Financial Ratios (Explanation Part 1)

Introduction to Financial Ratios

Financial ratios relate or connect two amounts from a company’s financial statements (balance sheet, income statement, statement of cash flows, etc.). The purpose of financial ratios is to enhance one’s understanding of a company’s operations, use of debt, etc.

The use of financial ratios is also referred to as financial ratio analysis or ratio analysis. That along with vertical analysis and horizontal analysis (all of which we discuss) are part of what is known as financial statement analysis.

Benefit of Financial Ratios

A significant benefit of calculating a company’s financial ratios is being able to make comparisons with the following:

• The averages for the industry in which the company operates
• The ratios of another company in its industry
• Its own ratios from previous years
• Its planned ratios for the current and future years

The comparisons may direct attention to areas within a company that need improvement or where competitors are more successful.

Limitations of Financial Ratios

Some of the limitations of financial ratios are:

• They are based on just a few amounts taken from the financial statements from a previous year. Current and future years could be different due to innovations, economic conditions, global competitors, etc.

• The comparison is useful only with companies in the same industry. This becomes difficult when other companies operate in several industries and their financial statements report only consolidated amounts.

• Companies may apply accounting principles differently. For instance, some U.S. companies use LIFO to assign costs to its inventory and cost of goods sold, while some use FIFO. Some companies will be more conservative when estimating the useful life of equipment, when recording an expenditure as an expense rather than as an asset, and more.

• Since financial statements reflect the historical cost principle, some of a company’s most valuable assets (trade names, logos, unique reputation, etc. that were developed internally) are not reported on the company’s balance sheet.

• They provide a minuscule amount of information compared to the information included in the five main financial statements and the publicly traded corporation’s annual report to the U.S. Securities and Exchange Commission (SEC Form 10-K).

Our Discussion of 15 Financial Ratios

Our explanation will involve the following 15 common financial ratios:

Part 2: Financial ratios using balance sheet amounts

• Ratio #1 Working capital
• Ratio #2 Current ratio
• Ratio #3 Quick (acid test) ratio
• Ratio #4 Debt to equity ratio
• Ratio #5 Debt to total assets

Part 3: Financial ratios using income statement amounts

• Ratio #6 Gross margin (gross profit percentage)
• Ratio #7 Profit margin
• Ratio #8 Earnings per share
• Ratio #9 Times interest earned (interest coverage ratio)

Part 4: Financial ratios using amounts from the balance sheet and the income statement

• Ratio #10 Receivables turnover ratio
• Ratio #11 Days’ sales in receivables (average collection period)
• Ratio #12 Inventory turnover ratio
• Ratio #13 Days’ sales in inventory (days to sell)
• Ratio #14 Return on stockholders’ equity

Part 5: Financial ratios using cash flow statement amounts

• Ratio #15 Free cash flow

Part 5 also includes a discussion of vertical analysis (resulting in common-size income statements and balance sheets) and horizontal analysis (resulting in comparative financial statements and trends over longer time periods).

Part 6 will give you practice examples (with solutions) so you can test yourself to see if you understand what you have learned. Calculating the 15 financial ratios and reviewing your answers will improve your understanding and retention.