Financial Ratios - Measuring Financial Health
Now that you understand the balance sheet and income statement, financial ratios let you extract meaningful insights from those numbers. Ratios are the primary toolkit for fundamental analysis.
Liquidity Ratios
Liquidity ratios measure a company's ability to meet short-term obligations: can it pay its bills?
| Ratio | Formula | Interpretation |
|---|---|---|
| Working capital | Current assets - Current liabilities | Dollar amount of short-term cushion; must be positive for healthy liquidity |
| Current ratio | Current assets / Current liabilities | Ability to pay short-term obligations; higher is better; >1.0 = positive working capital |
| Quick ratio (Acid test) | (Current assets - Inventory) / Current liabilities | More conservative than current ratio; excludes inventory |
- Quick assets = Cash + Marketable securities + Accounts receivable (current assets minus inventory)
- The acid test is more stringent because inventory is the least liquid current asset (it may not be easily converted to cash)
Exam Tip: Gotchas
- The quick ratio removes inventory from current assets because inventory is the least liquid current asset. If a company has a high current ratio but a low quick ratio, it is heavily dependent on inventory for its liquidity.
- Current ratio includes ALL current assets; quick ratio excludes inventory. The exam frequently tests this distinction.
Solvency/Leverage Ratios
Solvency ratios measure long-term financial risk: how much debt does the company carry?
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt-to-equity ratio | Total debt / Total shareholders' equity | Measures financial leverage; higher = more leveraged = higher bankruptcy risk |
| Bond ratio | Total bonds outstanding / Total capitalization | Proportion of capital structure funded by debt |
- Total capitalization = Long-term debt + Preferred stock + Common equity (shareholders' equity)
- A rising debt-to-equity ratio signals increasing reliance on borrowed funds
- Bond investors focus heavily on leverage ratios to assess credit risk
Exam Tip: Gotchas
- Total capitalization includes long-term debt, preferred stock, AND common equity. A common mistake is forgetting preferred stock when calculating total capitalization.
- A rising debt-to-equity ratio is a warning sign for bondholders, not just equity investors. More debt means higher bankruptcy risk and potentially lower bond ratings.
Efficiency Ratios
Efficiency ratios measure how effectively a company uses its assets.
| Ratio | Formula | Interpretation |
|---|---|---|
| Inventory turnover | Cost of goods sold (COGS) / Average inventory | How quickly inventory is sold; higher = more efficient |
| Cash flow | Net income + Depreciation + Depletion + Amortization | Approximation of actual cash generated (adds back non-cash charges) |
- High inventory turnover means the company is moving product quickly
- Cash flow adds back non-cash expenses to approximate true cash generation
Profitability Ratios
Profitability ratios measure how well a company converts revenue and assets into profit.
| Ratio | Formula | Interpretation |
|---|---|---|
| Gross profit margin | Gross profit / Revenue | Percentage of revenue remaining after COGS |
| Net profit margin | Net income / Revenue | Percentage of revenue that becomes profit after ALL expenses |
| Return on equity (ROE) | Net income / Shareholders' equity | How efficiently the company generates profit from shareholders' investment |
| Asset coverage | (Total assets - Intangible assets) / Total debt outstanding | Safety measure for bondholders; tangible assets available to cover debt |
| Net asset value (NAV) per bond | (Total assets - Intangible assets - Current liabilities) / Number of bonds outstanding | Net tangible asset backing per bond |
| Bond interest coverage | Earnings before interest and taxes (EBIT) / Annual interest expense | Times interest earned; how many times earnings can cover interest payments |
| Book value per share | (Total assets - Liabilities - Intangible assets - Preferred stock) / Common shares outstanding | Tangible book value per common share |
- ROE is a key competitiveness measure: it shows how much profit each dollar of equity generates
- Bond interest coverage (times interest earned) tells bondholders how safe their interest payments are; higher is better
- Book value per share represents the accounting value of each share if the company were liquidated
Exam Tip: Gotchas
- Book value per share excludes intangible assets (goodwill, patents) AND preferred stock. The exam may include these in the assets figure to test whether you know to subtract them. Tangible assets only, common shareholders only.
- Bond interest coverage uses EBIT (earnings before interest and taxes), not net income. Using net income would undercount because interest has already been subtracted.
Valuation Ratios
Valuation ratios compare a stock's market price to its fundamental measures.
| Ratio | Formula | Interpretation |
|---|---|---|
| Price-to-earnings (P/E) ratio | Market price per share / Earnings per share (EPS) | How much investors pay per dollar of earnings |
| Dividend payout ratio | Annual dividends per share / EPS | Percentage of earnings paid out as dividends |
| Current yield (stocks) | Annual dividend per share / Current market price | Income return on a stock at today's price |
Understanding P/E Ratios
- A high P/E ratio suggests the market expects strong future earnings growth (growth stock)
- A low P/E ratio may indicate the stock is undervalued or the market expects declining earnings (value stock)
- Use fully diluted EPS in P/E calculations for the most conservative measure
Exam Tip: Gotchas
- The P/E ratio uses MARKET PRICE (not book value) in the numerator. Do not confuse P/E ratio with book value per share. Also, a high P/E is not automatically "good"; it may mean the stock is overpriced relative to earnings.
- Dividend payout ratio + retention ratio = 100%. What is not paid out as dividends is retained by the company. If payout ratio is 40%, the retention ratio is 60%.