To analyze the financial condition of a company, we rely on Financial Statements. Financial ratios, derived from Financial Statements, make this analysis possible. These ratios also come in handy when you need to compare different companies. Let's first understand what these ratios mean. Then, we will look at the different categories they fall into and study the key ratios within each category.
What are Financial Ratios?
They are expressions that give us the relationship between different components of the Financial Statements. When used properly, they tell an important story about the underlying business. However, they must always be used in the context of other ratios and information available on a business .... not on a stand-alone basis.
Important Categories of Financial Ratios
For the investment process, we can group financial ratios into the following categories: Liquidity — how capable is the company in meeting its short-term debt obligations? Asset Turnover — how efficiently does the company use its assets? Leverage — what is the company's debt load like compared to its net worth? Operating Performance/Profitability — how well is the company utilizing its resources to make profits and create shareholder value? Valuation — is the stock price of the company trading at an attractive price? As we delve into the details within each category, we will refer to our fictitious Smart Widget Inc. (SWI) Balance Sheet, Income Statement,and Cash Flow Statement.
Liquidity ratios measure the ability of a company to meet its short-term debt obligations. Here are some of the main ratios covered under this category: Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = 182.02 / 58.37 = 3.1
A current ratio greater than 1 is a rough indication that a companiy has sufficient resources to pay its current liability. Rough because it does not tell us how quickly the company can convert its non-cash current assets into cash to pay off its current liabilities. Hence, this ratio must never be used by itself, but in conjunction with other liquidity ratios. Quick Ratio:
Quicks Ratio = (Cash + Accounts Receivable) / Current Liabilities Quick Ratio = (47.56 + 64.76) / 58.37 = 1.9
The quick ratio is a better indicator of the company's ability to cover its current liabilities since we're only considering that part of the current assets that is in cash, or will be converted to cash within the next 90 days. Our example yields us a quick ratio of 1.9, suggesting that SWI can easily pay off its current liabilities and some more!
ASSET TURNOVER RATIOS
Asset turnover ratios measure the efficiency of a company in using its assets. The main ratios covered in this category are: Receivables Turnover:
How quickly does a company collect its accounts receivables? The receivable turnover ratio helps answer that question. Receivables Turnover = Total Revenue / Accounts Receivable
Total Revenue can be obtained from the Income Statement,while Accounts Receivable is found on the Balance Sheet.Plugging the numbers in for our example, we get: Receivables Turnover = 426.89 / 64.76 = 6.6
Now let's assume that Accounts Receivable was a constant $64.76 million throughout the year. A Receivables Turnover of 6.6 means that this receivable amount was fully paid out and replaced by an equivalent amount of receivables around 7 times in the year. Another way of saying this is Accounts Receivables "turned over" 7 times during the year. It's more convenient to think about this in terms of days. If we divide the days in the accounting period for our example (365) by the Receivables Turnover, we get: Average Receivable Collection Period = 365 / 6.6 = 55 days
So, SWI can expect to collect its receivables in an average of 55 days. This ratio is useful in determining how well a company does in collecting money from its debtors. Inventory Turnover:
This ratio shows the average rate at which inventory moves out of...
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