## What are Financial Ratios?

**Financial ratios are used by the investment community to analyze a company’s finances.**

The ratios are built from items coming from a company’s income statement, balance sheet, and statement of cash flows.

**There are many different financial ratios held within 5 main categories:**

**Performance****Efficiency****Liquidity****Leverage****Valuation**

Using financial ratios, you can begin to dissect a company’s reported financial numbers and get a picture on aspects of the business to **make educated investment decisions.**

You can answer questions like:

*How much of a company’s revenue ends up turning into profit?**Is a company selling its inventory quickly and are they collecting payments quickly?**Does the company have enough cash to pay off its current liabilities due within a year?**Is this company too levered and at risk?**Is this company under-valued or over-valued?*

Financial ratios are only effective for analysis when you **compare** them versus other companies, industries, and benchmarks. You’ll also need to compare them for a company at **different points in time as well.**

In this section below, we’ll walk through the main financial ratios contained within the 5 categories. **I’ll tell you what they are, how to calculate them, what they mean, and how you can interpret them.**

## Performance

**Performance ratios analyze a company’s financial performance.**

### Net Profit Margin Ratio

Net Profit Margin Ratio = Net Income / Revenue

- Amount of net income or profit generated as a percentage of revenues
- Higher is better as it implies that much of a company’s revenue will end up turning into profit

### Gross Profit Margin Ratio

Gross Profit Margin Ratio = Gross Profit / Revenue

- Amount of gross profit generated as a percentage of revenues
- Higher is better for the same reason as above. A high gross profit margin implies that a large amount of revenue will end up becoming gross profit
- Gross profit can be increased by raising prices and increasing revenues or lowering expenses

### Operating Profit Margin Ratio

Operating Profit Margin Ratio = Operating Profit (or EBIT) / Revenue

- Amount of operating profit generated as a percentage of revenue
- Higher is better for the same reasons as a high net profit and gross profit margin ratio
- Operating profit can be increased by increasing revenues or lowering expenses

### Return on Assets (ROA) Ratio

Return on Assets (ROA) Ratio = Net Income / Assets

- Amount of profit generated as a percentage of the company’s total assets
- Tells you how good a company is at managing their assets by determining how much profit they generate with their assets
- A higher ratio is better

### Return on Invested Capital (ROIC) Ratio

Return on Invested Capital (ROIC) Ratio = Net Operating Profit After Tax (NOPAT) / Invested Capital

- Tells investors how much profit is being generated as a percentage to the amount they invested
- It shows how efficiently a company is using invested funds to generate a profit
- Higher is better and a high ROIC has a high correlation to positive stock performance

### Return on Equity (ROE) Ratio

Return on Equity (ROE) Ratio = Net Income / Total Equity

- The amount of profit generated from the amount of equity of a company
- A higher ratio is better and should be compared to other companies within the industry to analyze if it is above, at, or below the average

## Efficiency

**Efficiency ratios analyze how efficiently a company is at managing its assets and resources. **

### Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio = Sales / Accounts Receivables

- Tells you how effective a company is on collection of receivables (or money owed to the company)
- A high ratio shows that the company is conservative in the credit it lends out and has efficient systems in place for collection of funds for that credit
- A low ratio can show that a company is too loose with the credit it gives out and is not able to get those funds back efficiently

### Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

- Shows how effectively a company manages its inventory by turning inventory into sold goods
- A higher inventory turnover ratio is a positive sign because it means that a company is quickly selling its inventory and there is demand for their products

### Accounts Payable Turnover Ratio

Accounts Payable Turnover Ratio = Net Credit Sales / Accounts Payable

- Shows the speed at which a company pays off its accounts payable amounts
- A high ratio shows that a company is quick to pay off people such as their suppliers
- If the ratio is low, it implies the company is slow to pay its suppliers and that slowing can be a reason of concern

### Asset Turnover Ratio

Asset Turnover Ratio = Sales / Total Assets

- Total sales generated as a percentage of total assets of the company
- It shows the company’s efficiency in generating sales from its assets
- A higher ratio is better. When compared to another company, if Company 1 has a higher asset turnover ratio than Company 2, Company 1 shows to be more efficient at generating sales from its assets

### Working Capital Turnover Ratio

Working Capital Turnover Ratio = Sales / Working Capital

- Total sales generated as a percentage of a company’s working capital
- Remember, working capital = current assets – current liabilities
- Therefore, the working capital turnover ratio shows how efficient a company is at using its current assets and current liabilities to produce sales
- A higher ratio is better
- A low ratio can imply that a company has too many assets in accounts receivable and inventory

### Days of Sales Outstanding Ratio

Days of Sales Outstanding Ratio = 365 / Accounts Receivable Turnover Ratio

- Shows how many days it takes for a company to collect on payments after a sale has been made
- Lower is better for this ratio. A lower amount of days shows that a company is quick to collect on payments after it makes a sale

### Days’ Sales in Inventory Ratio

Days’ Sales in Inventory Ratio = 365 / Inventory Turnover Ratio

- Shows the number of days it took a company to sell its inventory
- Lower is better. A lower number for days’ sales in inventory ratio shows that a company takes less days to sell its inventory, meaning that the inventory is liquid and not sitting on shelves

## Liquidity

**Liquidity ratios analyze a company’s ability to pay its short-term and long-term debt obligations.**

### Current Ratio

Current Ratio = Current Assets / Current Liabilities

- Shows the ratio of the amount of current assets a company has versus its amount of current liabilities
- A higher ratio is better because it shows a company has enough current assets to take care of its current liability obligations within 12 months
- A lower ratio can imply that a company will be at risk for distress or default on its short-term obligations

### Quick Ratio

Quick Ratio = (Current Assets – Inventory) / Current Liabilities

- Another ratio to show a company’s ability to take care of its short-term liability obligations with its current assets
- Quick ratio is different from the current ratio because it strips out inventory from the numerator, which takes out one of a company’s most liquid form of assets
- The quick ratio shows the ability of a company to pay its current liabilities without the need to sell its inventory and can be a better gauge on a company’s ability pay its current liabilities than the current ratio
- Higher is better

### Cash Ratio

Cash Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities

- The cash ratio shows a company’s ability to pay its current liabilities with its cash or near cash resources
- This ratio is a more conservative liquidity ratio compared to the current ratio and quick ratio because it shows the most liquid resources a company has to pay off short-term liabilities
- A higher ratio is better

### Operating Cash Flow Ratio

Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

- The operating cash flow ratio shows the ability for a company to pay off its current liabilities with its operating cash flow amount
- A higher ratio is better
- As an example, a operating cash flow ratio of 4.5 would mean that a company could pay off its current liabilities with its operating cash flow amount 4.5 times

## Leverage

**Leverage ratios analyze the amount of capital a company has coming from debt and if there is potential for risk.**

### Debt Ratio

Debt Ratio = Total Debt / Total Assets

- Shows how much debt a company has relative to its assets
- A ratio of greater than one shows that a company has more debt than it does assets
- This can heighten the risk of a company as the debt ratio increases
- A lower debt ratio is usually better

### Debt to Equity Ratio

Debt to Equity Ratio = Total Debt / Total Shareholders’ Equity

- Shows the amount of debt compare to the shareholder’s equity of the company
- A higher ratio shows that a company is using more funds from debt than funds from investors
- A lower ratio is better

### Debt to Capital Ratio

Debt to Capital Ratio = Total Debt / (Total Debt + Total Shareholders’ Equity)

- Shows the company’s amount of debt relative to its total amount of capital
- Gives insight on a companies financial structure
- A lower number is better, as it implies less risk with a company having less debt relative to its total capital amount

### Interest Coverage Ratio

Interest Coverage Ratio = Operating Income (EBIT) / Interest Payments

- Amount of operating income or EBIT relative to the interest payment obligations of a company
- A higher interest coverage ratio is better as it shows that a company is capable of paying its interest payments
- An interest coverage ratio of 4 would mean that a company can pay its interest payments with its EBIT amount 4 times over

### Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio (DSCR) = Operating Income (EBIT) / Total Debt Service

- Amount of EBIT relative to the total debt obligations of a company
- A higher ratio is better and shows how much EBIT is available to pay its total debt service
- Like the example with interest coverage ratio, a DSCR of 4 would mean that a company can pay its total debt service 4 times over with its amount of EBIT

## Valuation

**Valuation ratios are used to try to determine the value of a company.**

### Price to Earnings (P/E) Ratio

Price to Earnings (P/E) Ratio = Price per Share / Earnings per Share (EPS)

- Used for valuing a company based on the price per share on its stock versus the earning per share earned by a company
- When a P/E ratio is high relative to historical values or an industry average, it implies that a stock is over-valued or expensive
- A high ratio would mean that a stocks price per share is much higher than its earnings amount per share
- A low ratio implies that a stock is under-valued or cheap

### Price to Cash Flow (P/CF) Ratio

Price to Cash Flow (P/CF) Ratio = Price per Share / Operating Cash Flow per Share

- A valuation ratio measuring a companies stock price verse its amount of operating cash flow per share
- It shows how much operating cash flow a company can generate relative to its stock price
- Some like to use it over the P/E ratio because EPS can be manipulated through accounting, but cash flow cannot be altered as easily

### Price to Sales (P/S) Ratio

Price to Sales (P/S) Ratio = Price per Share / Total Sales per Share

- Shows the price per share of a company versus the sales amount per share a company generates
- It shows the amount you would pay per share to generate $1 of sales from that stock
- P/S ratio doesn’t take into account earnings or profitability
- A P/S ratio of 5 would mean you are paying $5 for a stock to generate $1 in sales
- A lower ratio implies you are getting a good deal on the price of a stock for $1 in sales

### Price to Earnings to Growth (PEG) Ratio

Price to Earnings to Growth (PEG) Ratio = P/E Ratio / EPS Growth Rate

- Shows a company’s P/E ratio versus the growth rate of its earnings per share (EPS)
- It is used for valuation while also taking into account a company’s earnings growth
- A higher PEG ratio is associated with an over-value or expensive stock
- A lower PEG ratio is associated with a under-valued or cheap stock

### Price to Book Value Ratio

Price to Book Value Ratio = Price per Share / Book Value Per Share

- Shows the price per share of a stock relative to is book value per share of stock
- book value = total assets – total liabilities
- Higher generally means a stock is over-valued and a lower ratio means it is undervalued

### Dividend Yield Ratio

Dividend Yield Ratio = Annual Dividend / Share Price

- Shows the annual dividend issued by a company versus its share price
- Higher dividend yields are generally attractive, but not at the expense of the denominator (share price) decreasing and causing the higher dividend yield

### Dividends Per Share (DPS) Ratio

Dividends per Share (DPS) Ratio = Total Dividends / Shares Outstanding

- Shows the amount of dividends versus the amount of shares outstanding
- This ratio will show investors the amount of dividends they will receive per share of stock
- If you are investing for the purpose of receiving dividends, a higher DPS is attractive
- A lower DPS does not necessarily raise a red flag. It could mean that the company is using funds to reinvest into itself rather than pay dividends. This reinvestment could lead to a larger increase in value of your holdings than the dividend you would have received

### Enterprise Value to EBITDA (EV/EBITDA) Ratio

Enterprise Value to EBITDA (EV/EBITDA) Ratio = EV / EBITDA

- A commonly used valuation ratio showing the entire value of a company versus the amount of EBITDA the company generates
- Used for valuation by those looking to acquire a company because it takes into account the value of debt. If you purchase a company, you are purchasing the equity and debt
- Enterprise Value (EV) = market value of equity + market value of debt – cash or cash equivalents
- EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization
- Lower ratios are seen as under-valued and higher ratios are seen as over-valued

### Enterprise Value to Sales (EV/Sales) Ratio

Enterprise Value to Sales (EV/Sales) Ratio = EV / Sales

- This ratio is used to value a company by looking at its enterprise value versus the sales generated
- It is seen as a more accurate predictor of valuation than the price to sales (P/S) ratio because EV/Sales takes debt into consideration as well
- Lower ratios are seen as under-valued and higher ratios are seen as over-valued