll, taxation, and interest payments. Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each Rupee of a company's revenue is utilized to cover the costs of goods sold.

It can be expressed in absolute terms:

Gross margin = Net Sales - Cost of goods sold + annual sales return

or as the ratio of gross profit to sales revenue, usually in the form of a percentage:

Gross Profit Margin = (Revenue-Cost of goods sold)/Revenue

However in an insurance concern Gross Profit Margin is calculated by dividing underwriting results by the net earned premium.

While net earned premium is the result of gross written primium  net of premiums ceded to re- insurers, underwriting results reflect the net earned premium after deducting insurance cliams, transfers to long term ins fund etc.

Formula for Gross Profit Rate

Gross Profit Rate (Year 2009)          =          Gross Profit  * 100

                                                                        Revenue

Gross Profit Markup

The mathematical relationship between Gross Profit Markup and Gross Profit Margin can be expressed as follows:

Gross Profit Margin (GM) = [Markup/(1 + Markup)]

Thus markup can be defined as an amount added to a cost price in calculating a selling price.

Thus;

Gross Profit Markup = Gross Profit/ Cost of Sales

However in an insurance concern Gross Profit Markup is calculated by dividing underwriting results by the net result of net earned premium minus underwriting resuls.

Gross Profit Markup                         =          Gross Profit  * 100   

                                                                      Cost of sales                          

                                                        =          Gross Profit   *   100

                                                                     Net Revenue- Gross Profit

Operating Profit Rate

In business, operating margin, operating income margin, operating profit margin or return on sales (ROS) is the ratio of operating income (operating profit) divided by net sales, usually presented in percent.

It is a measurement of what proportion of a company's revenue is left over, before taxes and other indirect costs (such as rent, bonus, interest, etc.), after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, such as interest on debt. A higher operating margin means that the company has less financial risk.

Operating Profit Rate                        =          Operating Profit    *   100

                                                                        Net Revenue

Net Profit Rate

Profit margin, net margin, net profit margin or net profit ratio all refer to a measure of profitability. It is calculated by finding the net profit as a percentage of the revenue

Net Profit Rate                                  =          Net Profit    *   100

                                                                        Net Revenue

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Return on Investment (Return on Capital Employed) (BPIT)

ROCE compares earnings with capital invested in the company. It could be considered as one of the key profitability ratios of an insurance company. However this comprises two components, namely Profit Before Earnings and Tax (PBIT) and Capital Employed.

 PBIT

In an insurance concern PBIT is noramlly equivalent to the profit from operations (the numerator of the ratio).

Capital Employed (share holder funds)

In the denominator we have net assets or capital. Capital Employed in general is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities or fixed assets plus working capital.

ROCE uses the reported (period end) capital numbers.

Formula for ROCE (Return on Capital Employed)

ROCE (Return on Capital Employed)               =          PBIT                       *   100

                                                                                                Capital Employed

Return on Equity

Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.

ROE is equal to a fiscal year's net income (after preferred stock dividends but before common stock dividends) divided by total equity (excluding preferred shares), expressed as a percentage. As with many financial ratios, ROE is best used to compare companies in the same industry.

High ROE yields no immediate benefit. Since stock prices are most strongly determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms) for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings reinvested in the company at a high ROE rate, which in turn gives the company a high growth rate.

ROE         =            Profit after I,T & PD x 100

                                    Equity

Return On Assets

An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment".

ROA                 =                 Net Profit* x 100

                                                   Total Assets

ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company.

The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment.

EPS – Earnings Per Share

The EPS formula does not include preferred dividends for categories outside of continued operations and net income. Earning per share for continuing operations and net income are more complicated in that any preferred dividends are removed from net income before calculating EPS.

The portion of a company’s profit allocated to each outstanding share of common stock earning per share serves as an indicator of a company’s profitability. 

EPS     =          Earnings (Profit)

Weighted number of equity shares in issue

When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time.  However, data sources sometimes  simplify the calculation by using the number of shares outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

Price Earning Ratio – P/E

The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E", "PER", "earnings multiple", or simply "multiple") is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation, a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio. The P/E ratio has units of years, which can be interpreted as "number of years of earnings to pay back purchase price", ignoring the time value of money. In other words, P/E ratio shows current investor demand for a company share. The reciprocal of the PE ratio is known as the earnings yield. The earnings yield is an estimate of expected return to be earned from holding the stock if we accept certain restrictive assumptions (a discussion of these assumptions can be found here).

P/E Ratio            =         Market price per share

                                               EPS

Dividend Yield

A financial ratio that shows how much a company pays out in dividends each year relative to its share price.  In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:

Quantifies the relationship between DPS (dividend per share) and market price per share.

Dividend Yield                =       DPS (Dividend Per Share)

                                                         Market Price Per Share

Dividend yield is a way to measure how much cash flow you are getting for each rupee invested in an equity position - in other words, how much "bang for your buck" you are getting from dividends. Investors who require a minimum stream of cash flow from their investment portfolio can secure this cash flow by investing in stocks paying relatively high, stable dividend yields.

Note that dividend yield changes because of two things. First, the stock price goes up (yield drops) or down (yield increases). Second, the company increases the dividend (yield increases) or cuts the dividend (yield drops). However, note that the yield being paid at the time we purchase the stock is what we investment will earn from dividends as long as you hold the stock, regardless of what the share price does. Dividend yield is an important part of your rate of return on an investment. If we purchase a stock that goes up by 8% in a year while paying a 3% dividend, then we've earned 11% on your money.

Dividend Cover

This show how many times over the profits could have paid the dividend. For example, if the dividend cover is 3, this means that the firm's profit attributable to shareholders was three times the amount of dividend paid out.

Dividend Cover   =             Pat  - Prefereance Dividend   

                                                 Ordinary Dividend 

Dividend cover is a measure of the ability of a company to maintain the level of dividend paid out. The higher the cover, the better the ability to maintain dividends if profits drop. These needs to be looked at in the context of how stable a company's earnings are: a low level of dividend cover might be acceptable in a company with very stable profits, but the same level of cover at company with volatile profits would indicate that dividends are at risk. 

Because buyers of high yield shares tend to want a stable income, dividend cover is an important number for income investors. 

 

The inverse of this ratio is the proportion of earnings that belong to ordinary shareholders which are distributed to them. This is known as the dividend payout ratio.

A company who has a dividend cover ratio of 1.0 pays out all earnings in dividends. This means that should earnings fall, the company might be forced to cut annual dividend payments. If the company has financial reserves, it may be able to make the annual payment from these cash reserves in the short term.

Many firms use annual dividend payments as a signal to shareholders and the market of confidence, so in the short term, directors will be reluctant to reduce payments, unless the firm is in trouble.

Dividend Payout

The dividend payout ratio measures the percentage of a company's net income that is returned to shareholders in the form of dividends. 

          Dividend Payout =                       Ordinary Dividend       

                                                        Pat - Prefereance Dividend

The Dividend Payout Ratio is a model for Cash Flow Measurement used by investors to determine if a company is generating a sufficient level of cash flow to assure a continued stream of dividends to them. It is also a measurement of the amount of current net income paid out in dividends rather than retained by the business.

The Dividend Payout Ratio Formula (Cash Flow Measurement Formula) is relatively straightforward: Divide total annual dividend payments by annual Net Income plus Non-cash Expenses minus Non-cash Sales.

Calculating the Dividend Payout Ratio for one year provides a very unreliable indication only. A better approach is to run a trend line on the ratio for several years to see if a general pattern of decline or increase emerges.

This ratio is useful in projecting the growth of company as well. Its inverse, the Retention Ratio (the amount not paid out to shareholders in the form of dividends), can help project a company’s growth.

Measuring Liquidity

Current Ratio

Current Ratio      =                                Current Assets        X 100

                                                             Current Liabilities           

The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies  within the same industry.

This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and prepaid as assets that can be liquidated. The components of current ratio (current assets and current liabilities) can be used to derive working capital (difference between current assets and current liabilities). Working capital is frequently used to derive the working capital ratio, which is working capital as a ratio of sales.

Quick Ratio

An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.

The quick ratio is calculated as:

  Quick Ratio       =         Current Assets   - Inventory     X 100

                                                         Current Liabilities              


The quick ratio is more conservative than the current ratio, a more well-known liquidity measure, because it excludes inventory from current assets. Inventory is excluded because some companies have difficulty turning their inventory into cash. In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength. 

Receivable Days

Receivable days measures the average no of days that a company takes to collect revenue, after a sale has been made. This ratio is an index of the relationship between outstanding receivables and sales achieved over a given period of time.

When a company does credit sales, company will have debtors. There is a credit policy which specifies the no of days given for the customers to pay their amount dues. Thereby the no of days extended depend on the industry. Management should be efficient to collect its debts quickly. Actually this ratio measures the management efficiency. Because it’s important for the liquidity of the company. When the company turns the sales into cash quickly, the company gets a chance to place the cash to use again, normally to reinvest and make more sales.

When the company shortens the receivable days too much it could lose customers. Same as that if the company gives more time for the customers to pay their bills then the company might face a cash shortage. Less no of days is better for the company.

Sometimes high no of receivable days indicates the customers are dissatisfied with the company's product or service, or sales are being made to customers that are less credit-worthy, or sales people have to offer longer payment terms in order to generate sales. 

Receivable Days              =              Closing trade receivables x 365

                   Revenue

Inventory Days

Successful inventory management is an essential part of a company. Too much inventory means paying for storage, possible waste or theft, the opportunity cost that the time and space used to hold onto inventory that remains unsold could have been used instead to buy products that would sell. Having too little inventory, on the other hand, could lead to shortages and possibly missed sales opportunities.

Inventory days indicate the average no of days goods remain in the inventory before being sold. The process of turning of raw materials into cash. Inventory days can be called as days cover, days of inventory or days sales to inventory.

 Inventory days        =               Closing Inventory x 365

                                                       Cost of sales (Revenue)

Lower the no of days in the inventory emphasis the company efficiency. It increases the company liquidity level as well. In other hand low inventory days indicates company is not keeping enough stock on hand to meet demands. Higher the no indicates that there is lack of demand for the product being sold.

Payable Days

Accounts Payables are the debts that must be paid off with in a given period of time. It is the unpaid invoices, bills statement of goods or services rendered by the outside contractors, vendors or suppliers. There is a credit policy which agreed between the company and other party like suppliers. Accounts payables are often referred to as “Payables”. This is a ratio measures how long a company is taking to pay its trade creditors. Trade payables appears on the company‘s balance sheet under current liability section.

Paying bills on time and according to the specific terms and conditions can affect company credit ratings and ultimately business relationships. If the payable days are low it implies that the company pays its liabilities quickly. Normally it’s better to have a larger no of payable days. Because the longer company holds money before paying its bills, company could earn more money by placing money in the bank. This is only true if the company does pay its creditors. But if the company takes long time to settle the payments, the company will be considering as a not worthy company in the industry.

But there may be different terms and conditions exist in which payment for a service is expected. Such as some of the services require payment upon receipt, which means compensation is due immediately after the service is rendered. Others have 10, 30, or 90 day terms in which payment is accepted. Not only that in credit lines, where payment is due once a month, is also a standard practice.

However the accounts payable administrator should keep track of terms and conditions, whether they are following accordingly, otherwise it will create a bad impression of the company within the industry.

                    Payable Days              =           Closing trade payables x 365

         Cost of sales

Asset Turnover

Asset Turnover measures the company’s efficiency, productivity at using its assets in generating sales or revenue. Sometimes this ratio is referred as efficiency ratio, asset utilization ratio or asset management ratio.

Every company had assets of some sort, even it’s a home based business or an international conglomerate, and every company produces goods and services for sale to a consumer market. The asset turnover can be very helpful in measuring progress in each and every area.

Asset Turnover indicates the relationship between the net assets employed and the revenue it yields. This ratio is useful to determine the amount of sales that are generated from each penny of assets. Therefore this ratio is much useful for the growth of the companies to check whether their growing revenue is proportion to sales.  A company should have a proper balance maintained between debt and equity. It indicates a pricing strategy as companies with low profit margins tend to have high asset turnover and those with high profit margins have low asset turnover.

High ration is considered desirable for the company, it indicates the company operating performance. A higher asset turnover ratio represents greater shareholder wealth. A low asset ration means inefficient utilization of fixed assets. Revenue value can be taken from the company’s income statement and the net assets from the balance sheet.

Asset Turnover   =    Revenue

                               Net assets

Debt to Total Assets Ratio

Debt to Total Assets ratio measures a company's financial risk which determines how much of company’s assets have been financed by debt. This ratio measures company’s solvency as well. This is a very broad ratio which includes all the short-and long-term debt and all types of both tangible and intangible assets.

If the ratio is less than one indicates the company’s assets are financed through equity. Same as that ratio is greater than one, most of the company’s assets are financed through debt. Higher the ratio the greater the risk will be associated. More than that higher the ratio indicates the low borrowing capacity of a firm, which in turn will indicate financial flexibility. The number it yields tells investors a number of things.

To improve the Debt to Assets ratio, a company could do so many things like debt-equity swap, an additional stock issue or selling assets to pay down some of the debt. Therefore companies use strategies depending on the conditions and how much they want to improve that debt/asset ratio number.

Actually this ratio differ from one company to another, depend on the company specific situations. Some companies manage to do well with the high no ratio due to number of reasons.

Total Debt x 100

 Total Assets

Advantages and Disadvantages of High Gearing

Advantages of High Gearing

Borrowing may allow the firm to take on profitable projects

Taking on more profitable projects may allow the company to expand and in the future reduce its Gearing ratio

Borrowing may be a quick and cheap form of financing a project compared to other means such as share issues which may not all be taken up

Disadvantages of High Gearing

If the company has low profits then it may struggle to meet interest payments, leading to a higher risk of being liquidated

The firm may find it harder to get further loans, since investors will be put off by the high gearing level

Advantages and Disadvantages of Low Gearing

Advantages of Low Gearing

Changes in interest rates especially upward trends have a lower effect on the firm

Less risk of liquidation occurring due to not being able to pay off interest payments

Reduced Interest payments, so more investment can occur elsewhere and the firm can have more cash flow to take on bigger and potentially more profitable projects

Disadvantages of Low Gearing

The firm is expected to make regular dividend payments

The higher ratio of Shareholder funds will mean that the company will now be owned by its shareholders more relatively.

Gearing Ratio

Gearing Ratio I

Gearing Ratio            =                         Debt x 100

                                                             Equity

Variations to the basic quantification,

Gearing Ratio II

Gearing Ratio         =        Debt       x 100

                                        Debt + Equity

Expresses debt as a function of total   funding profile

What is Gearing?

Gearing is a tool that is used by investors and businesses to show how much of the long term finance came from loans and how much came from shareholder funds. It also shows how exposed the firm is to financial risk.

Gearing Ratio

The Gearing Ratio looks at the level of borrowing that a company has taken on in the form of loans and compares that to the total long term finance that a business has.

As a ratio, obtain a percentage figure from the formula. Since the formula shows the ratio of Loans to (shareholder funds + Loans), the percentage obtained tells us a few things.

High Gearing – where a high % of the long term finance is in the form of loans. A high percentage is a figure that is over 50%.

Low Gearing – where a low % of the long term finance is in the form of loans. A low percentage is a figure that is between 0% and 50%

What Does the Gearing Figure mean for the Business and Shareholders?

Gearing shows a firms exposure to financial risk. A high gearing percentage tells us that the firm has a high level of loans compared to shareholder funds. The high level of loans also means that the firm has to pay a higher interest charge. This means that if profits were low, or did not meet predicted levels then the firm would have a tough time paying off the interest charges, which would affect other areas of the firm e.g. a lower investment into Research & Development for a year. So the greater the gearing percentage the greater the exposure to risk and the risk of interest rate rises.

For shareholders and potential investors the gearing level is important, and as such it is a very important tool when analyzing whether a business is a viable investment:

Potential investors view firms that are highly geared as being a risky investment

Higher gearing raises the exposure to interest rate changes, so investors will be put off investing if they feel that interest rates will rise

Higher gearing means that the company will be in risk of liquidation if it cannot meet interest payments

Investors looking to give a loan to the company will also look at the gearing ratio

A highly geared company will already be paying high interest charges, so investors will be put off from give it a further loan as the firm may not be able to pay it back

A low geared firm is more likely to get a loan from investors since its loan payments are low, and its exposure to risk is also low.