Understanding Key Financial Ratios
Economic Ratios Explained
Asset Turnover Ratios
Total Assets Turnover
Formula: Net Sales / Average Total Assets
Fixed Assets Turnover
Formula: Net Sales / Average Fixed Assets (PPE – Accumulated Amortization)
Current Assets Turnover
Formula: Net Sales / Average Current Assets
Sales Profitability Ratios
Gross Profit Margin
Formula: (Net Sales – Cost of Sales) / Net Sales
Operating Profit Margin
Formula: EBIT / Net Sales
Economic Profitability Ratios
Return on Assets (ROA)
Formula: EBIT / Average Total Assets
Return on Assets After Interest Expense
Formula: EBT / Average Total Assets
Return on Assets After Tax
Formula: (Profit or Loss) / Average Total Assets
Financial Profitability Ratios
Financial Profitability (Before Taxes)
Formula: EBT / Average Equity
Return on Equity (ROE)
Formula: (Profit or Loss) / Average Equity
Valuation Ratios
Price-to-Cash Flow Ratio
Formula: Price per Share / Cash Flow per Share
Payout Ratio
Formula: Dividends / Profit
Book-to-Market Ratio
Formula: Equity (Book Value) / Market Capitalization (Number of Shares * Price per Share)
Earnings Per Share (EPS)
Formula: Profit / Number of Shares
Cash Flow Per Share
Formula: Cash Flow / Number of Shares
Dividend Per Share
Formula: Dividends / Number of Shares
Return on Share
Formula: (Change in Price + Dividends) / Initial Price
Dividend Yield
Formula: Dividend per Share / Price per Share
Real Yield Dividend
Formula: Dividend per Share / Initial Price
Price-to-Earnings Ratio (P/E Ratio)
Formula: Price per Share / Earnings Per Share
Understanding the Price-to-Earnings (P/E) Ratio
The P/E ratio measures how much investors are willing to pay for each dollar of a company’s earnings. It reflects investor expectations about the company’s future prospects.
- High P/E Ratio: Indicates that shareholders expect strong future earnings growth and are willing to pay a premium for the stock.
- Low P/E Ratio: Suggests that shareholders have less confidence in the company’s future earnings potential and are therefore willing to pay less for the stock.
The P/E ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company’s earnings.
Example: An investor is willing to pay €16 for €1 of current earnings.
Book-to-Market Ratio Explained
The book-to-market ratio compares a company’s book value (historical cost) to its market value (market capitalization). It is used to identify potentially undervalued or overvalued securities.
Formula: Book Value / Market Value
Dividend Yield Explained
Dividend yield shows how much a company pays out in dividends each year relative to its share price. It typically ranges between 2% and 5%, but can vary based on the company’s type, other ratios, and future prospects.
Return on Equity (ROE) Explained
A decrease in ROE indicates that the company’s ability to generate profits has declined and that it requires more capital. It may also suggest that management is not effectively managing shareholders’ capital.
Operating Leverage Explained
Operating leverage is crucial because a small change in sales can significantly impact profits. Understanding the level of operating leverage is essential for pricing policy. A company with high operating leverage must be cautious not to set prices too low, as it needs to generate sufficient contribution margin to cover its fixed costs.
Financial Leverage Explained
High financial leverage can be beneficial during economic booms but can lead to cash flow problems during recessions if sales revenue is insufficient to cover interest payments.