Principles of Revenue Recognition
Revenue is reported on the top line of the income statement. Accrual accounting... Read More
Financial ratios are used to express one financial quantity with reference to another. Financial ratios can assist with company and security valuations, as well as stock selections, and forecasting.
A variety of categories may be used to classify financial ratios. Although the names of these categories and the ratios that are included in each of them can vary significantly, common categories that are used include activity, liquidity, solvency, profitability, and valuation ratios. Each category measures a different aspect of a company’s business. However, all categories are important in the evaluation of a company’s overall ability to generate cash flows from its business operations.
Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how efficiently a company performs its daily tasks such as managing its various assets. These ratios generally combine income statement information in the numerator and balance sheet information in the denominator.
The list below describes the most commonly used activity ratios:
Computation: cost of goods sold/average inventory
Interpretation: the ratio can be used to measure the effectiveness of inventory management. A higher inventory turnover ratio implies that inventory is held for a shorter time period.
Computation: number of days in period/inventory turnover
Interpretation: the ratio can also be used to measure the effectiveness of inventory management. A lower DOH implies that inventory is held for a shorter time period.
Computation: revenue/average receivables
Interpretation: this measures the efficiency of a company’s credit and collection processes. A relatively high receivables turnover ratio may indicate that a company has highly efficient credit and collections. Similarly, it could imply that a company’s credit or collection policies are too stringent.
Computation: number of days in period/receivables turnover
Interpretation: this measures the time that elapses between a sale and cash collection. It reflects how fast a company collects cash from customers to whom it extends credit. A low DSO indicates that a company is efficient in its credit and collection processes.
Computation: purchases/average trade payables
Interpretation: this measures the number of times per year that a company theoretically pays off all its creditors.
Computation: number of days in period/payables turnover
Interpretation: this reflects the average number of days that a company takes to pay its suppliers.
Computation: revenue/average working capital
Interpretation: this indicates how efficiently a company generates revenue with its working capital. A high working capital turnover ratio indicates greater efficiency.
Computation: revenue/average net fixed assets
Interpretation: this measures how efficiently a company generates revenues from its investments in fixed assets. A higher fixed asset turnover ratio indicates a more efficient use of fixed assets in generating revenue.
Computation: revenue/average total assets
Interpretation: this measures a company’s overall ability to generate revenues with a given level of assets. A low asset turnover ratio can be an indication of inefficiency or the relative capital intensity of the company.
Liquidity ratios measure a company’s ability to satisfy its short-term obligations. These ratios reflect a company’s position at a point in time. They, therefore, usually use ending balance sheet data rather than averages. The list below describes the most commonly used liquidity ratios.
Computation: current assets/current liabilities
Interpretation: a higher current ratio indicates a higher level of liquidity or ability to meet short-term obligations.
Computation: (cash + short-term marketable investments + receivables)/current liabilities
Interpretation: a higher quick ratio indicates a higher level of liquidity or ability to meet short-term obligations. It is a better indicator of liquidity than the current ratio in instances where inventory is illiquid.
Computation: (cash + short-term marketable investments)/current liabilities
Interpretation: the ratio is a reliable measure of liquidity in a crisis.
Computation: (cash + short-term marketable investments + receivables)/daily cash expenditures
Interpretation: this measures how long a company can pay its daily expenditures using only its existing liquid assets, without any additional cash inflow.
In addition to the above ratios, the cash conversion cycle is an additional liquidity measure that can be used. Computed as DOH + DSO – Number of days of payables, it measures the length of time that is required for a company to go from cash paid (used in operations) to cash received (as a result of operations).
Solvency ratios measure a company’s ability to satisfy its long-term obligations. They provide information relating to the relative amount of debt in a company’s capital structure. Moreover,they reveal the adequacy of a company’s earnings and cash flow to cover interest expenses and other fixed charges as they fall due.
There are two types of solvency ratios: (i) debt ratios, which focus on the balance sheet and measure the amount of debt capital relative to equity capital; and (ii) coverage ratios, which focus on the income statement and measure the ability of a company to cover its debt payments. Both sets of ratios are useful in assessing a company’s solvency and evaluating the quality of its bonds and other debt obligations.
Below is a list of the most commonly used solvency ratios:
Computation: total debt/total assets
Interpretation: this measures the percentage of a company’s total assets that are financed with debt. A higher ratio implies higher financial risk and weaker solvency.
Computation: total debt/(total debt + total shareholders’ equity)
Interpretation: this measures the percentage of a company’s capital (debt + equity) that is represented by debt. A higher ratio implies higher financial risk and weaker solvency.
Computation: total debt/total shareholders’ equity
Interpretation: this measures the amount of debt capital relative to equity capital. A higher ratio implies higher financial risk and weaker solvency.
Computation: average total assets/average total equity
Interpretation: this measures the number of total assets that are supported for each one money unit of equity. The higher the ratio, the more leveraged the company in its use of debt and other liabilities to finance assets.
Computation: EBIT/interest payments
Interpretation: this measures the number of times that a company’s EBIT could cover its interest payments. A higher ratio indicates stronger solvency.
Computation: (EBIT + lease payments)/(interest payments + lease payments)
Interpretation: this measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover its interest and lease payments. A higher ratio indicates stronger solvency.
Profitability ratios measure a company’s ability to generate profits from its resources (assets). There are two types of profitability ratios: (i) return-on-sales profitability ratios, which express various sub-totals on the income statement as a percentage of revenue, and(ii) return-on-investment profitability ratios, which measure income relative to the assets, equity, or total capital employed by a company.
The list below describes the most commonly used solvency ratios:
Computation: gross profit/revenue
Interpretation: this indicates the percentage of revenue that is available to cover operating and other expenses and to generate profit. A higher gross profit margin indicates a combination of higher product pricing and lower product costs.
Computation: operating income/revenue
Interpretation: an operating profit margin that increases faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads.
Computation: EBT (earnings before tax but after interest)/revenue
Interpretation: this reflects the effect on the profitability of leverage and other non-operating income and expenses.
Computation: net income/revenue
Interpretation: this measures how much of each dollar collected as revenue translates into profit.
Computation: operating income/average total assets
Interpretation: this measures the return (before deducting interest on debt capital) that is earned by a company on its assets.
Computation: net income/average total assets
Interpretation: this measures the return earned by a company on its assets.
Computation: EBIT/Short- and long-term debt and equity
Interpretation: this measures the profits that a company earns on all of the capital that it employs.
Computation: net income/average total equity
Interpretation: this measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity.
Computation: (net income – preferred dividends)/average common equity
Interpretation: this measures the return earned by a company only on its common equity.
Valuation ratios measure the quantity of an asset or flow that is associated with the ownership of a specified claim.
The list below provides a list and description of the most commonly used valuation ratios:
Computation: price per share/earnings per share
Interpretation: this tells how much an investor in common stock pays per dollar of earnings.
Computation: price per share/cash flow per share
Interpretation: this measures a company’s market value relative to its cash flow.
Computation: price per share/sales per share
Interpretation: this compares a company’s stock price to its revenue. It is sometimes used as a comparative price metric when a company does not have a positive net income.
Computation: price per share/book value per share
Interpretation: this compares a stock’s market value to its book value. It is often used as an indicator of market judgment about the relationship between a company’s required rate of return and its actual rate of return. A higher ratio implies that investors expect management to create more value from a given set of assets, all else equal.
Question 1
You have been provided with the following information on Company ABC for the year 2020:
Revenue: $5,276,987;
Gross profit: $3,534,099; and
Net income: $2,956,123.
Company ABC’s net profit margin is closest to:
- 56.02%.
- 66.97%
- 83.64%
Solution
The correct answer is A.
Net profit margin = Net income/revenue = $2,956,123/$5,276,987= 56.02%
Question 2
Which of the following categories of ratios could be used to evaluate a company’s ability to pay back a bank loan?
- Liquidity ratios.
- Solvency ratios.
- Profitability ratios.
Solution
The correct answer is B.
Solvency ratios measure a company’s ability to meet long-term obligations such as bank loans and bond obligations.
A is incorrect. Liquidity ratios measure a company’s ability to satisfy its short-term obligations.
C is incorrect. Profitability ratios measure a company’s ability to generate profits from its resources (assets).