# Financial Ratios – Financial Ratio Analysis

The following is a guide to some common ratios used to measure the fi nancial performance of a business. Different industries have different benchmarks for each ratio. It is important to understand the trends in a company’s performance from period-to-period and the relative performance of a company within its industry for each ratio.

Revenue:

Measures the percentage growth of revenues from one year to the next.

Gross Profit Margin:

Measures the percentage of revenue remaining to contribute towards operating expenses, after deducting product costs per dollar of revenue. The higher the percentage, the higher the contribution per dollar of revenue. Gross profit margin formula or Gross profit margin calculator is given below.

Above formula explains how to calculate gross profit margin.

Measures the relative cost of operating the business. Can be measured for each individual expense (e.g. rent, wages, etc.) as a percentage of revenue. The lower the percentage, the lower the expenses relative to revenue. Overhead margin is also known as “overhead ratio“.

EBITDA Percentage of Sales:

EBITDA measures the Earnings Before Interest, Tax, Depreciation and Amortization. EBITDA margin measures the operating costs of a business relative to sales.

Net Profit Margin:

Represents the profitability and efficiency of the business. Generally, the higher the percentage, the better because it indicates efficient management and expense control. Net profit margin formula is given below.

Net profit margin is also known as net profit margin ratio. Above formula explains what is net profit margin and how to calculate net profit margin.

Interest Coverage Ratio:

Measures an organization’s ability to pay interest owing. Generally, the higher the number the better – 2 times interest coverage is a common benchmark in many industries. Interest coverage ratio formula or interest coverage ratio calculator is given below.

Return on Equity (ROE) or Return on Common Stockholders Equity:

Tests the financial return the owners of a business are earning, relative to their investment. Generally, the higher the percentage, the better. Use this ratio to assess risk and reward. Return on equity formula or return on equity calculator is given below.

Current Ratio:

Measures the ability of the company to pay current debt over the next 12 months (specifically, the number of times current assets can cover current debts). Generally, the higher the number the better (2:1 is a common benchmark in many industries). If the ratio is too high (e.g. 4:1), it indicates inefficient use of capital as current assets generally have the lowest returns. Current Ratio formula is given below.

Quick Ratio (or Acid Test):

The number of times the most liquid assets (e.g. cash, short-term investments, and accounts receivable) can cover immediate debts (usually 90 days). Generally, the higher the number the better (1:1 is a common benchmark in many
industries). If the ratio is too high, it indicates inefficient use of capital. Quick ratio formula is given below.

Debt to Equity Ratio:

Used by lenders to examine their risk relative to the owners’ risk. Some debt is good, but too much can cause financial distress. \$1 of debt for every \$2 of equity is a common benchmark in many industries (1:2). Debt to equity ratio formula is given below.

Debt to Total Assets:

Measures how much a company’s assets are financed through debt. The higher the ratio, the greater the difficulty a company will have in repaying its creditors. Debt to Total Assets formula is given below.

Days Sales Outstanding (DSO):

Calculates the average number of days the A/R is outstanding, and indicates how well it is being managed. Generally, the less days outstanding, the less risk. This ratio is crucial in the service industry. DSO should be compared to similar periods in a cyclical business.

Inventory Days on Hand:

Calculates the average number of days the current inventory will last, and how well the inventory is being managed. Generally, the lower the inventory days on hand, the less the holding costs (e.g. shrinkage, interest, etc.). Inventory days on hand should be compared to similar periods in a cyclical business.

Inventory Turnover:

Calculates the number of times inventory is replenished within one year. Generally, the lower the inventory turnover, the less times per year inventory is being replenished which results in elevated holding costs. Inventory turnover should be compared to similar periods in a cyclical business. Inventory turnover formula is given below.

Return on Assets (ROA):

Compares the net income earned in a period to the amount of assets used to generate that income. Generally, the higher the percentage, the better. Return on assets formula is given below.

Assets Turnover:

Tests how efficiently a business utilizes its assets to generate sales. Assets turnover formula is given below.

Accounts Receivable Turnover (ART):

Calculates how many times a business collects its accounts receivable throughout the year. The higher the ratio, the more times per year accounts receivable is being collected. Accounts receivable turnover formula is given below.

Earnings per Share (EPS):

Tests the amount of dollar return a company is making for every outstanding common share. This ratio assesses the profitability of a company. Earnings per share formula or EPS formula is given below.

Book Value per Common Share:

Determines the value associated with each common share after all debts are paid.

Dividend Payout Ratio:

Calculates dividends paid as a percentage of net income. Dividend payout ratio formula is given below.

Price to Earnings Ratio:

Provides the investor with a measurement of stock price to actual earnings of the corporation. It is sometimes used as an indicator to buy or sell stock. Price to earnings ratio formula is given below.

Note:

The purpose of ratio analysis is to help the reader of financial statements ask the appropriate questions and understand which issues need to be addressed. Keep in mind that no single ratio will be able to provide the complete story. Much like a puzzle, you need all the pieces to see the whole picture.

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