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In previous articles, we learned how to read and understand the items in a set of financial statements; the next job is to assess and analyse them. The best way to analyse financial statements is through financial ratios. The theory of financial ratios was put forward by Benjamin Graham, widely known as the father of fundamental analysis. Financial ratios help explain how sensibly a company allocates its assets, how well it performs and how safe its capital position is, by comparing its figures with its own history and with other companies in the same industry.
What are financial ratios?
Financial ratios show the relationship between items in the financial statements, such as between debt and equity, or between revenue and total assets. Before we look at how they are calculated and used, we need to understand some basic characteristics of financial ratios.
On its own, a company’s financial ratio tells you very little. For example, Company A in the textile and garment industry has a net profit margin of 15%. How useful is that information? Is a 15% margin relatively high, or low? If we also know that companies in the same industry have an average net profit margin of, say, around 10%, the ratio suddenly says a lot. Clearly, Company A earns a higher margin than the industry average, possibly because its products are better – allowing higher selling prices – or because its management is very good at controlling costs.
In this “Financial ratios” series, we will cover how each ratio is constructed and its formula, but we will not be learning to calculate them ourselves: the data on the Internet already does that for us, and you can easily collect it from specialist websites such as cafef.vn, vietstock or wichart.vn. Still, seeing the formula helps you better understand what each ratio means and how to use it.
The 4 basic groups of financial ratios
Profitability ratios help analysts measure a company’s ability to generate profit. They tell you whether the company is doing well at producing earnings. A company’s profitability also signals how competent its management is. Because profit is needed to expand the business and pay dividends to shareholders, profitability is an important factor to consider.
Leverage ratios (solvency ratios) measure the company’s capital structure (debt + equity), and thereby how safe and how efficient its capital allocation is.
Liquidity ratios, also called short-term solvency ratios, show the company’s ability to meet its short-term obligations, and are also used to gauge the safety of its capital position in the short term.
Activity ratios measure how efficiently the company uses its assets to generate revenue and profit. They help us understand how effective the company’s management is.
Let’s go through the formula for each group of ratios.
Profitability ratios
- Gross profit margin is calculated by dividing gross profit by net revenue, where:
Gross profit = Net revenue – Cost of goods sold
For a single product, revenue is the product’s selling price, and cost of goods sold is the direct cost of producing it (for a manufacturer) or the cost of purchasing it (for a trading, retail or wholesale business). Gross profit and gross profit margin therefore show the difference between revenue and cost of goods sold.
Gross margin tells you a lot, starting with the company’s price competitiveness. Imagine a general downturn that forces every company in the industry to cut prices: clearly, the company with a high gross margin will suffer smaller losses, and may even take market share from weaker rivals that drop out. The ratio also reflects how well the company uses its resources and how productive it is: a company with advanced production lines keeps its costs down, which lifts its gross margin.
Net profit margin (net profit after-tax margin, NPAT margin) is calculated by dividing profit after tax by net revenue. It shows how much net profit the company generates from each dong of revenue. Unlike gross margin, net margin takes into account the other costs incurred in generating profit, such as selling expenses, administrative expenses, interest and tax.
Several other ratios are also commonly used to assess profitability, such as EBITDA margin and EBIT margin.
ROE (return on equity) is the ratio of profit after tax to average shareholders’ equity. ROE is usually the first ratio investors look at, because it helps them assess the return they will earn on capital invested in the company. The ROE formula:
ROE = Profit after tax / Average shareholders’ equity
It measures how effectively the company generates profit from shareholders’ investment (i.e. shareholders’ equity). This makes it an extremely important ratio for deciding whether to invest in a company.
ROA (return on assets) is the ratio of profit after tax to total assets. It reflects how the company uses its assets to generate profit, and therefore genuinely reflects management’s ability to use assets and capital to produce earnings.
ROA = Profit after tax / Average total assets
Financial leverage ratios
Most companies that want to grow fast and reach a certain size cannot avoid using debt. Borrowing gives a company quick access to money to invest in new projects, expand its operations and increase profits. But debt is a double-edged sword: it becomes a burden when the company cannot repay it, or when the extra profit it generates does not cover the interest cost.
To assess a company’s ability to meet its debt obligations and the weight of its debt burden, analysts use leverage ratios. These are the three main leverage ratios we will cover:
- Financial leverage = Average total assets / Average shareholders’ equity
- Debt-to-assets ratio
- Debt-to-equity ratio
From these formulas you can see that as a company’s debt rises, its leverage ratios rise too. Companies want to use high leverage to generate profit, but if leverage is too high it brings credit risk. Companies with low leverage face less of this risk, but cannot grow as quickly as companies that use debt. These ratios are therefore useful for comparing the credit risk of different companies alongside their revenue and profit growth rates.
Liquidity ratios
Liquidity ratios are designed to assess a company’s ability to repay its short-term debts. A safe structure of current assets helps a company improve its liquidity.
- Current ratio: calculated by dividing current assets by current liabilities. Ideally it should be above 1, showing that highly liquid assets can cover short-term liabilities. The higher the ratio, the safer the company’s capital position.
- Quick ratio: for a company selling products that are not very liquid, inventory is hard to sell and convert into cash quickly. To remove the uncertainty around inventory, analysts use the quick ratio.
Quick ratio = (Cash + Short-term financial investments + Receivables) / Current liabilities
- Cash ratio: cash divided by current liabilities. This ratio is used when the company’s receivables are unreliable. However, relatively few companies can keep this ratio above 1.
Liquidity ratios are usually only used to assess a company’s liquidity against its own history. A rising liquidity ratio reflects the company’s ability to manage its working capital.
To assess a company’s interest burden, a commonly used measure is the interest coverage ratio, calculated as:
Interest coverage ratio = EBIT / Interest expense
Where: EBIT = Profit after tax + Tax + Interest expense
The higher this ratio, the less the company’s profit is weighed down by interest, meaning operating profit is better able to cover interest payments.
Activity ratios
Activity ratios measure how efficiently a company uses its assets, to assess whether its investment in assets actually produces business results. The main activity ratios are:
- Total asset turnover: revenue divided by average total assets, showing how many times revenue turns over total assets. The higher the ratio, the better the company uses its resources to generate revenue. You can replace total assets with fixed assets to measure the efficiency of that asset group.
- Receivables turnover: revenue divided by average receivables. The higher the ratio, the less the company is burdened with “chasing customers for payment”, reducing the risk of bad debt. For example, when a company with a weak position in its industry wants to win a large customer, it has to accept giving that customer longer payment terms, which lowers its receivables turnover.
- Inventory turnover: cost of goods sold divided by average inventory. Put simply, it shows how many times the goods sold in a period turn over the inventory. A higher ratio reflects better inventory management, showing that inventory is sold quickly.
- Payables turnover: the amount the company pays its suppliers divided by trade payables. The lower the better: it reflects the company’s bargaining position in paying suppliers, meaning it can pay over a long period and buy a lot on credit.
We will meet again in other interesting articles in this series on fundamental stock analysis.
Happy trading!
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