Financial Ratios & Terms

What are Financial Ratios?
How do Financial Ratios help your Business?
Types of Financial Ratios

Financial Terms: #A-E, F-L, M-S, T-Z

What are Financial Ratios?

Wikpedia:

A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm’s creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies.[1] If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

http://en.wikipedia.org/wiki/Financial_ratio

 

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How do Financial Ratios help my Business?

 

Financial Ratios are used in a number of fields, including investing, start-ups, banking, mergers and acquisitions, divestitures, corporate management, and more.

These ratios help you make the right decision in different scenarios. They quantify numbers that are meaningless on their own, identify important notions of business industries and operations, and allow you to compare different set of variables with respect to each other.

 

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Types of Financial Ratios

Operating Performance Ratios

    • Fixed-Asset Turnover: A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company’s ability to generate net sales from fixed-asset investments – specifically property, plant and equipment (PP&E) – net of depreciation. A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues.
    • Operating Cycle: Expressed as an indicator (days) of management performance efficiency, the operating cycle is a “twin” of the cash conversion cycle. While the parts are the same – receivables, inventory and payables – in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

Cash Flow Indicator Ratios

Free cash flow is most often defined as operating cash flow minus capital expenditures, which, in analytical terms, are considered to be an essential outflow of funds to maintain a company’s competitiveness and efficiency.

The cash flow remaining after this deduction is considered “free” cash flow, which becomes available to a company to use for expansion, acquisitions, and/or financial stability to weather difficult market conditions. The higher the percentage of free cash flow embedded in a company’s operating cash flow, the greater the financial strength of the company.

    • Operating Cash Flow/Sales Ratio: This ratio, which is expressed as a percentage, compares a company’s operating cash flow to its net sales or revenues, which gives investors an idea of the company’s ability to turn sales into cash.

It would be worrisome to see a company’s sales grow without a parallel growth in operating cash flow. Positive and negative changes in a company’s terms of sale and/or the collection experience of its accounts receivable will show up in this indicator.

    • Cash Flow Coverage Ratio: This ratio measures the ability of the company’s operating cash flow to meet its obligations – including its liabilities or ongoing concern costs.

The operating cash flow is simply the amount of cash generated by the company from its main operations, which are used to keep the business funded.

The larger the operating cash flow coverage for these items, the greater the company’s ability to meet its obligations, along with giving the company more cash flow to expand its business, withstand hard times, and not be burdened by debt servicing and the restrictions typically included in credit agreements.

    • Dividend Payout Ratio: This ratio identifies the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. The dividend payout ratio is an indicator of how well earnings support the dividend payment.

Here’s how dividends “start” and “end.” During a fiscal year quarter, a company’s board of directors declares a dividend. This event triggers the posting of a current liability for “dividends payable.” At the end of the quarter, net income is credited to a company’s retained earnings, and assuming there’s sufficient cash on hand and/or from current operating cash flow, the dividend is paid out. This reduces cash, and the dividends payable liability is eliminated.
 
Liquidity Measurement Ratios

    • Current Ratio: The concept behind this ratio is to ascertain whether a company’s short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.
    • Quick Ratio: The quick ratio – aka the quick assets ratio or the acid-test ratio – is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.
    • Cash Ratio: The cash ratio is an indicator of a company’s liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities.
    • Cash Conversion Cycle: This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable. The cash conversion cycle (CCC) measures the number of days a company’s cash is tied up in the production and sales process of its operations and the benefit it gets from payment terms from its creditors. The shorter this cycle, the more liquid the company’s working capital position is. The CCC is also known as the “cash” or “operating” cycle.

Profitability Indicator Ratios

    • Profit Margin Analysis: In the income statement, there are four levels of profit or profit margins – gross profit, operating profit, pretax profit and net profit. The term “margin” can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.

Basically, it is the amount of profit (at the gross, operating, pretax or net income level) generated by the company as a percent of the sales generated. The objective of margin analysis is to detect consistency or positive/negative trends in a company’s earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company’s earnings that drive its stock price.

    • Effective Tax Rate: This ratio is a measurement of a company’s tax rate, which is calculated by comparing its income tax expense to its pretax income. This amount will often differ from the company’s stated jurisdictional rate due to many accounting factors, including foreign exchange provisions. This effective tax rate gives a good understanding of the tax rate the company faces.
    • Return On Assets: This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.
    • Return On Equity: This ratio indicates how profitable a company is by comparing its net income to its average shareholders’ equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
    • Return On Capital Employed: The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equity to reflect a company’s total “capital employed”. This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base.

By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
 
Debt Ratios

    • Overview of Debt: An amount of money borrowed by one party from another. Many corporations/individuals use debt as a method for making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
    • Debt Ratio: A ratio that indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load.
    • Debt-Equity Ratio: A measure of a company’s financial leverage calculated by dividing its total liabilities by stockholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets.
    • Capitalization Ratio: The capitalization ratio measures the debt component of a company’s capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders’ equity) to support a company’s operations and growth.
    • Interest Coverage Ratio: A ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) of one period by the company’s interest expenses of the same period
    • Cash Flow to Debt Ratio: 1. A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities – financing, operations or investing – although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance.
      2. An accounting statement called the “statement of cash flows”, which shows the amount of cash generated and used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a company’s financial strength.

Investment Valuation Ratios

    • Per Share Data: Per-share data can involve any number of items in a company’s financial position. In corporate financial reporting – such as the annual report, Forms 10-K and 10-Q (annual and quarterly reports, respectively, to the SEC) – most per-share data can be found in these statements, including earnings and dividends.
    • Price/Book Value Ratio: A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.
    • Price/Cash Flow Ratio: A measure of the market’s expectations of a firm’s future financial health. Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to the price-earnings ratio, this measures provides an indication of relative value.
    • Price/Earnings Ratio: A valuation ratio of a company’s current share price compared to its per-share earnings.
    • Price/Earnings to Growth Ratio: A ratio used to determine a stock’s value while taking into account earnings growth.
    • Price/Sales Ratio: A ratio for valuing a stock relative to its own past performance, other companies or the market itself. Price to sales is calculated by dividing a stock’s current price by its revenue per share for the trailing 12 months.
    • Dividend Yield: A ratio for valuing a stock relative to its own past performance, other companies or the market itself. Price to sales is calculated by dividing a stock’s current price by its revenue per share for the trailing 12 months.
    • Enterprise Value Multiple: A ratio used to determine the value of a company. The enterprise multiple looks at a firm as a potential acquirer would, because it takes debt into account – an item which other multiples like the P/E ratio do not include.
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All information found at http://www.investopedia.com/