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# Financial ratios companies

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Will the organization be able to meet its obligations in the short and long term? How effectively is the organization using its resources? Of course, some of the ratios such as the profitability ratios if not assessed against other ratios do not mean anything.

Also, if you want to know more about one company you have to analyze it in comparison with other companies which present the same characteristics, such as industry, geography, customers, and so on. For example, if you are performing analysis on Apple Inc. Instead, you should compare Apple Inc. Although the financial statements give you already a great deal of information about the business, there is still something missing. Financial ratios are a simple way to interpret those financial statements to extract critical insights to assess a company from the inside or the outside.

In short, either you are a manager looking for ways to improve your business. There are several financial ratios to assess the health of a business. Sone of the key ratios used by managers includes the following:. Those financial ratios, in particular, help us assess five things:.

Liquidity is the capacity of a business to find the resources needed to meet its obligations in the short term. For such reason, the liquidity on the Balance Sheet is measured by the presence of Current Assets in excess of Current Liabilities or the relationship between current assets and current liabilities.

For several reasons; Imagine, you are establishing contact with a new supplier. The supplier wants some sort of guarantee that you will be able to meet future obligations. Therefore, he asks for a credit report about your organization. This report shows whether an organization has enough liquidity to sustain its operations in the short term. Based on the main liquidity ratios of your organization a rating will be assigned.

The rating is a grade the organization gets if it meets specific criteria. Based on that rating the supplier will decide whether to entertain business with you or not. Of course, the Rating itself is more qualitative and quantitative.

In other words, the numbers provided by the liquidity ratios will be intersected with other metrics such as profitability ratios and leverage ratios. Another example, imagine you want to open an overdraft account with a local bank. The same scenario applies since the local bank will assess your credit score before approving the overdraft. Thereby, the bank will look at your BS and see how liquid the organization is.

It measures the short-term capability of a business to repay for its obligations:. Also, it depends on the kind of industry you are operating within. Of course, a clothing store or specialty food store will have a much higher current ratio. Thereby the current assets will be 4 or 5 times the current liabilities, mainly due to large inventories.

Other companies, such as the ones operating in the retail industry can have current ratios lower than 1, due to favorable credit conditions from their suppliers. For example, companies such as Burger King will have a ratio as high as 1.

On the Balance Sheet BS the items are listed from the most liquid cash to the least liquid inventories and prepaid expenses. The first section of the BS shows the current assets subsection part of the Assets section. Current Assets are those converted into cash within one accounting cycle.

Therefore, while the current ratio tells us if an organization has enough resources to pay for its obligations within one year or so, the Quick ratio or acid test is a more effective way to measure liquidity in the very short term. Indeed, the quick ratio formula is:. How do we define liquid assets?

Although inventory and pre-paid expenses are current assets, they are not always turned into cash as quickly as anyone would think. The quick ratio will be 1. To assess if there was an improvement in the creditworthiness of the business we have to compare this data with the previous year. Although, a quick ratio of over 1, can generally be accepted, below one is usually seen as undesirable since you will not be able to pay very short-term obligations unless part of the inventories is sold and converted into cash.

This is the third current ratio, less commonly used compared to the current and quick ratio. If the quick ratio is more stringent in comparison to the current ratio, the absolute ratio is the strictest of the three. This is given by:. Generally, cash on hand and marketable securities are part of the absolute assets. The purpose of the absolute ratio is to determine the liquidity of the business in the very short term a few days. Using one current ratio or the other is really up to you, and it depends on the kind of analysis performed.

Of course, if you want to know if an organization would be able to pay in the three-month time frame, then, the Quick Ratio may be a more appropriate measure of liquidity compared to the Current Ratio. For two simple reasons, on the one hand, the Current Ratio is not stable enough to tell whether a company will be able to meet its obligations in the short-term since it comprises items such as Inventories and Prepaid Expenses which are hardly converted into cash.

On the other hand, the Absolute Ratio takes into account just those items, Cash, cash equivalents, and short-term investments which are very volatile. Indeed, I would not be surprised if you saw the Absolute Ratio swinging from one excess to the other. In fact, companies usually invest their cash right away in other long-term assets that will produce future benefits for the organization.

Therefore, unless you are Microsoft, which saves billions in cash reserves, I would not rely on the Absolute Ratio as well. The Financial Statement, which tells us whether a company is making profits or not is the Income Statement or Profit and Loss Statement.

The main profitability ratios used in financial accounting are:. This is the relationship between Gross Profit and sales, and it is expressed in percentages:. This ratio is critical, since for many organizations, in particular, manufacturing, most of the costs are associated with CoGS Cost of Goods Sold.

For example, if you have to produce an Ice cream, you have to buy raw materials to make it. Well, the raw materials and the work needed to produce the final product are considered CoGS. In other words, those are the costs required before the Ice cream can be sold.

Therefore, this measure can be beneficial to assess the operational profitability of the business. In short, the Gross Profit Margin tells us whether we are properly managing our inventories as well. This is a relationship between Operating Profit and Sales, and it is expressed in percentage:. This measure compared to the Gross Profit Margin has a wider spectrum, and it assesses the profitability of the overall operations.

Managers cannot control Taxes and Interest payments although they can reduce the leverage. Therefore, the Operating Profit is the measure that truly tells us how the management is administrating the business. This measure assesses whether the company is profitable enough, considering the capital invested in the business. Indeed, it tells for each dollar invested in the business, how much return is generated.

The ROCE will be 0. Therefore, for every dollar invested in the business the company made 20 cents. The higher the ROCE, the better it is for its stakeholders. Consequently, an increasing ROCE over time is a good sign. This is one of the most used ratios in finance. The formula for the ROE is:. Also, an increasing ROE is a good sign. It means that the shareholders are getting rewarded over time for their risky investments. This leads to more future investments by other shareholders and the appreciation of the stock.

In fact, the problem with this ratio lies in its denominator. For instance, the Net Income is produced through assets that the company bought. Assets can be acquired either through Equity Capital or Debt Liability. Consequently, when companies decide to finance their assets through Debt, usually revenue accelerates at a higher speed compared to interest expenses.

That, in turn, generates an artificially high Return on Equity. For such reason, it is important to use this ratio cautiously and in conjunction with other leverage ratios as well such as the Debt to Equity ratio. The solvency ratios also called leverage ratios help to assess the short and long-term capability of an organization to meet its obligations.

In fact, while the liquidity ratios help us to evaluate in the very short term the health of a business, the solvency ratios have a broader spectrum. Be reminded that the assets can be acquired either through debt or equity. The relationship between debt and equity tells us the capital structure of an organization. Until debt helps the organization to grow this leads to an optimal capital structure. When, instead, the debt grows and interest expenses grow exponentially too much this can be a real problem.

Consequently, the Solvency Ratios help us to answer questions such as: Is the company using an optimal capital structure? If not, is debt or equity the problem? If the debt is the problem, will the company be able to repay its contracted debt through its earnings?

This ratio explains how much more significant is the debt in comparison to equity. This ratio can be expressed either as a number or a percentage. The debt to equity ratio is also defined as the gearing ratio and measures the level of risk of an organization.

Indeed, too much debt generates high-interest payments that slowly erode the earnings. When things go right, and the market is favorable companies can afford to have a higher level of leverage. However, when economic scenarios change such companies find themselves in financial distress.

Indeed, as soon as the revenues slow down, they are not able to repay their scheduled interest payments. Therefore, those companies will have to restructure their debt or face bankruptcy, as happened during the economic downturn to many businesses.

Is it good or bad? Of course, a gearing ratio of 4 is very high. This means that if things go wrong for a few months, you will not be able to sustain the business operations. Not all contracted debt is negative. Indeed, debt that allows you to pay fixed interest helps companies to find their optimal capital structure.

Instead, any increase in interest payments may result in burdening indebtedness and consequently financial distress. If we go back to the coffee shop example, the debt to equity ratio of 4 is ok if all the other coffee shops in the neighborhood operate with the same level of risk. It can be that operating margins for the coffee shop are so high that they can handle the debt burden. Imagine the opposite scenario, where all the coffee shops in the area operate with a leverage of 2.

If the price of the raw materials skyrocket, you will have to raise the cost of the coffee cup. This, in turn, will slow down the revenues. While many coffee shops in the neighborhood will be able to handle the situation, your coffee shop with a gearing of 4 will go bankrupt after a while. This ratio helps us to further investigate the debt burden a business carries.

In the previous example, we saw how the leverage could lead to financial distress. The interest coverage tells us if the earnings generated are enough to cover the interest expenses. Indeed the interest coverage formula is:.

The EBIT earnings before interest and taxes has to be large enough to cover the interest expense. A low ratio means that the company has too much debt and earnings are not enough to pay for its interest expense. A high ratio means instead the company is safe. Keep in mind that being too safe can be limiting as well. In fact, an organization that is not able to leverage on debt may miss many opportunities or become the target of larger corporations.

How do we compute the interest coverage ratio? Therefore you will get the EBIT. Take the EBIT and divide it by your interest expense. This implies that the EBIT is 1. Therefore the company generates just enough operating earnings to cover for its interest. However, it is very close to the critical level of 1.

Below one the company is risky. Indeed, it may be short of liquidity and close to bankruptcy anytime soon. The formula is:. How do we compute the debt to asset ratio? A ratio lower than 0. For enterprise. Last edited May — 3 min read. This is one of the most frequently used types of financial ratios, giving a quick indicator of business liquidity.

To calculate the quick ratio, you must subtract current inventory from current assets and then divide this by liabilities:. If the quick ratio is greater than one, the business is in a good financial position. Another financial ratio to consider is debt to equity. This looks at whether or not a business is borrowing more than it can reasonably pay back using equity as a metric.

To calculate debt to equity, you must divide total liabilities by shareholders equity:. When this ratio is greater than one, the company holds more debt. If the value is below one, it indicates that the company holds less debt. A third ratio pertaining to liabilities is the working capital ratio, also known as the current ratio. Like the quick ratio, this looks at how well a company can pay its existing debts.

The working capital ratio looks like this when written as a formula:. The higher the working capital ratio, the easier it will be for a business to pay off debts using its current assets. In other words, it measures the amount an investor would pay for each dollar earned. This gives you a quick idea if a stock is under or overvalued. Along these same lines is the earnings per share or EPS, another quick ratio to use when assessing future earnings.

To calculate EPS, you must divide net income by the number of outstanding common shares during the financial year. This can potentially be a negative number, if the company has traded at a loss over the year. Speaking of profitability, the profit margin is one of the fundamental financial ratios to be aware of. This shows you how efficiently a company is managing its overall costs, or how well it converts revenue into profit. The formula for profit margin is:.

You can then multiply the result by to convert it into a percentage. The higher the profit margin, the more efficient the company is in converting sales to profits. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices.