Financial Ratios Research Paper Starter

Financial Ratios

Financial ratios are an important tool to help understand a firm's financial condition. Ratios can be derived from published financial statements and used to compare performance among peers as well as performance within a company over time. This article is devoted to exploring financial ratios in five categories: Profitability, Activity, Liquidity, Leverage and Market Value.

Keywords: Benchmarking; Financial Statement Analysis; Liquidity; Leverage; Market Value; Profitability

Financial Ratios

Overview

Financial ratios allow analysts to synthesize large amounts of financial and accounting information into metrics that can be easily compared and contrasted. Examination of these ratios can help to assess the financial health of a firm. There are numerous parties that utilize financial ratios to provide insight into company performance. Stockholders, potential investors, managers, lenders, creditors, regulatory agencies and competitors are each interested in different ratios.

Financial ratios are often used in benchmarking. Comparisons are made between the financial ratios of a firm and those of its peers or an industry standard. A financial ratio can be used as a yardstick for measuring how the firm stacks up against its competition. Internal comparisons are also commonly made. Looking at historical financial ratios over a period of time can uncover important trends. Financial ratios are an excellent tool for understanding if the company's performance is improving or declining. The results of the ratio analysis can indicate a positive trend or raise red flags for areas of concern.

Each financial ratio is a simple calculation. The inputs for these calculations can be found in a firm's published financial statements. An understanding of the accounting practices is necessary for each firm being compared. When comparing two companies, adjustments might need to be made so that the accounting information is represented in a similar way.

Various questions can be answered by analyzing financial ratios. Are profit margins improving or deteriorating? How well are assets being utilized by the organization? How liquid is the organization? Is the company a good credit risk? Does the company have the ability to meet its interest payments? How much are investors willing to pay for each dollar of earnings? What proportion of net income was paid out in dividends?

There are twenty commonly used financial ratios that are discussed in this article. These ratios fall into five distinct categories:

  • Profitability
  • Activity/Efficiency
  • Liquidity
  • Leverage
  • Market Value

Applications

The following section of this article provides formulas for calculating each ratio and an explanation for why the ratio is valuable.

Profitability Ratios

Profitability Ratios are a set of metrics which illustrate how well a firm is using its resources to earn income. These ratios are helpful in assessing how successful management is at controlling costs and ultimately generating profit for the firm.

Net Profit Margin = Net Profit after Taxes/Net Sales

Net Profits after Taxes and Net Sales numbers are found on a firm's income statement. Net Profit Margin provides information on how much of the firm's revenue makes its way to the bottom line. Profit margins should not be analyzed in isolation. Profit margins from two different companies cannot be simply compared to determine which one is "better." For example, different industries can have wildly different economic models and therefore standard profit margins will vary significantly. In addition, the net profit margin could be low due to some investment for the future. The profit margin also does not take into account the volume of sales. If a company's strategic approach was to be a low cost leader, then the margins might be low. However, the company could still have attractive profits due to the velocity and volume of sales. It is best to compare the profit margins of firms with similar competitive approaches in the same industry. This ratio is also helpful for a company to evaluate its own historical margins over time. Upward movement over time indicates a positive trend.

Return on Sales (or ROS)
Net Sales — Operating Expenses/Net Sales

Net Sales and Operating Expense numbers are found on a firm's income statement. Return on Sales looks at the profit margin from an operational perspective. It excludes the impact of financing and interest payments. As with Net Profit Margin, be mindful of the situation of the firm and the industry when doing a comparison. Just as was seen with Net Profit Margin, upward movement over time indicates a positive trend.

Gross Profit Margin = Net Sales — Cost of Goods Sold/Net Sales

Net Sales numbers are found on a firm's income statement. Cost of Goods Sold is usually found on the income statement. However in some cases, this information is not available in published financial statements. Gross Profit Margin shows the percentage of revenue left after subtracting out the expenses incurred producing the product (e.g., materials and labor). The same caveats for comparing Net and Operating Profit Margin also applies to Gross Profit Margin. The higher the Gross Profit Margin, the more funds available to cover overhead costs and yield a profit.

Return on Assets (or ROA)
Net Profit After Taxes/Average Total Assets

Net Profit after Taxes is found on a firm's income statement and Total Assets are found on the firm's balance sheet. To calculate Average Total Assets, simply add the previous year and current year's Total Assets and divide by 2. Return on Assets is a key profitability indicator. This ratio helps measure how effectively the company is utilizing its assets. The higher the number, the more effective the assets being employed. However, since the capital intensity of each industry differs so significantly, this ratio should not be used to compare firms in different industries.

Return on Equity (or ROE) = Net Profit After Taxes/Stockholder's Equity

Net Profit after Taxes is found on a firm's income statement and Stockholder's Equity is found on the firm's balance sheet. To calculate Average Stockholder's Equity, simply add the previous year and current year's Stockholder's Equity and divide by 2. Return on Equity provides a measure for how well the stockholder's capital contribution is being utilized and translated into profit.

Earnings per Share (or EPS) = Net Income — Preferred Stock Dividends/ Average Number of Shares of Common Stock Outstanding

Net Income after Preferred Stock Dividends is often found on a firm's income statement and Number of Shares of Common Stock Outstanding is often found on the firm's balance sheet. To calculate Average Number of Shares of Common Stock Outstanding, simply add the previous year and current year's Number of Shares of Common Stock Outstanding and divide by 2. The Earnings per Share ratio provides the profit generated for each share of stock. Investors like to see growth in this ratio year over year.

Activity/Efficiency Ratios

Activity Ratios provide insight into how effectively the assets of the organization are being managed. Putting together the results of several of these metrics will show how quickly the firm can convert assets into cash. Proficient asset utilization will lessen the need for additional capital.

Asset Turnover Net Sales/Average Total Assets

Net Sales numbers are found on a firm's income...

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