Understanding Financial Ratios

Numbers in the financial statements by itself gives us a decent understanding of the business. But as Albert Einstein mentioned, “All things are relative”. A business making $1million consistently may sound like a good business until you realize that the business requires $100million of capital to operate. Such a business only gives 1% return. We might as well put our money in long term bonds which carries minimum risk.

 

So to help us put things into perspective, we can use ratios to better guide us in understanding the business. Ratios are a comparison of 2 numbers. Like the example we just mentioned, if a business is making $1million and it has capital of $100million, we can get the ratio of Return on Capital = $1million/ $100million = 0.01 or 1%.

 

This gives us a view of really how profitable this business is given the sum of capital poured in. And we can see that 1% is not very good.

 

Following this, we would like to share 5 different categories of ratios and the specific ratios used in each categories. The 5 categories are:

 

  1. Profitability Ratios

 

  1. Efficiency Ratios:  Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. This gives us a sensing of how effect the decisions made by the management is.

 

  1. Liquidity Ratios: Liquidity ratios helps us evaluate a company’s ability to meet its current obligations.

 

  1. Leverage Ratios: These ratios concentrate on the long-term health of a business – particularly the effect of the capital/finance structure on the business

 

  1. Investor/ Market Ratio: These ratios will guide us to understanding whether it is a good time to buy the business.

 

 

Profitability Ratios

 

Profitability ratios help users determine the overall effectiveness of management regarding returns generated on sales and investments.

 

 

Ratio What it means The Formula
Profitability
Gross Profit Margin This ratio tells us something about the business’s ability consistently to control its production costs or to manage the margins its makes on products its buys and sells. Whilst sales value and volumes may move up and down significantly, the gross profit margin is usually quite stable (in percentage terms). However, a small increase (or decrease) in profit margin, however caused can produce a substantial change in overall profits. [Gross Profit / Revenue] x 100 (expressed as a percentage
Operating Profit Margin Assuming a constant gross profit margin, the operating profit margin tells us something about a company’s ability to control its other operating costs or overheads. [Operating Profit / Revenue] x 100 (expressed as a percentage)
Return on capital employed (“ROCE”) ROCE is sometimes referred to as the “primary ratio”; it tells us what returns management has made on the resources made available to them before making any distribution of those returns. Net profit before tax, interest and dividends (“EBIT”) / total assets (or total assets less current liabilities
Efficiency
Sales /Capital Employed A measure of total asset utilisation. Helps to answer the question – what sales are being generated by each pound’s worth of assets invested in the business. Note, when combined with the return on sales (see above) it generates the primary ratio – ROCE. Sales / Capital employed
Sales or Profit / Fixed Assets This ratio is about fixed asset capacity. A reducing sales or profit being generated from each pound invested in fixed assets may indicate overcapacity or poorer-performing equipment. Sales or profit / Fixed Assets
Stock Turnover Stock turnover helps answer questions such as “have we got too much money tied up in inventory”? An increasing stock turnover figure or one which is much larger than the “average” for an industry, may indicate poor stock management. Cost of Sales / Average Stock Value
Credit Given / “Debtor Days” The “debtor days” ratio indicates whether debtors are being allowed excessive credit. A high figure (more than the industry average) may suggest general problems with debt collection or the financial position of major customers. (Trade debtors (average, if possible) / (Sales)) x 365
Credit taken / “Creditor Days” A similar calculation to that for debtors, giving an insight into whether a business is taking full advantage of trade credit available to it. ((Trade creditors + accruals) / (cost of sales + other purchases)) x 365
Liquidity
Current Ratio A simple measure that estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time. Current Assets / Current Liabilities
Quick Ratio (or “Acid Test” Not all assets can be turned into cash quickly or easily. Some – notably raw materials and other stocks – must first be turned into final product, then sold and the cash collected from debtors. The Quick Ratio therefore adjusts the Current Ratio to eliminate all assets that are not already in cash (or “near-cash”) form. Once again, a ratio of less than one would start to send out danger signals. Cash and near cash (short-term investments + trade debtors)
Solvency
Gearing Gearing (otherwise known as “leverage”) measures the proportion of assets invested in a business that are financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not “optional” in the same way as dividends. However, gearing can be a financially sound part of a business’s capital structure particularly if the business has strong, predictable cash flows. Borrowing (all long-term debts + normal overdraft) / Net Assets (or Shareholders’ Funds)
Interest cover This measures the ability of the business to “service” its debt. Are profits sufficient to be able to pay interest and other finance costs? Operating profit before interest / Interest
Market Valuation
Earnings per share (“EPS”) EPS measures the overall profit generated for each share in existence over a particular period. Earnings (profits) attributable to ordinary shareholders / Weighted average ordinary shares in issue during the year
Price-Earnings Ratio (“P/E Ratio”) At any time, the P/E ratio is an indication of how highly the market “rates” or “values” a business. A P/E ratio is best viewed in the context of a sector or market average to get a feel for relative value and stock market pricing.

 

Market price of share / Earnings per Share
Dividend Payout This is known as the “payout ratio”. It provides a guide as to the ability of a business to maintain a dividend payment. It also measures the proportion of earnings that are being retained by the business rather than distributed as dividends.

 

(Latest dividend per ordinary share /Earnings Per  Share) x 100
Dividend Yield Dividend yield is a way to measure how much cash flow you are getting for each dollar 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.

 

(Latest dividend per ordinary share / Share Price) x 100
Price to 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.

 

A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that this varies by industry.

 

This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately.

Share Price/ Book Value Per Share
Price Earnings to Growth The price/earnings to growth (PEG) ratio is used to determine a stock’s value while taking the company’s earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. While a high P/E ratio may make a stock look like a good buy, factoring in the company’s growth rate to get the stock’s PEG ratio can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. P/E ratio/Annual EPS Growth

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Cheers,
Mind Kinesis Research Team

 

 

 

 

 

 

 

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