Financial ratios are relationships determined from a company's financial information and used for comparison purposes. Examples include such often referred to measures as return on investment (ROI), return on assets (ROA), and debt-to-equity, to name just three. These ratios are the result of dividing one account balance or financial measurement with another. Usually these measurements or account balances are found on one of the company's financial statements—balance sheet, income statement, cashflow statement, and/or statement of changes in owner's equity. Financial ratios can provide small business owners and managers with a valuable tool with which to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In addition, tracking various ratios over time is a powerful means of identifying trends in their early stages. Ratios are also used by bankers, investors, and business analysts to assess a company's financial status.
Ratios are calculated by dividing one number by another, total sales divided by number of employees, for example. Ratios enable business owners to examine the relationships between items and measure that relationship. They are simple to calculate, easy to use, and provide business owners with insight into what is happening within their business, insights that are not always apparent upon review of the financial statements alone. Ratios are aids to judgment and cannot take the place of experience. But experience with reading ratios and tracking them over time will make any manager a better manager. Ratios can help to pinpoint areas that need attention before the looming problem within the area is easily visible.
Virtually any financial statistics can be compared using a ratio. In reality, however, small business owners and managers only need to be concerned with a small set of ratios in order to identify where improvements are needed.
It is important to keep in mind that financial ratios are time sensitive; they can only present a picture of the business at the time that the underlying figures were prepared. For example, a retailer calculating ratios before and after the Christmas season would get very different results. In addition, ratios can be misleading when taken singly, though they can be quite valuable when a small business tracks them over time or uses them as a basis for comparison against company goals or industry standards.
Perhaps the best way for small business owners to use financial ratios is to conduct a formal ratio analysis on a regular basis. The raw data used to compute the ratios should be recorded on a special form monthly. Then the relevant ratios should be computed, reviewed, and saved for future comparisons. Determining which ratios to compute depends on the type of business, the age of the business, the point in the business cycle, and any specific information sought. For example, if a small business depends on a large number of fixed assets, ratios that measure how efficiently these assets are being used may be the most significant. In general, financial ratios can be broken down into four main categories—1) profitability or return on investment; 2) liquidity; 3) leverage, and 4) operating or efficiency—with several specific ratio calculations prescribed within each.
PROFITABILITY OR RETURN ON INVESTMENT RATIOS
Profitability ratios provide information about management's performance in using the resources of the small business. Many entrepreneurs decide to start their own businesses in order to earn a better return on their money than would be available through a bank or other low-risk investments. If profitability ratios demonstrate that this is not occurring—particularly once a small business has moved beyond the start-up phase—then entrepreneurs for whom a return on their money is the foremost concern may wish to sell the business and reinvest their money elsewhere. However, it is important to note that many factors can influence profitability ratios, including changes in price, volume, or expenses, as well as the purchase of assets or the borrowing of money. Some specific profitability ratios follow, along with the means of calculating them and their meaning to a small business owner or manager.
Gross profitability: Gross Profits/Net Sales—measures the margin on sales the company is achieving. It can be an indication of manufacturing efficiency, or marketing effectiveness.
Net profitability: Net Income/Net Sales—measures the overall profitability of the company, or how much is being brought to the bottom line. Strong gross profitability combined with weak net profitability may indicate a problem with indirect operating expenses or non-operating items, such as interest expense. In general terms, net profitability shows the effectiveness of management. Though the optimal level depends on the type of business, the ratios can be compared for firms in the same industry.
Return on assets: Net Income/Total Assets—indicates how effectively the company is deploying its assets. A very low return on asset, or ROA, usually indicates inefficient management, whereas a high ROA means efficient management. However, this ratio can be distorted by depreciation or any unusual expenses.
Return on investment 1: Net Income/Owners' Equity—indicates how well the company is utilizing its equity investment. Due to leverage, this measure will generally be higher than return on assets. ROI is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROI in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROI can mean that management is doing a good job, or that the firm is undercapitalized.
Return on investment 2: Dividends +/− Stock Price Change/Stock Price Paid—from the investor's point of view, this calculation of ROI measures the gain (or loss) achieved by placing an investment over a period of time.
Earnings per share: Net Income/Number of Shares Outstanding—states a corporation's profits on a per-share basis. It can be helpful in further comparison to the market price of the stock.
Investment turnover: Net Sales/Total Assets—measures a company's ability to use assets to generate sales. Although the ideal level for this ratio varies greatly, a very low figure may mean that the company maintains too many assets or has not deployed its assets well, whereas a high figure means that the assets have been used to produce good sales numbers.
Sales per employee: Total Sales/Number of Employees—can provide a measure of productivity. This ratio will vary widely from one industry to another. A high figure relative to one's industry average can indicate either good personnel management or good equipment.
Liquidity ratios demonstrate a company's ability to pay its current obligations. In other words, they relate to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. All small businesses require a certain degree of liquidity in order to pay their bills on time, though start-up and very young companies are often not very liquid. In mature companies, low levels of liquidity can indicate poor management or a need for additional capital. Any company's liquidity may vary due to seasonality, the timing of sales, and the state of the economy. But liquidity ratios can provide small business owners with useful limits to help them regulate borrowing and spending. Some of the best-known measures of a company's liquidity include:
Current ratio: Current Assets/Current Liabilities—measures the ability of an entity to pay its near-term obligations. "Current" usually is defined as within one year. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business.
Quick ratio (or "acid test"): Quick Assets (cash, marketable securities, and receivables)/Current Liabilities—provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations.
Cash to total assets: Cash/Total Assets—measures the portion of a company's assets held in cash or marketable securities. Although a high ratio may indicate some degree of safety from a creditor's viewpoint, excess amounts of cash may be viewed as inefficient.
Sales to receivables (or turnover ratio): Net Sales/Accounts Receivable—measures the annual turnover of accounts receivable. A high number reflects a short lapse of time between sales and the collection of cash, while a low number means collections take longer. Because of seasonal changes this ratio is likely to vary. As a result, an annual floating average sales to receivables ratio is most useful in identifying meaningful shifts and trends.
Days' receivables ratio: 365/Sales to receivables ratio—measures the average number of days that accounts receivable are outstanding. This number should be the same or lower than the company's expressed credit terms. Other ratios can also be converted to days, such as the cost of sales to payables ratio.
Cost of sales to payables: Cost of Sales/Trade Payables—measures the annual turnover of accounts payable. Lower numbers tend to indicate good performance, though the ratio should be close to the industry standard.
Cash turnover: Net Sales/Net Working Capital (current assets less current liabilities)—reflects the company's ability to finance current operations, the efficiency of its working capital employment, and the margin of protection for its creditors. A high cash turnover ratio may leave the company vulnerable to creditors, while a low ratio may indicate an inefficient use of working capital. In general, sales five to six times greater than working capital are needed to maintain a positive cash flow and finance sales.
Leverage ratios look at the extent to which a company has depended upon borrowing to finance its operations. As a result, these ratios are reviewed closely by bankers and investors. Most leverage ratios compare assets or net worth with liabilities. A high leverage ratio may increase a company's exposure to risk and business downturns, but along with this higher risk also comes the potential for higher returns. Some of the major measurements of leverage include:
Debt to equity ratio: Debt/Owners' Equity—indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt to equity ratio—that is, a higher proportion of owner-supplied capital—though a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity.
Debt ratio: Debt/Total Assets—measures the portion of a company's capital that is provided by borrowing. A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt. This ratio is similar, and can easily be converted to, the debt to equity ratio.
Fixed to worth ratio: Net Fixed Assets/Tangible Net Worth—indicates how much of the owner's equity has been invested in fixed assets, i.e., plant and equipment. It is important to note that only tangible assets (physical assets like cash, inventory, property, plant, and equipment) are included in the calculation, and that they are valued less depreciation. Creditors usually like to see this ratio very low, but the large-scale leasing of assets can artificially lower it.
Interest coverage: Earnings before Interest and Taxes/Interest Expense—indicates how comfortably the company can handle its interest payments. In general, a higher interest coverage ratio means that the small business is able to take on additional debt. This ratio is closely examined by bankers and other creditors.
By assessing a company's use of credit, inventory, and assets, efficiency ratios can help small business owners and managers conduct business better. These ratios can show how quickly the company is collecting money for its credit sales or how many times inventory turns over in a given time period. This information can help management decide whether the company's credit terms are appropriate and whether its purchasing efforts are handled in an efficient manner. The following are some of the main indicators of efficiency:
Annual inventory turnover: Cost of Goods Sold for the Year/Average Inventory—shows how efficiently the company is managing its production, warehousing, and distribution of product, considering its volume of sales. Higher ratios—over six or seven times per year—are generally thought to be better, although extremely high inventory turnover may indicate a narrow selection and possibly lost sales. A low inventory turnover rate, on the other hand, means that the company is paying to keep a large inventory, and may be overstocking or carrying obsolete items.
Inventory holding period: 365/Annual Inventory Turnover—calculates the number of days, on average, that elapse between finished goods production and sale of product.
Inventory to assets ratio Inventory/Total Assets—shows the portion of assets tied up in inventory. Generally, a lower ratio is considered better.
Accounts receivable turnover Net (credit) Sales/Average Accounts Receivable—gives a measure of how quickly credit sales are turned into cash. Alternatively, the reciprocal of this ratio indicates the portion of a year's credit sales that are outstanding at a particular point in time.
Collection period 365/Accounts Receivable Turnover—measures the average number of days the company's receivables are outstanding, between the date of credit sale and collection of cash.
Although they may seem intimidating at first glance, all of the aforementioned financial ratios can be derived by simply comparing numbers that appear on a small busi-ness's income statement and balance sheet. Small business owners would be well-served by familiarizing themselves with ratios and their uses as a tracking device for anticipating changes in operations.
Financial ratios can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies. Ratio analysis, when performed regularly over time, can also help small businesses recognize and adapt to trends affecting their operations. Yet another reason small business owners need to understand financial ratios is that they provide one of the main measures of a company's success from the perspective of bankers, investors, and business analysts. Often, a small business's ability to obtain debt or equity financing will depend on the company's financial ratios.
Despite all the positive uses of financial ratios, however, small business managers are still encouraged to know the limitations of ratios and approach ratio analysis with a degree of caution. Ratios alone do not make give one all the information necessary for decision making. But decisions made without a look at financial ratios, the decision is being made without all the available data.
see also Balance Sheets; Cash Flow Statements; Income Statements; Return on Assets
Casteuble, Tracy. "Using Financial Ratios to Assess Performance." Association Management. July 1997.
Clark, Scott. "Financial Ratios Hold the Key to Smart Business." Birmingham Business Journal. 11 February 2000.
Clark, Scott. "You Can Read the Tea Leaves of Financial Ratios." Birmingham Business Journal. 25 February 2000.
Gil-Lafuente, Anna Maria. Fuzzy Logic In Financial Analysis. Springer, 2005.
Hey-Cunningham, David. Financial Statements Demystified. Allen & Unwin, 2002.
Taulli, Tom. The Edgar Online Guide to Decoding Financial Statements. J. Ross Publishing, 2004.
Hillstrom, Northern Lights
updated by Magee, ECDI
USE AND USERS OF RATIO ANALYSIS
ASSET UTILIZATION RATIOS
MARKET VALUE RATIOS
COMMON SIZE RATIOS
CAUTIONS ON THE USE AND INTERPRETATION OF FINANCIAL RATIOS
Financial ratios are one of the most common tools of managerial decision making. A ratio is the comparison of one number to another—mathematically, a simple division problem. Financial ratios involve the comparison of various figures from financial statements in order to gain information about a company's performance. It is the interpretation, rather than the calculation, that makes financial ratios a useful tool for business managers. Ratios may serve as indicators, clues, or red flags regarding noteworthy relationships between variables used to measure the firm's performance in terms of profitability, asset utilization, liquidity, leverage, or market valuation.
There are basically two uses of financial ratio analysis: to track individual firm performance over time, and to make comparative judgments regarding firm performance. Firm performance is evaluated using trend analysis—calculating individual ratios on a per-period basis, and tracking their values over time. This analysis can be used to spot trends that may be cause for concern, such as an increasing average collection period for outstanding receivables or a decline in the firm's liquidity status. In this role, ratios serve as red flags for troublesome issues, or as benchmarks for performance measurement.
Another common usage of ratios is to make relative performance comparisons. For example, comparing a firm's profitability to that of a major competitor or observing how the firm stacks up versus industry averages enables the user to form judgments concerning key areas such as profitability or management effectiveness. Financial ratios are used by parties both internal and external to the firm. External users include security analysts, current and potential investors, creditors, competitors, and other industry observers. Internally, managers use ratio analysis to monitor performance and pinpoint strengths and weaknesses from which specific goals, objectives, and policy initiatives may be formed.
Perhaps the type of ratios most often used and considered by those outside a firm are profitability ratios. Profitability ratios provide measures of profit performance that serve to evaluate the periodic financial success of a firm. One of the most widely-used financial ratios is net profit margin, also known as return on sales.
Return on sales provides a measure of bottom-line profitability. For example, a net profit margin of 6 percent means that for every dollar in sales, the firm generated six cents in net income.
Two other margin measures are gross profit margin and operating margin.
Gross margin measures the direct production costs of the firm. A gross profit margin of 30 percent would indicate that for each dollar in sales, the firm spent seventy cents in direct costs to produce the good or service that the firm sold.
Operating margin goes one step further, incorporating nonproduction costs such as selling, general, and administrative expenses of the firm. Operating profit is also commonly referred to as earnings before interest and taxes, or EBIT. An operating margin of 15 percent would indicate that the firm spent an additional fifteen cents out of every dollar in sales on nonproduction expenses, such as sales commissions paid to the firm's sales force or administrative labor expenses.
Two very important measures of the firm's profitability are return on assets and return on equity.
Return on assets (ROA) measures how effectively the firm's assets are used to generate profits net of expenses. An ROA of 7 percent would mean that for each dollar in assets, the firm generated seven cents in profits. This is an extremely useful measurement for any firm's management
|Gross profit margin||Return on assets|
|Operating margin||Return on equity|
|Net profit margin|
performance as it is the job of managers to utilize the assets of the firm to produce profits.
Return on equity (ROE) measures the net return per dollar invested in the firm by the owners, the common shareholders. An ROE of 11 percent means the firm is generating an eleven-cent return per dollar of net worth.
In each of the profitability ratios mentioned above, the numerator in the ratio comes from the firm's income statement. Hence, these are measures of periodic performance, covering the specific period reported in the firm's income statement. Therefore, the proper interpretation for a profitability ratio such as an ROA of 11 percent would be that, over the specific period (such as fiscal year 2004), the firm returned eleven cents on each dollar of asset investment.
Asset utilization ratios provide measures of management effectiveness. These ratios serve as a guide to critical factors concerning the use of the firm's assets, inventory, and accounts receivable collections in day-to-day operations. Asset utilization ratios are especially important for internal monitoring concerning performance over multiple periods, serving as warning signals or benchmarks from which meaningful conclusions may be reached on operational issues. An example is the total asset turnover (TAT) ratio.
This ratio offers managers a measure of how well the firm is utilizing its assets in order to generate sales revenue. An increasing TAT would be an indication that the firm is using its assets more productively. For example, if the TAT for 2003 was 2.2×, and for 2004 it was 3×,the interpretation would follow that in 2004, the firm generated three dollars in sales for each dollar of assets, and an additional eighty cents in sales per dollar of asset investment over the previous year. Such change may be an indication of increased managerial effectiveness.
A similar measure is the fixed asset turnover (FAT) ratio.
Fixed assets (such as plant and equipment) are often more closely associated with direct production than are current assets (such as cash and accounts receivable), so many analysts prefer this measure of effectiveness. A FAT of 1.6× would be interpreted as the firm generating $1.60 in sales for every $1.00 it had in fixed assets.
Two other asset utilization ratios concern the effectiveness of a firm's asset management. Inventory is an important economic variable for management to monitor since dollars invested in inventory have not yet resulted in any return. Inventory is an investment, and it is important for the firm to maximize its inventory turnover. The inventory turnover ratio is used to measure this aspect of performance.
Cost of goods sold (COGS) derives from the income statement and indicates the expense dollars attributed to the actual production of goods sold during a specified period. Inventory is an asset on the balance sheet. Because the balance sheet represents the firm's assets and liabilities at one point in time, an average figure is often used from two successive balance sheets. Managers attempt to increase this ratio, since a higher turnover ratio indicates that the firm is going through its inventory more often due to higher sales. A turnover ratio of 4.75×, or 475 percent, means the firm sold and replaced its inventory stock more than four and one-half times during the period measured on the income statement.
One of the most critical ratios that management must monitor is days sales outstanding (DSO), also known as average collection period.
This represents a prime example of the use of a ratio as an internal monitoring tool. Managers strive to minimize the firm's average collection period, since dollars received from customers become immediately available for reinvestment. Periodic measurement of the DSO will “red flag” a lengthening of the firm's time to collect outstanding accounts before customers get used to taking longer to pay. A DSO of 36 means that, on average, it takes 36 days to collect on the firm's outstanding
Asset Utilization Ratios
|Total asset turnover||Days sales outstanding|
|Inventory turnover||Fixed asset turnover|
accounts. This is an especially critical measure for firms in industries where extensive trade credit is offered, but any company that extends credit on sales should be aware of the DSO on a regular basis.
Leverage ratios, also known as capitalization ratios, measure the firm's use of debt financing. These are extremely important for potential creditors who are concerned with the firm's ability to generate the cash flow necessary to make interest payments on outstanding debt. Thus, these ratios are used extensively by analysts outside the firm to make decisions concerning the provision of new credit or the extension of existing credit. It is also important for management to monitor the firm's use of debt financing. The commitment to service outstanding debt is a fixed cost to a firm, resulting in decreased flexibility and higher break-even production rates. Therefore, the use of debt financing increases the risk associated with the firm. Managers and creditors must constantly monitor the trade-off between the additional risk that comes with borrowing money and the increased opportunities that new capital provides. Leverage ratios provide a means of such monitoring.
Perhaps the most straightforward measure of a firm's use of debt financing is the total-debt ratio.
There are only two ways to finance the acquisition of any asset: debt (using borrowed funds) and equity (using funds from internal operations or selling stock in the company); total debt ratio covers both. A debt ratio of 35 percent means that, for every dollar of assets the firm has, thirty-five cents were financed with borrowed money. The natural corollary is that the other sixty-five cents came from equity financing. This is known as the firm's capital structure—35 percent debt and 65 percent equity. Greater debt means greater leverage, and more leverage means more risk. How much debt is too much is highly subjective, and opinions vary from one manager to another. To a large extent, the nature of the business will determine debt risk. Large manufacturers, who require heavy investment in fixed plant and equipment, will require higher levels of debt financing than will service firms such as insurance or advertising agencies.
The total debt of a firm consists of both long- and short-term liabilities. Short-term (or current) liabilities are often a necessary part of daily operations and may fluctuate regularly depending on factors such as seasonal sales. Many creditors prefer to focus their attention on the firm's use of long-term debt. Thus, a common variation on the total debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the numerator.
Similarly, many analysts prefer a direct comparison of the firm's capital structure. Such a measure is provided by the debt-to-equity ratio.
This is perhaps one of the most misunderstood financial ratios, as many confuse it with the total debt ratio. A debt-to-equity ratio of 45 percent would mean that for each dollar of equity financing, the firm has 45 cents in debt financing. This does not mean that the firm has 45 percent of its total financing as debt; debt and equity percentages, together, must sum to one (100 percent of the firm's total financing). A little algebra will illustrate this point. Let x = the percent of equity financing (in decimal form), so 0.45x is the percent of debt financing. Then x + 0.45 x = 1, and x = 0.69. So, a debt to equity ratio of 45 percent indicates that each dollar of the firm's assets is financed with sixty-nine cents of equity and thirty-one cents of debt. The point here is to caution against confusing the interpretation of the debt-to-equity ratio with that of the total debt ratio.
Two other leverage ratios that are particularly important to the firm's creditors are the times-interest-earned and the fixed-charge coverage ratios. These measure the firm's ability to meet its on-going commitment to service debt previously borrowed. The times-interest-earned (TIE) ratio, also known as the EBIT (earnings before interest and tax) coverage ratio, provides a measure of the firm's ability to meet its interest expenses with operating profits.
For example, a TIE of 3.6× indicates that the firm's operating profits from a recent period exceeded the total interest expenses it was required to pay by 360 percent. The higher this ratio, the more financially stable the firm and the greater the safety margin in the case of fluctuations
|Total debt ratio||Times interest earned|
|Long-term debt ratio||Fixed charge coverage|
in sales and operating expenses. This ratio is particularly important for lenders of short-term debt to the firm, since short-term debt is usually paid out of current operating revenue.
Similarly, the fixed charge coverage ratio, also known as the debt service coverage ratio, takes into account all regular periodic obligations of the firm.
The adjustment to the principal repayment reflects the fact that this portion of the debt repayment is not tax deductible. By including the payment of both principal and interest, the fixed charge coverage ratio provides a more conservative measure of the firm's ability to meet fixed obligations.
Managers and creditors must closely monitor the firm's ability to meet short-term obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-term debt. Current liabilities represent obligations that are typically due in one year or less. The current and quick ratios are used to gauge a firm's liquidity.
A current ratio of 1.5× indicates that for every dollar in current liabilities, the firm has $1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used to satisfy the liabilities if the firm ran short of cash. However, some current assets are more liquid than others. Obviously, the most liquid current asset is cash. Accounts receivable are usually collected within
|Current ratio||Quick ratio|
one to three months, but this varies by firm and industry. The least liquid of current assets is often inventory. Depending on the type of industry or product, some inventory has no ready market. Since the economic definition of liquidity is the ability to turn an asset into cash at or near fair market value, inventory that is not easily sold will not be helpful in meeting short-term obligations. The quick (or acid test) ratio incorporates this concern.
By excluding inventories, the quick ratio is a more strident liquidity measure than the current ratio. It is a more appropriate measure for industries that involve long product production cycles, such as manufacturing.
Managers and investors are interested in market ratios, which are used in valuing the firm's stock. The price-earnings ratio and the market-to-book value ratio are often used in the valuation analysis. The price/earnings ratio, universally known as the PE ratio, is one of the most heavily-quoted statistics concerning a firm's common stock. It is reported in the financial pages of newspapers, along with the current value of the firm's stock price.
Caution is warranted in the calculation of PE ratios. Analysts use two different components in the denominator: trailing earnings and forecast earnings. Trailing earnings refer to the firm's reported earnings, per share, over the last twelve months of operation. Forecast earnings are based on security analyst forecasts of what they expect the firm to earn in the coming twelve-month period. Neither definition is more correct than the other; one should simply pay attention to which measure is used when consulting published PE ratios. A PE ratio of 16 means investors are willing to pay $16 for $1 worth of earnings. PE ratios are used extensively, on a comparative basis, to analyze investment alternatives. In investment lingo, the PE ratio is often referred to as the firm's “multiple.” A high PE is often indicative of investors' belief that the firm has very promising growth prospects, while firms in more mature industries often trade at lower multiples.
A related measure used for valuation purposes is the market-to-book value ratio. The book value of a firm is defined as:
Market Value Ratios
|Price/earnings ratio||Market-to-book ratio|
Technically, the book value represents the value of the firm if all the assets were sold off, and the proceeds used to retire all outstanding debt. The remainder would represent the equity that would be divided, proportionally, among the firm's shareholders. Many investors like to compare the current price of the firm's common stock with its book, or break-up, value.
This is also known as the price/book ratio. If the ratio is greater than one, which is often the case, then the firm is trading at a premium to book value. Many investors regard a market-to-book ratio of less than one an indication of an undervalued firm. Interpretation of market ratios—high PEs versus low PEs—is highly subjective. Nonetheless, these measures provide information that is valued both by managers and investors regarding the market price of a firm's stock.
Common size ratios are used to contrast and compare the financial statements of large and small enterprises. Using the common size ratio, an analyst can determine which variables and which trends are affecting businesses of all sizes, and which of these is affecting small business more than larger business (and vice versa). Common size ratios are used to compare data about inventory, total assets, cost of goods sold, gross profit, overhead and production costs, and overall yearly revenue from one firm to another, usually one significantly larger than the other.
The comparison of one company to another company using common size ratios is sometimes called a cross-sectional analysis, and will include industry averages to draw a comparison for both entities. Often the common size ratio will use comparative data about an industry's leader by which to compare another smaller, more modest operation to see how it might be progressing.
Financial ratios represent tools for insight into the performance, efficiency, and profitability of a firm. Ratio calculation and interpretation can be confusing. For example, if someone refers to a firm's profit margin, are they referring to gross profit margin, operating margin, or net profit margin? Is debt ratio a reference to total debt ratio, long-term debt ratio, or debt-to-equity ratio? Confusing these can make the use of ratio analysis a frustrating experience.
Financial ratios should be interpreted with care. A net profit margin of 12 percent may be outstanding for one type of industry and mediocre to poor for another. This highlights the fact that individual ratios should not be interpreted in isolation. Trend analyses should include a series of identical calculations, such as following the current ratio on a quarterly basis for two consecutive years. Ratios used for performance evaluation should always be compared to some benchmark, either an industry average or the identical ratio for the industry leader.
Another factor in ratio interpretation is identifying whether individual components, such as net income or current assets, originate from the firm's income statement or balance sheet. The income statement reports performance over a specified time period, while the balance sheet gives static measurement at a single point in time. These issues should be recognized when interpreting the results of ratio calculations.
Despite these issues, financial ratios are useful for internal and external evaluations of a firm's performance. A working knowledge and ability to use and interpret ratios remains a fundamental aspect of effective financial management. Financial ratios were widely used and highly valued during the stock market decline of 2000, when the bottom dropped out of the soaring “dot.com” economy. Throughout the long run-up, some financial analysts warned that the stock prices of many technology companies—particularly Internet start-up businesses—were overvalued based on the traditional rules of ratio analysis. Yet investors largely ignored such warnings and continued to flock to these companies in hopes of making a quick return.
Conversely, the 2008 crossroads in energy and fuel management—and China's growing need for oil and other raw materials—has been largely forecasted and interpreted using financial ratios. Investors and analysts alike have weathered rough parts of this supply and demand crisis by evaluating market circumstances with ratios and facing the truth rather than ignoring it.
In the end, it becomes clear that the old rules still apply, and that financial ratios remain an important means of measuring, comparing, and predicting a firm's performance.
SEE ALSO Balance Sheets; Cash Flow Analysis and Statement; Financial Issues for Managers; Income Statements
Fridson, Martin, and Fernando Alvarez. Financial Statement Analysis: A Practitioner's Guide. New York: John Wiley, 2002.
Harrington, Diana R. Corporate Financial Analysis: Decisions in a Global Environment. 4th ed. Chicago: Richard D. Irwin, Inc., 1993.
Helfert, Erich A. Techniques of Financial Analysis: A Modern Approach. 9th ed. Chicago: Richard D. Irwin, Inc., 1997.
NetMBA.com. “Financial Ratios.” Available from: http://www.netmba.com/finance/financial/ratios.
NetMBA.com. “Common Size Financial Statements.” Available from: http://www.netmba.com/finance/statements/commonsize/.
Soros, George. The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means. New York: PublicAffairs, Perseus Books, 2008.