Financial Ratio Analysis Flashcards
Current Ratio (Purpose/Downside)
Purpose = question for suppliers - will this firm be able to pay its suppliers if it closed - liquidity. Measures ability to cover short term liabilities with current assets.
Downside = assumption that current assets can be converted at book value quickly (obsolete inventory?). Too high may not be good either (ie too liquid and not investing?). An acceptable ratio is industry specific. A “low” rate of 1 could be bad or it could be a company that has accounts payable (liability) which are only due quarterly paired with a high inventory turnover.
Quick Ratio (Purpose / Downside)
Purpose = similar to current ratio but removes inventory for companies with inventory which has a higher risk of becoming obsolete
Downside = as with any risk measure doesn’t measure reward. A high quick ratio may be good for suppliers and creditors but may not be good for business generally.
Profit Margin (Purpose/Downside)
Purpose = how much of every dollar earned in revenue is hitting the bottom line. Profitability. Low margin could mean low cost high volume strategy. Indication of competitive levels (low margin typically means high competition).
Downside = hard to compare across industries. A drop may mean firm is targeting a bigger market but at a lower margin or is trying to scale.
ROE (Purpose / Downside)
Purpose = how much profit is generated for every pound / dollar invested by shareholders. In a way the granddaddy of all ratios. If ROE is high, share price typically higher meaning it is typically easier to borrow and for cheaper and use if assets typically efficient. Note: if ROE is higher than ROA it indicates firm is successfully leveraging (ie generating more profits than paying interest) but remember leverage cuts both ways.
Downside = liabilities and equity can be manipulated to improve ratio (ie share buybacks or funding expenses with debt instead of equity). Important to compare ROE and ROA as per above.
ROA (Purpose / Downside)
Purpose = efficiency ratio. How much profit is generated for every dollar of assets (ie how are your assets working for you).
Downside = can’t be used across industries as they will be specific to assets required on sector by sector basis.
EBITDA Margin (Purpose / Downside)
Purpose = similar to profit margin but closer to cash position. Advantages for comparing cross border organisations where tax positions may be different. Significant difference between EBITDA and EBIT indicates significant DA write offs / PP&E intensive sector / company
Downside = hard to compare across industries. A drop may mean firm is targeting a bigger market but at a lower margin or is trying to scale.
Debt to Assets (Purpose / Downside)
Purpose = measures proportion of debt to assets in a percentage so can be compared across companies / industries. Percentage of assets financed by debt. Measure of risk. Decreasing percentage would be generally an improvement on risk.
Downside = broad and doesn’t consider long term v short term liabilities. Nor does it factor in market value of assets (based on book value)
Debt to Capitalisation (Purpose)
measure of leverage by highlighting mix of debt and equity as a percentage of debt to total of debt and equity.
Interest Coverage Ratio (Purpose / Downside)
Purpose = measures the degree to which a company can make interest payments on its debt. Rate of 1 means a company can just cover its interest payments. Think monthly pay check v mortgage payment. Risk measure. Determine whether a firm is at risk of collapse (failure to service debt being the main reason for failures)
Downside = doesn’t factor in assets or equity which could be sold to raise funds
Asset Turnover (Purpose / Downside)
Purpose = measures how effectively a company is utilising its assets. How many pounds of revenue are generated for every pound of asset.
Downside = doesn’t exclude assets which aren’t used in productivity or are idle for the period measured
Inventory Turnover (Purpose / Downside)
Purpose = measures how efficiently a company is managing its inventory. A change indicates a change in efficiency (either more or less efficient). Higher turnover = shorter DSI.
Downside = not an effective measure for service companies. High turnover may indicate just in time manufacturing or missing out on sales due to stock outs. Lower cost of storage but possibly higher cost of manufacturing. Can’t compare across industries (groceries v. car dealership). Increase in turnover could be due to drop in prices / margin.
Accounts Receivable Turnover (Purpose / Downside)
Purpose = efficiency measure. How many times did a company convert receivables into cash. Changes mostly due to 1) changes in credit extended to customers; 2) efficiency in collection team; 3) changes in economy. Important for cash flow planning. High ratio indicates a b2c business (DSO< 30 days) whereas a lower rate indicates a b2b business (DSO >30 days)
Downside = internal measure as difficult to get credit sales figure from public info (unless you just use all sales like we do for FRA). Doesn’t measure effect on sales increases. Decrease receivables turnover may be good for sales. It may also mean you’re selling to less solvent customers.
Accounts Payable Turnover (Purpose / Downside)
Purpose = measure of how quickly a firm is paying its suppliers. Increase can positively impact cash position.
Downside = an increase is either good because increases cash flow cycle or bad because company is having trouble paying its suppliers who may tighten sales terms or increase prices.
EPS (Purpose / Downside)
Purpose = valuation ratio. Shows earnings achieved per outstanding share of company. Quick reference for valuation analysis as ultimate goal is to earn profit for shareholders. Higher EPS usually corresponds with higher stock price.
Downside = doesn’t factor in debt financing. An increase in EPS (usually considered good) could be hiding an increased reliance on debt/leverage so important to use in conjunction with other ratios (DuPont). Also be aware of impact of stock issuance or buybacks which can change equity element of equation.
P/E Ratio (Purpose / Downside)
Purpose = valuation ratio. Measures how many years of earnings would be required to cover the stock price (ie quick measure of how “cheap” or “expensive” a stock is)
Downside = can only be used within industries as an “accurate” comparison. Assumes stock will rise or fall to fair market value in cheap v expensive analysis which is speculative.
