Performance Ratios: Why look at financial ratios? [Ratios in General]

What we are going to cover?

  • Why look at financial ratios?
  • Ratios in General
  • Banking ratios
  • Insurance ratios
  • Financial Services ratios

Why look at financial ratios?

Financial ratios should be used because they are:

  • Single source of truth
  • Wealth of information
  • Forward-looking statements
  • Key decision makers

 

Ratios in General

  • Activity Ratio
  • Liquidity Ratio
  • Solvency Ratio
  • Profeitability Ratio

Activity ratios

Activity ratios are used to measure how efficiently a company utilizes its assets. The ratios provide investors with an idea of the overall operational performance of a firm.

Key activity ratios:

  1. Inventory turnover is calculated by dividing cost of goods sold by average inventory. A higher turnover than the industry average means that inventory is sold at a faster rate, signaling inventory management effectiveness.
    Additionally, a high inventory turnover rate means less company resources are tied up in inventory.
  2. Receivables turnover is calculated by dividing net revenue by average receivables. This ratio is a measure of how quickly and efficiently a company collects on its outstanding bills. The receivables turnover indicates how many times per period the company collects and turns into cash its customers’ accounts receivable.
  3. Payables turnover measures how quickly a company pays off the money owed to suppliers. The ratio is calculated by dividing purchases (on credit) by average payables. A high number compared to the industry average indicates that the firm is paying off creditors quickly, and vice versa.
  4. Asset turnover measures how efficiently a company uses its total assets to generate revenues. The formula to calculate this ratio is simply net revenues divided by average total assets. Our asset turnover ratio of 0.72x indicates that the firm generates $0.72 of revenue for every $1 of assets that the company owns. A low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is operating in a capital-intensive environment.

 

Liquidity ratios

Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios. They are especially important to creditors. These ratios measure a firm’s ability to meet its short-term obligations.

• Key liquidity ratios:

  1. Current ratio measures a company’s current assets against its current liabilities. The current ratio indicates if the company can pay off its short-term liabilities in an emergency by liquidating its current assets.
  2. Quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio compares the cash, short-term marketable securities and accounts receivable to current liabilities. The thought behind the quick ratio is that certain line items, such as prepaid expenses, have already been paid out for future use and cannot be quickly and easily converted back to cash for liquidity purposes.
  3. Cash ratio is calculated as simply cash and short-term marketable securities divided by current liabilities. Cash and short-term marketable securities represent the most liquid assets of a firm. Short-term marketable securities include short-term highly liquid assets such as publicly traded stocks, bonds and options held for less than one year.

Solvency ratios

Solvency ratios measure a company’s ability to meet its longer-term obligations. Analysis of solvency ratios provides insight on a company’s capital structure as well as the level of financial leverage a firm is using.

• Key solvency ratios:

  1. Debt-to-assets ratio is the most basic solvency ratio, measuring the percentage of a company’s total assets that is financed by debt. The ratio is calculated by dividing total liabilities by total assets. A high number means the firm is using a larger amount of financial leverage, which increases its financial risk in the form of fixed interest payments.
  2. Debt-to-capital ratio measures the amount of a company’s total capital (liabilities plus equity) that is provided by debt (interesting bearing notes and short- and long-term debt). Once again, a high ratio means high financial leverage and risk.
  3. Debt-to-equity ratio measures the amount of debt capital a firm uses compared to the amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses the same amount of debt as equity and means that creditors have claim to all assets, leaving nothing for shareholders in the event of a theoretical liquidation.
  4. Interest coverage ratio, also known as times interest earned, measures a company’s cash flows generated compared to its interest payments. The ratio is calculated by dividing EBIT (earnings before interest and taxes) by interest payments. The higher the figure, the less chance a company has of failing to meet its debt repayment obligations. A high figure means that a company is generating strong earnings compared to its interest obligations.

 

Profitability ratios

Profitability ratios are arguably the most widely used ratios in investment analysis. These ratios include the ubiquitous “margin” ratios, such as gross, operating and net profit margins. These ratios measure the firm’s ability to earn an adequate return.

• Key profitability ratios:

  1. Gross profit margin is simply gross income (revenue less cost of goods sold) divided by net revenue. The ratio reflects pricing decisions and product costs. If a company has a higher gross profit margin than is typical of its industry, it likely holds a competitive advantage in quality, perception or branding, enabling the firm to charge more for its products.
  2. Operating profit margin is calculated by dividing operating income (gross income less operating expenses) by net revenue. Operating expenses include costs such as administrative overhead and other costs that cannot be attributed to single product units.
  3. Net profit margin compares a company’s net income to its net revenue. This ratio is calculated by dividing net income, or a company’s bottom line, by net revenue. It measures a firm’s ability to translate sales into earnings for share
  4. Return on assets is calculated as net income divided by total assets. It is a measure of how efficiently a firm utilizes its assets. A high ratio means that the company is able to efficiently generate earnings using its assets. holders.
  5. Return on equity measures net income less preferred dividends against total stockholder’s equity. This ratio measures the level of income attributed to shareholders against the investment that shareholders put into the firm. It takes into account the amount of debt, or financial leverage, a firm uses. If there are large discrepancies between the return on assets and return on equity, the firm may be incorporating a large amount of debt.

Banking ratios

We were told that statement analysis for financial institutions is different from other industries primarily because unlike other firms
banks are in the business of selling money. Hence, their ways of making profits is also different.

Key banking ratios are as follows:

  1. Net interest margin = (Investment returns – Interest expenses) / (Average interest earning assets). Interpretation: This is a profitability ratio for financial institutions. If lending department makes bad decisions this ratio can be negative. This ratio is equivalent to gross margin for non-financial firms. Interest return is composed of the interest earned from the investment portfolio whereas interest expense is primarily the interest paid to depositors.
  2. Loan to Deposits ratio = Total loans / Total deposits.
  3. Interpretation: This is a category of liquidity ratio. Higher value means banks might run into a liquidity crunch whereas a lower value
    would mean the bank can do better with its deposits.
  4. Costs to Income = Operating Costs / Net income: Considering EBIT here would be beneficial as it would remove the effects of taxation across different geographies. Interpretation: This ratio is an efficiency ratio and can be interpreted as the cost a financial institution incurs to generate revenue.
    5. Return on Assets = Net Income / Total Average Assets
    Interpretation: This ratio is interpreted as the assets needed to generate revenue. This is an efficiency ratio.

Wealth Management ratios

Key wealth management ratios are as follows:

1. Sharpe Ratio = (Portfolio return – risk-free return) / standard deviation of the portfolio
Interpretation: The Sharpe ratio can also help explain whether a portfolio’s excess returns are due to smart investment decisions or a
result of too much risk. This basically compares the returns with risks taken by the investor. One of the shortcomings of the model is
that it assumes standard deviation to be normally distributed.

2. Treynor ratio = ( Portfolio return – risk-free return) / (portfolio beta)
Interpretation: This ratio is very close to Sharpe ratio but considers the portfolio beta in place of the variance. This makes it backward
looking and a shortcoming.

3. Alpha: This is the excess return of a stock over the market return. This is a number.
Interpretation: This ratio is also called non-systematic return or company-specific return. This shows the ability to beat the market and
generate excess returns.

4. Beta: This is the measure of volatility or the systematic risk.
Interpretation: This ratio is used to judge how the stock moves w.r.t. the market. A beta of 1 means the stock is experiencing same
shocks as the market. Ideally, investors try to diversify this risk and move beta to 0. It is the slope of the line which describes the
relation between security returns and the returns of the market portfolio also called the characteristic line.

5. Leverage Ratio = Total debt / Total Assets
Interpretation: This ratio reflects how leveraged a firm i.e how much of its assets are funded by debt. It should be looked at from the
industry benchmarks point of view or the trend should be looked at rather than an independent evaluation of this number.

6. Return on Capital employed (ROCE) = (EBIDTA / Total Capital Employed)
Interpretation: A higher ratio implies capital strategy which is profitable and efficient.
Capital Asset Pricing Model: Expected return of a security = Risk-free return + Beta * (Risk Premium) where Risk Premium / Excess
return = Market Returns – Risk Free Returns.

 

Leave a Comment