Financial Ratios
What are Financial Ratios?
Financial ratios, alternatively termed as financial or accounting ratios, play a pivotal role in aiding stakeholders, including investors, management, and analysts, in comprehending the business’s financial standing and in making informed decisions. Their simplicity in interpretation and calculation has rendered them indispensable tools for evaluating a business.
By analysing financial ratios derived from various financial statements such as the balance sheet, cash flow statement, and income statement, stakeholders can gauge different aspects including efficiency, solvency, profitability, debt levels, and overall financial position of the business.
According to the requirements of AASB 101, financial information is presented in a manner that is consistent over time and comparable across entities. This consistency is crucial for financial ratio analysis, allowing analysts to compare ratios across different periods and companies effectively.
Ratios for Assessing Profitability
Profitability ratios are essential metrics used to assess a business’s ability to generate profits, which are vital for business growth and shareholder returns. AASB 101 ensures that the revenue and expense recognition principles directly influence the calculation of profit margins, providing a consistent basis for profitability analysis. The profitability ratios provide insights into how effectively the business converts its revenue into profits.
Gross Profit Margin
The gross profit margin is a crucial profitability ratio that indicates the percentage of revenue remaining after deducting the direct costs associated with producing goods or delivering services. In simpler terms, it reveals how efficiently a business is generating profits from its core business operations before considering other operating expenses.
Gross profit margin = net sales – cost of goods or services sold/net sales X 100
Net Sales: This represents the total revenue generated by the business from its primary business activities. It excludes any returns, discounts, or allowances.
Cost of Goods Sold (COGS): This includes all expenses directly associated with producing goods or delivering services. It typically includes costs such as raw materials, labour, and manufacturing overhead.
A higher gross profit margin indicates that the business retains a larger portion of its revenue as gross profit after covering the costs directly related to production. This suggests efficiency in managing production costs and pricing strategies, which can lead to higher profitability.
Net Profit Margin
Net profit margin is a key financial ratio that provides insight into a business’s efficiency in converting sales revenue into profits. It indicates the percentage of revenue that remains as net profit after deducting all expenses.
The net profit margin is calculated by dividing net profit (or net income) by total sales revenue and then multiplying the result by 100 to express it as a percentage.
Net profit margin = net profit/sales X 100
A higher net profit margin indicates that the business efficiently manages its expenses relative to its net sales revenue, resulting in a larger portion of revenue being retained as net profit. This suggests effective cost control, operational efficiency, and profitability.
Conversely, a lower net profit margin may indicate challenges such as higher operating costs, increased competition, or pricing pressures, which can negatively impact profitability and financial performance over time.
Operating Profit Margin
The operating profit margin is a key financial ratio that measures the efficiency of a business’s operations by assessing the proportion of revenue retained as operating income after deducting operating expenses from gross profit. This metric provides insights into the business’s ability to control costs and manage its operational efficiency.
The operating profit margin is calculated by subtracting operating expenses from gross profit and then dividing the result by revenue, expressed as a percentage.
Operating profit margin = gross profit – operating expenses/revenue X 100
Operating Expenses: Operating expenses include all expenses incurred in the regular operations of the business, such as selling, general, and administrative expenses (SG&A). These expenses are deducted from the gross profit to calculate operating income or profit before interest and taxes (PBIT).
Operating expenses represent the costs associated with running the business beyond the direct production costs, including salaries, rent, utilities, marketing, and administrative expenses.
Revenue: Revenue here is referring to net sales. Revenue is the starting point for calculating profitability ratios and reflects the business’s ability to generate income from its products or services.
Operating profit margin focuses on the relative impact of operating expenses, which include selling, general, and administrative expenses (SG&A), on the business’s overall profitability. Since management has more control over operating expenses than costs directly related to sales, a higher operating profit margin signifies effective cost management practises.
Return on Assets (ROA)
Return on Assets (ROA) is a fundamental financial ratio that evaluates how efficiently a business utilises its assets to generate profits. It serves as a crucial metric for assessing the financial performance and efficiency of a business’s asset utilisation.
The Return on Assets ratio is calculated by dividing the net profit by the total assets and then multiplying the result by 100 to express it as a percentage.
Return on asset ratio (%) = (Net profit / Total assets) x 100
Total Assets: Total assets encompass all of the business’s resources and investments, including tangible assets such as property, equipment, and inventory, as well as intangible assets such as patents and trademarks. It represents the total value of assets owned and utilised by the business in its operations.
ROA provides insights into how effectively the business generates income from its assets. A higher ROA indicates that the business efficiently utilises its assets to generate profits, while a lower ROA may suggest inefficiencies or underutilisation of assets.
ROA serves as a valuable benchmark for comparing the business’s performance with industry averages or competitors’ ratios. By comparing ROA with industry benchmarks, investors can assess the business’s relative efficiency in asset utilisation and profitability.
ROA can also be compared to the risk free rate of return to assess the business’s performance relative to the inherent risks of operating the business. Ideally, the business’s ROA should exceed the risk free rate of return to justify the additional risks involved in operating the business.
Return on Equity (ROE)
Return on Equity (ROE) is a vital financial ratio that evaluates the efficiency of a business in generating profits from the equity invested by its shareholders. It measures the business’s ability to generate returns on the equity capital contributed by shareholders.
Calculation: The Return on Equity ratio is calculated by dividing the net profit by the owner’s equity and then multiplying the result by 100 to express it as a percentage.
Return on equity (%) = Net profit / Owner’s equity
Owner’s Equity: Owner’s equity represents the residual interest in the business’s assets after deducting its liabilities. It represents the shareholders’ equity capital invested in the business.
ROE evaluates how effectively the business utilises the equity capital invested by its shareholders to generate profits. A higher ROE indicates that the business is efficiently utilising shareholder equity to generate returns. On the flip side, a lower ROE may suggest inefficiencies or poor utilisation of shareholder funds.
Investors consider ROE as a key indicator of management performance and the business’s ability to generate returns on shareholder equity. A higher ROE is generally viewed favourably by investors, as it indicates efficient use of shareholder funds and potential for higher returns.
Return on Capital Employed (ROCE)
ROCE provides insights into the business’s ability to generate returns from its total capital base, including both equity and debt. By incorporating debt liabilities, ROCE offers a more comprehensive profitability indicator than ROE, as it considers the business’s total pool of capital.
This broader perspective enables stakeholders to assess the business’s ability to generate returns from its entire pool of invested capital, including funds raised from both shareholders and creditors.
For measuring return on capital investments, AASB 136 Impairment of Assets is critical. It requires entities to ensure that their assets’ carrying amounts do not exceed their recoverable amounts, affecting the accuracy of return on investment calculations by ensuring that asset values are not overstated.
The Return on Capital Employed ratio is calculated by dividing the net income by the capital employed, which is the sum of average debt liabilities and average shareholders’ equity. The formulae is as follows:
ROCE = Net Income / Capital Employed
Capital Employed = Avg. Debt Liabilities + Avg. Shareholders Equity
Net Income: Net income represents the business’s total profit after deducting all expenses from its total revenue. It reflects the business’s bottom line profitability and financial performance.
Capital Employed: Capital employed is the total amount of capital invested in the business’s operations, comprising both debt liabilities and shareholders’ equity. It represents the funds utilised by the business to generate profits.
Since ROCE measures management’s ability to generate earnings from the business’s total capital base. A higher ROCE indicates efficient utilisation of both equity and debt capital to generate profits, reflecting effective capital allocation and operational performance.
Ratios for Assessing Liquidity
Liquidity ratios are essential financial metrics used to assess a business’s ability to meet its short term financial obligations promptly. These ratios are derived from information found in the balance sheet and cash flow statement, focusing on the business’s working capital performance.
Working capital represents the funds available to cover current and short term liabilities, emphasising the importance of liquidity in managing day to day financial operations.
AASB 107 Statement of Cash Flows is instrumental in managing working capital and short term funding needs by detailing cash inflows and outflows, which are essential for liquidity ratio analysis, including current and quick ratios
By evaluating liquidity ratios, a business can gauge its capacity to fulfil short term debts promptly. Unlike solvency ratios, which assess the business’s ability to settle all debts, liquidity ratios specifically analyse the business’s ability to address immediate financial obligations. Therefore, they serve as vital indicators of the business’s financial health, providing insights into its liquidity position.
Liquidity ratios act as a warning system for a business, signalling when it may be facing a shortage of available funds. These ratios quantify the level of liquidity, including cash and easily convertible assets, available to cover debts. They offer a broad overview of the business’s financial well being, highlighting potential liquidity challenges or strengths.
Current Ratio
The Current Ratio is a financial metric used to assess a business’s ability to meet its short term financial obligations with its short term assets. It measures the proportion of current assets available to cover current liabilities, reflecting the business’s liquidity position. It is also called Working Capital Ratio.
The Current Ratio is calculated by dividing the business’s current assets by its current liabilities.
Current Ratio = Current Assets / Current Liabilities
The Current Ratio provides insights into the business’s liquidity and its ability to repay short term debts. A ratio above 1 indicates that the business has more current assets than current liabilities, suggesting sufficient liquidity to meet its obligations. A ratio of 2 or higher is often considered favourable, indicating a strong liquidity position.
Conversely, a ratio below 1 suggests that the business may struggle to settle its short term debts if they were due immediately, potentially facing cash flow challenges.
It’s essential to consider industry norms and the business’s specific circumstances when interpreting the Current Ratio, as acceptable ratios may vary across different sectors.
Additionally, while a higher Current Ratio generally indicates better liquidity, excessively high ratios may imply inefficient asset management, such as holding excessive levels of inventory.
Quick Ratio (Acid Test Ratio)
The Quick Ratio, also known as the Acid Test Ratio, is a financial metric used to evaluate a business’s ability to meet its short term financial obligations using its most liquid assets. Unlike the Current Ratio, which considers all current assets, the Quick Ratio focuses only on the most liquid assets that can be readily converted into cash to settle short term liabilities.
The Quick Ratio is calculated by subtracting less liquid current assets, such as prepaid expenses and inventories, from total current assets, and then dividing the result by current liabilities.
Quick ratio = Current assets – Inventory – Prepaid Expenses/Current Liabilities
The Quick Ratio provides a more stringent assessment of a business’s ability to cover its short term obligations compared to the Current Ratio. By focusing on highly liquid assets such as cash, cash equivalents, short term investments, and accounts receivable, the Quick Ratio offers insights into the business’s immediate debt paying ability.
A Quick Ratio of 1:1 is generally considered ideal, indicating that the business has enough liquid assets to cover its current liabilities. A ratio lower than 1 may suggest that the business may struggle to meet its short term obligations using only its most liquid assets.
However, it’s essential to compare the Quick Ratio with the Current Ratio to gain a comprehensive understanding of the business’s liquidity position. If the Current Ratio is significantly higher than the Quick Ratio, it may indicate that the business’s liquidity heavily relies on less liquid assets like inventory, which may pose risks in meeting short term payments.
Cash Ratio
The Cash Ratio offers a stringent assessment of the business’s ability to settle short term debts using only its most liquid assets, excluding less liquid assets like inventory. By considering only cash and cash equivalents, which are highly liquid and readily available, the Cash Ratio provides insights into the business’s immediate debt paying ability.
The Cash Ratio is calculated by dividing the business’s cash and cash equivalents by its current liabilities.
Cash Ratio = Cash & Cash Equivalent / Current Liabilities
A higher Cash Ratio indicates a stronger liquidity position, suggesting that the business has sufficient liquid assets to cover its short term liabilities. On the other hand, a lower Cash Ratio may indicate potential liquidity challenges, indicating that the business may struggle to meet its immediate financial obligations using only its cash and cash equivalents.
The Cash Ratio is particularly useful during periods of financial distress or uncertainty, as it focuses on the most liquid assets that are readily available for meeting short term obligations.
Operating Cash Flow Ratio
The Operating Cash Flow Ratio evaluates the business’s ability to generate sufficient cash from its core operational activities to cover its short term debt obligations.
The Operating Cash Flow Ratio is calculated by dividing the cash flow from operations by the business’s current liabilities.
Operating cash flow ratio = cash flow from operations /current liabilities
Cash Flow from Operations (CFO): This represents the cash generated or used by a business’s core operating activities during a specific period. It includes cash received from customers, cash paid to suppliers and employees, and other operating expenses. CFO reflects the business’s ability to generate cash from its day to day business operations.
A ratio less than 1 indicates that the business may not be generating enough cash to meet its current liabilities. In such cases, the business may face challenges in paying off its short term debts using the cash generated from operations alone, potentially leading to liquidity issues.
When the Operating Cash Flow Ratio falls below 1, it suggests that the business may struggle to sustain its operations in the short run, as it may not have enough cash flow from operations to meet its immediate financial obligations.
This situation could indicate financial distress and may require the business to consider measures to improve its cash flow generation or manage its current liabilities more effectively.
Ratios for Assessing Operational Efficiency
Operational efficiency ratios, also known as activity ratios, assess a business’s effectiveness in utilising its resources to generate sales and income. These ratios analyse the business’s ability to manage its assets, working capital, and core business processes efficiently, providing insights into its operational performance and ability to create shareholder value.
Asset Turnover Ratio
The Asset Turnover Ratio provides insight into how efficiently a business utilises its assets to generate sales revenue. It measures the relationship between the business’s net sales and its average total assets over a specific period.
The Asset Turnover Ratio is calculated by dividing the business’s net sales by its average total assets.
Asset turnover ratio = net sales / average total assets
The Asset Turnover Ratio provides insight into the business’s efficiency in converting its asset base into sales revenue. A higher ratio indicates that the business generates more sales revenue per dollar of assets, suggesting efficient asset utilisation and effective business operations.
Alternatively, a lower ratio suggests inefficiency in asset utilisation, indicating that the business may not be effectively leveraging its asset base to generate revenue.
Inventory Turnover Ratio
Inventory turnover ratio is used to evaluate the efficiency with which a business manages its inventory by measuring how quickly inventory is sold and replaced within a specific period, usually a financial year. It reflects the relationship between the cost of goods sold (COGS) and the average inventory level during the same period.
AASB 102 Inventories and AASB 116 Property, Plant, and Equipment provide essential guidance on measuring and reporting costs associated with inventories and fixed assets. These standards impact cost of goods sold and depreciation expense calculations, which are crucial for evaluating operational efficiency
Inventory turnover can be calculated using various formulaes, but the fundamental principle remains consistent: dividing the cost of goods sold (COGS) by the average inventory.
Inventory Turnover = Cost of Goods Sold / Average Inventory
Cost of Goods Sold (COGS): This is the direct cost incurred by a business in producing goods or services that have been sold during a particular period. It includes expenses such as raw materials, labour, and manufacturing overhead. COGS does not include indirect expenses like distribution costs or marketing expenses.
Average Inventory: This is the average value of inventory held by a business during a specific period, typically calculated as the average of the beginning and ending inventory balances. It reflects the level of inventory maintained by the business over the period and is used to smooth out any fluctuations in inventory levels.
The inventory turnover ratio indicates how efficiently a business is managing its inventory and selling its products. A higher inventory turnover ratio typically suggests better performance, as it implies that inventory is being sold and replaced quickly. This may indicate strong sales performance, effective inventory management, and responsiveness to changes in market demand.
Furthermore, it shows a reduced risk of holding onto damaged or obsolete stock, as inventory is being sold off quickly, minimising the likelihood of inventory write offs or losses.
Conversely, a lower inventory turnover ratio may indicate inefficiencies in inventory management or weak sales performance. It could suggest overstocking, obsolete inventory, or challenges in meeting customer demand.
Accounts Payable Turnover Ratio
The accounts payable turnover ratio evaluates how fast a business settles its obligations to creditors and suppliers. It indicates the speed at which the business pays off its accounts payable, reflecting its management of supplier payments.
The accounts payable turnover ratio is calculated by dividing the net credit purchases by the average accounts payable.
Accounts Payable Turnover Ratio = Net Credit Purchases / Average Accounts Payable
To calculate the net credit purchases, one subtracts the beginning accounts payable balance from the ending accounts payable balance and adds any cash payments made to suppliers during the period.
The average accounts payable is determined by averaging the beginning and ending accounts payable balances.
A higher accounts payable turnover ratio indicates that the business is paying off its suppliers more frequently within the given period. This may suggest efficient invoice management and good relationships with suppliers, as the business is able to meet its payment obligations promptly or even before the due date.
It also signifies effective cash flow management, as the business is not holding onto excessive amounts of accounts payable for an extended period.
On the other hand, a lower accounts payable turnover ratio may suggest inefficiencies in payment processes or strained relationships with suppliers. It could indicate delays in settling accounts payable or difficulties in managing cash flow effectively.
Receivables Turnover Ratio
The receivables turnover ratio is a financial metric that assesses how efficiently a business converts its credit sales to cash by analysing its accounts receivable. Accounts receivable represent the amount owed to the business by its customers for goods or services sold on credit.
To calculate the receivables turnover ratio, one divides the net credit sales by the average accounts receivable.
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net credit sales refer to the total sales made on credit, excluding cash sales and any returns or allowances. Average accounts receivable is computed by averaging the beginning and ending balances of accounts receivable over a specific period.
A higher receivables turnover ratio indicates that the business is efficiently collecting payments from its customers. This suggests effective credit management and timely conversion of accounts receivable into cash. It signifies that customers are paying their dues promptly, contributing to healthy cash flow.
A lower receivables turnover ratio may indicate issues with revenue collection. It could suggest slow paying customers or ineffective credit management practises. A low ratio implies that the business is taking longer to convert its credit sales into cash, potentially leading to cash flow challenges and increased risk of bad debts.
Monitoring the receivables turnover ratio helps businesses evaluate the effectiveness of their credit policies and collection efforts. It provides insights into how efficiently the business manages its accounts receivable and its overall financial health.
Average Collection Period
The average collection period shows the time it takes for customers to settle their outstanding bills. It provides insight into the efficiency of the business’s accounts receivable management by indicating how long it typically takes to collect payments from customers.
Average Collection Period = (365 * Accounts Receivable Turnover Ratio) / Net Credit Sales
Net Credit Sales: This represents the total sales made on credit, excluding cash sales, sales returns, and sales allowances. It reflects the revenue generated by the business from credit transactions.
To calculate the net credit sales, the business applies the formulae:
Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances
A shorter average collection period indicates that customers are paying their bills more promptly, resulting in healthier cash flow and reduced risk of bad debts.
A longer average collection period suggests delays in collecting payments from customers, which could strain cash flow and increase the risk of overdue accounts. It may indicate issues such as ineffective credit policies, slow paying customers, or inadequate collection procedures.
Leverage Ratios
Leverage ratios are utilised by entities to evaluate the level of debt they have taken on, both in the short term and long term, to finance their operations. These ratios offer insights into the business’s debt levels.
The leverage ratio typically compares the amount of debt a business has to either its total assets or its equity, as indicated in its financial statements such as the balance sheet or income statement. By using this ratio, investors can gain an understanding of the business’s financial structure, particularly its reliance on debt for financing.
Additionally, lenders can use leverage ratios to assess the business’s ability to repay loans. Leverage ratios assist in assessing the business’s debt burden and its capacity to manage it effectively.
Debt Ratio
This ratio compares the total debt of a business, including both short term and long term debt, to its total assets. It provides insight into how much of the business’s assets are financed by debt.
A higher debt ratio indicates that a larger portion of the business’s assets is funded by debt, suggesting higher financial risk, whereas a lower debt ratio suggests that the business relies less on debt financing and may have more financial stability.
Debt Ratio = Total Debt / Total Assets
Debt to Equity Ratio
This ratio measures the proportion of debt financing relative to equity financing in the business’s capital structure. It compares the total debt to the total equity, providing an indication of the business’s financial leverage.
A higher debt to equity ratio suggests that the business relies more on debt financing, potentially increasing financial risk but also potentially boosting returns on equity.
Debt to Equity Ratio = Total Debt / Total Equity
Interest Coverage Ratio
This ratio assesses the business’s ability to cover its interest expenses with its earnings before interest and taxes (EBIT). It indicates the business’s capacity to meet its interest obligations from its operating income.
A higher interest coverage ratio implies that the business generates sufficient earnings to comfortably cover its interest payments, indicating financial stability. On the contrary, a lower ratio may suggest potential financial strain if the business struggles to cover its interest expenses. The formulae for the interest coverage ratio is:
Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expenses
Market Value Ratios
Market value ratios are useful for assessing the value of a business. These ratios are commonly used by external stakeholders such as market analysts and investors to evaluate the business’s worth, but internal management also utilises them to monitor the value per share of the business.
For estimating market value and conducting competitor analysis, AASB 101 ensures that financial statements provide a comprehensive and comparable set of financial data, facilitating the calculation of market to book ratios and other valuation metrics.
Earnings Per Share Ratio
The earnings per share (EPS) ratio indicates how much profit can be attributed to each share of the business’s stock. It’s calculated by dividing the business’s net income (total profit after deducting expenses, interest, and taxes) minus any preferred dividends by the average number of outstanding common shares. This ratio helps investors understand the profitability per share.
When external stakeholders assess financing options or make investment decisions, AASB 133 Earnings per Share provides a basis for calculating earnings per share (EPS), a key ratio for investors.
EPS = (Net Income – Preferred Dividends) / End of Period Common Shares Outstanding
Price Earnings Ratio
The price earnings (P/E) ratio reveals the price investors are willing to pay for each dollar of the business’s earnings. It’s a fundamental ratio that reflects how the market values the business’s shares. A higher P/E ratio indicates that investors anticipate higher future growth and are willing to pay a premium for the business’s stock.
Alternatively, a lower P/E ratio suggests either undervaluation of the stock or lower growth expectations. The formulae to calculate Price Earning Ratio is as follows:
P/E Ratio = Share Price / Earnings per Share
Book Value Per Share Ratio
It is a financial measure used to assess the accounting value of a business’s common equity on a per share basis. It reflects the value of assets minus liabilities attributed to common shareholders, divided by the total number of outstanding common shares.
Also known as net asset value per share or shareholders’ equity per share, this ratio helps investors understand the intrinsic value of each share. To calculate book value per share ratio, the formulae is as follows:
Book Value Per Share Ratio = (Total Equity – Preferred Equity) / Total Shares Outstanding
Dividend Yield Ratio
indicates the annual dividend income an investor can expect from a business’s stocks relative to its current market price. It is particularly important for investors seeking regular income from their investments.
The ratio is calculated by dividing the dividend per share by the share price, representing the value of dividends received for every share owned when the business pays dividends to shareholders.
Dividend Yield Ratio = Dividend Per Share / Share Price
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.
