Corporate Finance Ratios

An integral part of a company's investment analysis/evaluation

Corporate finance ratios are an integral part of a company's investment analysis/evaluation. In addition, these ratios help understand the financial health of the company.

Ratios help benchmark the performance of companies in a particular sector; by comparing the concerned company's financial ratios with that of companies from the same industry, one can understand the plight of finances.

Financial ratios can also be used to compare a company's current performance to its past performance to understand its growth. Sometimes, ratios are also compared with the overall economy of the country.

Ratios can be broadly divided into 5 categories - Liquidity, Debt Management, Asset Management, Profitability, and return to investors:

Liquidity:

1. Short-run Solvency:

• Current ratio
• Quick ratio
• Cash ratio
• CFO ratio
• Defensive interval

2 . Liquidity of Current Assets:

• Collection period
• Days inventory held
• Days payables outstanding

Debt Management:

1. Amount of debt

• Debt to assets
• Debt to equity
• Long-term debt to total capital

2. Coverage of Debt

• Times interest earned
• CFO to interest
• CFO to debt

Asset Management:

Profitability:

1. Margins

2. Returns

• ROIC
• Cash ROA
• ROA
• ROE

• Earnings per share
• ROE
• ROCE
• Dividend yield
• Dividend payout
• P/E

Let us understand all the corporate financial ratios and how their variations help investors make investment decisions

Liquidity Ratios

Liquidity ratios indicate the ability of a firm to pay off its debt and have a sustainable business without any external financing.

1. Current Ratio

Current Ratio =Current assets/Current liabilities

This ratio helps understand the ability of the firm to meet its short-term obligations using its current assets. The ratio is better used only as a comparison between two companies in the same sector.

However, 1 is the absolute threshold for this ratio. If the company's current ratio is less than 1(i.e., current liabilities are greater than current assets), then the company won't be able to meet its short-term obligations.

2. Quick Ratio

Quick Ratio = (Cash + Marketable securities + Net receivables)/Current liabilities

It is also known as the acid test ratio. This ratio is a modified version of the current ratio. Like the Current Ratio, the quick ratio measures the ability of a firm to meet its short-term obligations.

However, this ratio considers only the most liquid assets, i.e., that are quickly available hence the name quick ratio. It doesn't include inventory and prepaid expenses in its current assets.

Again, one is a recommended threshold; a quick ratio greater than 1 is preferred. However, it can vary from sector to sector.

3. Cash Ratio

Cash Ratio = (Cash + Marketable Securities)/Current liabilities

The cash ratio helps understand a company's likelihood of paying the short-term obligations only with the available cash & cash equivalents. The difference between the quick ratio and cash ratio is the term net receivables in the numerator.

Net receivables are the total money owed by a company to its customers; it can be in the form of EMI/loans, etc.

4. CFO Ratio

CFO Ratio = CFO/Average current liabilities

This ratio takes into consideration the cash generated from operating activities and the ability of cash generated from operating activities to meet its short-term obligations.

Cash flow can be calculated using net income, non-cash expenses, non-cash gains, etc. as follows:

Operating Cash Flow = Operating income + Non-Cash Charges - Change in Working Capital - Taxes

5. Defensive interval

Defensive interval = 365*(Cash + Marketable securities + Net receivables)/Projected expenditures(=COGS + Other operating expenses except depreciation)

The defensive interval ratio or defensive interval period estimates the number of days a company can survive using only its defensive assets without the aid of any external financial resources.

Since the ratio gives values in terms of days, we have a multiple of 365 in the numerator. Defensive assets are assets that provide steady income. These investments generally have lower returns and lower risk.

6. Working capital

Working Capital = Current assets - Current liabilities

Activity Ratios

Companies might use assets to the fullest capacity or might not be able to optimize the usage of assets. To understand this, we have activity ratios. Let us understand various activity ratios and how they affect investment decisions.

1. Receivable turnover

Receivable turnover = Net credit sales/Average net trade(Accounts) receivables

Net credit sales = Sales on credit - Sales returns - Sales allowances

This ratio measures the ability of customers to collect their receivables.

2. Average receivables collection day

Average receivables collection day = 365/Receivable turnover

Companies provide credit to their customers. The average receivables collection period calculates the average number of days in which the company receives its payments. The lower the ratio, the better liquidity is maintained in the company.

It also helps the company plan future investments/expenditures. A very low average receivables collection period can push away customers as it may have strict credit policies.

3. Inventory turnover

Inventory turnover = Cost of goods sold/Average total inventory

The inventory turnover ratio calculates how often the inventory is sold and replaced. The higher the value of the ratio, the more efficiently the inventory is managed. Thus high value is preferred in the case of inventory turnover.

4. Average days in inventory in stock

Average days in inventory in stock = 365/Inventory turnover

Days on average indicate a company's efficiency in handling inventory stocks. It measures the average number of days a company stores its inventory before selling.

5. Payables turnover

Payables turnover = Purchases(COGS + change in inventory) / Average accounts payable

This ratio calculates the average rate at which companies pay off the short-term debt it owes to their stakeholders. The higher the ratio, the higher the efficiency of the company in paying off its short-term debts.

There are various ways to interpret decreasing/increasing ratios. Suppose the payables turnover ratio is increasing, there is a possibility of financial issues for the company.

However, it can also mean the company negotiated with its suppliers on better terms from the point of financial strength.

Now, suppose the payables ratio is increasing; this means that the company can manage its finances effectively. However, it also means there is a possibility that the company is not reinvesting, thus declining its growth rate.

6. Average days payables outstanding

Average days payables outstanding = 365/Payables

This ratio gives the number of days a company takes to repay its short-term debt. Please note, average days payables outstanding measures the number of days or time period, while payables turnover measures the frequency.

Days payable outstanding is an important parameter for cash flow monitoring; using this one can find an optimum between accounts payable and accounts receivables.

Low and high days payable outstanding can be understood similarly to Payables turnover, except the hypothesis will be reversed for the two cases.

7. Operating cycle

Operating cycle = Receivables collection days + Inventory holding days

This measures the number of days for a complete cycle of business to take place:

Receive inventory -> sell inventory -> collect cash

8. Net trade cycle or cash cycle

Net trade cycle or cash cycle = Operating cycle - Average days payables outstanding

Cash is initially given as credit to the customers; then, the company sells products on credit. Once the company receives the amount from the customers, the company is ready to pay back its suppliers. This whole cycle is the net trade cycle or cash cycle.

The threshold for the net trade cycle is zero. If the cash cycle is positive, the company funds its process with a line of credit, and if it is negative, the company uses its funds to give credit to its customers.

9. Working capital turnover

Working capital turnover = Net sales/Average working capital

This ratio portrays the effectiveness of the company in managing its working capital; the higher ratio is preferred. After a point, the company is suggested to raise capital for more working capital.

10. Fixed asset turnover

Fixed asset turnover = Net sales/Average net fixed assets

As this ratio calculates sales generated per fixed capital, this ratio helps understand how effectively the company is managing its fixed assets. This ratio doesn't comment on the company's cash flow efficiency, and it just suggests fixed asset usage.

Profitability Ratios

Profitability ratios evaluate business efficiency in revenue and profit generation. Let us have a look at various Profitability Ratios and how they affect various decision-making processes:

1. Return on equity(ROE)

Return on equity(ROE) = Net income/Average total shareholders' equity

It is also known as return on net assets. Return on equity is preferred to have a high value as possible; this ratio cannot be too high to be a red flag.

2. Return on Assets(ROA)

Return on Assets(ROA) = [Net income+Interest expense*(1-tax rate)]/Average total assets

This ratio measures the efficiency of the company in generating profits per total asset. Comparing with other companies in the same sector makes sense as most of the companies have a similar set of asset bases.

The difference between ROA and ROE is ROE doesn't take into consideration a company's debt, thus making ROA a better ratio for comparison. Another variation for ROA is Operating income*(1-tax rate)/Total Assets.

There is no particular value for a good ROA; it varies from industry to industry.

3. Return on invested capital(ROIC)

Return on invested Capital(ROIC) = (NOPAT/Average invested capital)

where

NOPAT = EBIT * (1-tax rate)

This ratio measures the after-tax, pre-financing profits of a business to the average invested capital.

4. The gross profit margin on sales

The gross profit margin on sales = (Net sales - COGS = Gross profit margin)/Net sales

The gross profit margin on sales is one of the widely used ratios to measure a company's ability to generate profits.

5. Operating Margin

Operating Margin = EBIT/Net sales

Operating margin is also known as return on sales. Operating margin measures operating income generated per revenue. This ratio helps understand the level of profitability/ the efficiency of profit generation. Higher ratios are preferred.

6. The net profit margin on sales

The net profit margin on sales = Net income/Net sales

7. Cash return on assets

Cash return on assets = CFO/Average total assets

Cash return on assets is one of the most important parameters in investment-related decisions. High CROA indicates high earnings per total asset, which is a sign of high efficiency.

Businesses in the same sector/industry are compared before making any investments.

8. Earnings per share(EPS)

Earnings per share(EPS) = Net income less preferred dividends/Weighted common shares outstanding

9. Price-earnings ratio(P-E)

Price-earnings ratio(P-E) = Market price of stock/Earnings per share

Price-earnings ratio is one of the widely used metrics to evaluate a company's financials. This ratio helps understand if a company is overvalued or undervalued. A higher ratio suggests overvaluations.

However, this ratio, like other ratios, doesn't give complete information; hence it is suggested to compare with other companies from the same sector/industry. A lower P/E ratio indicates an investment opportunity.

10. Market to book ratio

Market to book ratio = Market value of equity/Book value of equity

Market to book ratio, also known as the price-to-book ratio, is calculated by dividing the company's stock price(market price share) by its book value per share. Book value is the value of tangible assets.

A lower market-to-book ratio is a preferred level for investment purposes, as it suggests the possibility of an undervalued stock price.

11. Dividend payout

Dividend payout = Cash dividends paid on common equity/Net income

12. Dividend yield

Dividend yield = Cash dividends paid per share of common equity/Price per share

Solvency Ratios

Solvency ratios assess the financial health of the company and evaluate the cash flows of the company, leverage, etc., to understand if the company would be able to pay back in case of solvency, bankruptcy, etc.

1. Financial leverage

Financial leverage = Total (average) assets/Total (average) shareholders' equity

Leverage is one of the most popular ways of increasing wealth. The term suggests the use of debt to increase investments. Ratio provides ways a company finances its operations.

Some of the other leverage ratios are:

Debt to total assets = Total debt/Total assets

Debt to equity = Total debt/Total shareholders' equity

2. Times interest earned(TIE)

Times interest earned(TIE) = EBIT/Interest expense

Times interest earned measures a company's ability to meet its debt interest rate using income(EBIT). In this case, a higher ratio is preferred as it suggests the good financial health of the company. This also suggests more potential leverage opportunities.

3. CFO to debt

CFO to debt = (CFO+interest and taxes paid in cash)/Average total liabilities

The operating cash flow to debt ratio indicates the company's financial health. A higher ratio suggests the company can better pay off its debt using operating cash flow.

Cash flow adequacy = CFO/(CAPEX+debt and dividends payments)

Cash flow adequacy, like the liquidity ratio, determines a company's ability to pay its current debts. However, along with current debt, future loans are also taken into consideration.

6. Book value per share

Book value per share = Common shareholders' equity/Outstanding shares

Book value per share itself is used as a term to calculate other solvency ratios. This metric helps understand the number of tangible assets present in the company.

Depending on the sector, book value per share can vary a lot. For example, a tech company has a lot invested in its IP; on the other hand, for manufacturing sectors, most of the assets are tangible.

NOTE

Since a single ratio doesn't give complete information, multiple ratios need to be compared to make an investment decision. Some of the most used ratios are P/E earnings, ROE, Face Value, Operating profit per share, Dividend yield, and book value.

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Researched and Authored by Punit Manjani | LinkedIn