Key Financial Ratios and Their Significance
Net Capital Ratios (Expressed in Days)
- Days Receivable = (Accounts Receivable / Sales) x 365
- Days Inventory = (Inventory / Cost of Goods Sold) x 365
- Indicates how many days a product takes to be totally sold.
- Days Payable = (Accounts Payable / Purchases) x 365
- Indicates the average time (in days) that a company takes to pay its bills and invoices to its trade creditors.
- A high (low) DP indicates that a company is paying its suppliers slower (faster).
- Operating Cycle = Days Inventory + Days Receivable
- Average period of time required for a business to make an initial outlay of cash to produce goods.
- Net Operating Cycle (NOC) = Operating Cycle – Days Payable
- Indicates the number of days a company has to wait to receive cash at the end of the production. The higher the NOC, the worse it is for the company, as it means more time waiting.
Turnover Ratios
- Inventory Turnover = Cost of Goods Sold / Inventories
- Indicates how many times inventory is created and sold during a period.
- Receivables Turnover = Total Revenue / Receivables
- Indicates how many times accounts receivable are created and collected during a period.
- Total Assets Turnover = Total Revenue / Total Assets
- Amount of sales created per 1€ of assets. The higher, the less capital intensive the business is (good for the company).
- Working Capital Turnover = Total Revenue / Working Capital
- Indicates the efficiency of putting working capital to work.
Financial Leverage
Financial Leverage = Debt / Equity
- For each € of financing, there is x€ of debt financing. The higher it is, the higher the financial risk (the higher the debt, the higher the risk).
- (Assets / Equity when you are asked for the Profit Margin + Asset Turnover + Financial Leverage or when you are asked for the Sustainable Rate of Growth. When you are just asked for the Operating Performance Part and the Financial Performance Analysis you use Debt / Equity.)
Return on Equity (ROE)
Return on Equity (ROE) = Net Income / Equity
- The higher the better. For each € invested in shares equity of a company, we are getting x€ as a return (owners).
Return on Assets (ROA)
Return on Assets (ROA) = Profit Margin x Asset Turnover
- ROA shows the efficiency with which a company allocates and manages its resources.
- Net Income / Assets = (Net Income / Sales) x (Sales / Assets)
- Indicates how much you are earning for every € invested in assets.
Invested Capital and Return on Invested Capital (ROIC)
Invested Capital = Interest-Bearing Debt + Equity
Net Operating Profit After Tax (NOPAT) = EBIT x (1 – Tax Rate)
ROIC (Return on Invested Capital) = NOPAT / Invested Capital
Financial Leverage (FL)
FL = Assets / Equity = (Debt + Equity) / Equity = Debt / Equity + Equity / Equity + 1 = Total Liabilities / Equity + 1
FL Check = Total Assets / Equity
Operational Leverage
Operational Leverage = Fixed Costs / Total Costs
- For each € of Total Costs, x€ are Fixed Costs. The higher the Fixed Costs, the lower the Operational Leverage should be. It is the measure of the overall risk to which a company is being exposed.
Average Interest Rate Paid (AIRP)
EBIT / Equity > AIRP
- Its additional unit of debt financial will increase the ROE.
EBIT / Equity < AIRP
- Its additional unit of debt financial will decrease the ROE.
AIRP = Interest Expenses / Total Liabilities
- For each € of liabilities, we are paying x€ in terms of interest.
ROE Decomposition
ROE = Profit Margin x Asset Turnover x Financial Leverage
Net Income / Equity = (Net Income / Sales) x (Sales / Assets) x (Assets / Equity)
ROE Decomposition = (EBIT / Assets) x (1 – Tax Rate) + [(EBIT / Assets) – AIRP] x (1 – Tax Rate) x (Debt / Equity)
Weighted Average Cost of Capital (WACC)
WACC = (Debt Financing / Total Financing) x Cost of Debt x (1 – Tax Rate) + (Equity Financing / Total Financing) x Cost of Equity
Economic Value Added (EVA)
EVA = (ROIC – WACC) x Invested Capital
Profit Margin (PM)
PM = Net Income / Net Sales
Price-to-Earnings Ratio (P/E)
P/E = (Market Value of Equity / Number of Shares) / (Net Income / Number of Shares)
- An investor is willing to wait for x years to invest to repair itself.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA = EBIT + Depreciation and Amortization (per share of common stock)
Book Value per Share
Book Value per Share = Book Value of Equity / Number of Shares
- Book Value of a single share of a company.
Dividend Payout Ratio
Dividend Payout Ratio = Dividends / Net Income
- For each € of income, it is paying x€ to shareholders in terms of dividends.
Dividends per Share
Dividends per Share = Dividends / Number of Shares
- Each shareholder receives x€ of dividends for each share it owns.
Understanding Financial Ratios
- Express one number in relation to another.
- Standardize financial data in terms of mathematical relationships expressed as percentages, times, or days.
- Facilitate comparisons—trends and across companies.
- Are interrelated.
Comparison Points
- Against industry leader.
- Against our own best historical performance.
Types of Financial Ratios
- Activity Ratios: How efficient are the firm’s operations and the firm’s management of assets?
- Liquidity Ratios: How well is the firm positioned to meet short-term obligations?
- Solvency Ratios: How well is the firm positioned to meet long-term obligations?
- Profitability Ratios: How and how much is the firm achieving returns on its investments?
- Valuation Ratios: How does the firm’s performance or financial position relate to its market value?
Working Capital Definitions
Turnover ratios reflect the number of times assets flow into and out of the company during the period. A turnover is a gauge of the efficiency of putting assets to work.
The operating cycle is the length of time from when a company makes an investment in goods and services to the time it collects cash from its accounts receivable. The net operating cycle is the length of time from when a company makes an investment in goods and services, considering the company makes some of its purchases on credit, to the time it collects cash from its accounts receivable. The length of the operating cycle and net operating cycle provides information on the company’s need for liquidity: The longer the operating cycle, the greater the need for liquidity.
Financial Flexibility and Debt Capacity
Financial flexibility is the ability to cope with unanticipated imbalances between sources and uses of funds.
Debt capacity is the maximum amount of debt that the company can service in bad times without endangering:
- Its access to refinancing.
- Its ability to undertake essential capital investments.
Financial Statements and Sustainable Growth
Financial Statements: Drivers of Operating Performance –> Evaluating Financial Performance –> Sustainable Rate of Growth
ROE measures the efficiency with which a company employs owners’ capital; earnings per dollar of invested capital or percentage return to owners on their capital.
Sustainable Rate of Growth
How to balance revenue and asset growth with operating and financing policies.