Financial Ratios Definitive Guide
Financial Ratios Definitive Guide
Financial Ratios Definitive Guide
Definitive Guide
Essential ratios for comprehensive
financial analysis
Definitions, formulas, examples, and interpretations of financial
ratios for profitability, return, efficiency, and leverage.
Authors
Scott Powell, Co-Founder and Chief Content Officer
Use CFI's Definitive Guide to help you or your team master financial ratio analysis. With our
comprehensive guide, organizations can establish a shared baseline understanding of financial
ratios while enhancing individual skills. Standardizing finance skills across the organization can lead
to improved consistency, accuracy, and efficiency in reporting, analysis, and decision-making.
To learn how to conduct a comprehensive financial evaluation of any organization, check out
Financial Analysis Fundamentals, a core course in CFI’s Certified Financial Modeling & Valuation
Analyst (FMVA)® program. This guide’s authors, Scott Powell, Duncan McKeen, and Jeff Schmidt,
bring decades of financial services and financial analysis training experience to design and teach the
curriculum for the FMVA program, providing training for teams and individual learners on essential
skills for practical financial analysis.
By combining real-time resources and role-based learning paths, CFI for Teams helps organizations
overcome these challenges to learning, development, and talent retention. From entry-level
analysts to client-facing advisors and future leaders, CFI for Teams’ custom learning journeys are
designed to get people role-ready quickly―for today’s challenges and tomorrow’s opportunities.
Benchmarking ............................................................................................................................................................... 10
II. Return, Profitability, and Expense Ratios 12
Return Ratios: Return on Equity (ROE) ................................................................................................................
13
V. Liquidity Ratios 35
Current Ratio ................................................................................................................................................................
36
This comprehensive guide to financial ratios empowers finance leaders and their
teams across organizations to extract key insights from financial statements. Within
this guide, you’ll find definitions, calculations, interpretation, industry benchmarks,
and examples for all critical categories - liquidity, asset management, debt
management, profitability, and market value ratios.
With a solid grip on financial ratios, managers and analysts across corporate finance,
banking, investment, and credit teams can thoroughly assess business performance
and make smart data-driven decisions.
In addition to using this guide, you or your team can learn how to conduct a
comprehensive financial evaluation of any organization in CFI’s Financial Analysis
Fundamentals course, taught by Scott Powell, CFI Co-Founder, Chief Content
Officer, and Definitive Guide co-author.
Types of Ratios
Corporate finance ratios can be broken down into two main categories and four subcategories.
The first group is performance ratios, which provide insights into how well a company is
performing. These ratios examine the company's returns, profitability, and the efficiency with
which it utilizes its assets.
In contrast, the second group comprises financial leverage ratios, which assess solvency and
liquidity. Solvency ratios focus on evaluating a company's long-term financial health and its
ability to meet long-term obligations. On the other hand, liquidity ratios analyze the company's
immediate cash position and its capacity to handle short-term financial needs and obligations.
Both solvency and liquidity are crucial factors to consider when assessing a company's overall
financial well-being.
Financial Analysis
Collect
The first step in conducting a comprehensive financial analysis is to gather multiple years of
historical financial statements, including income statements, balance sheets, and cash flow
statements. By examining data from multiple years, you can observe patterns and trends,
providing a more comprehensive view of the company's financial performance.
Calculate
Once you have collected the financial statements, it's time to calculate various financial
ratios. Financial ratios are powerful tools that allow you to assess a company's performance
and compare it to industry standards. Some commonly used ratios include liquidity ratios,
profitability ratios, and solvency ratios. By calculating these ratios, you can gain insights
into the company's liquidity, profitability, efficiency, and overall financial stability.
Interpret
With the calculated financial ratios in hand, it's crucial to interpret them effectively. Look
for trends and patterns that emerge from the ratios and try to uncover the stories behind
the numbers. For example, a declining profitability ratio may indicate inefficiencies or
increased competition, while a consistent growth in liquidity ratios may suggest a strong
cash position. By delving deeper into these ratios, you can better understand the
company's financial strengths and weaknesses.
Benchmark
Finally, it's important to benchmark the calculated ratios against an appropriate peer group
or industry averages to gain a broader perspective on a company's performance. This
comparison allows you to evaluate how the company fares in relation to its competitors or
the industry. By benchmarking, you can identify areas where the company excels or falls
behind, helping you pinpoint opportunities for improvement.
Remember, financial analysis is an ongoing process that requires continuous monitoring and
adjustment. Following these four steps—getting historic financial statements, calculating
financial ratios, interpreting the ratios, and benchmarking against peers—will equip you to make
informed decisions and uncover valuable insights into a business's financial health.
While calculating individual year-over-year change can be insightful, conduct your analysis using
multiple years of results, ideally a minimum of five years. This extended timeframe allows trends to
emerge, providing valuable insights for forecasting and future projections. Through the examination
of historical trends, we gain a better understanding of how to project future performance.
1 2 3
4 5 6
Each of the illustrations above help us make broad observations about trends.
We may observe consistent growth, On the other hand, if an industry is
represented by a line indicating a constant experiencing disruption, we may witness
year-over-year growth rate rapidly declining and accelerating declining
Conversely, we might identify a declining revenue, illustrated by a steep downward
revenue trend over time, depicted by a sloping curve. It is worth noting that this
downward sloping line pattern can also apply to costs, where a
company drastically reduces its expenses,
Alternatively, significant strategic changes or resulting in a declining cost curve
shifts within an industry may lead to steeper
growth, deviating from linear growth Further analysis may reveal a situation where
patterns seen in the previous examples. This revenue or expenses remain flat with no
exponential growth curve would be growth or change over time, represented by
characteristic of a company or industry a straight flat line
undergoing a major transformation. Lastly, we may encounter volatility, where a
company's revenue and expenses fluctuate,
exhibiting periods of growth followed by
decline and vice versa.
Regardless of the shape of the results, the key is to assess trends over several years of results
and use those trends to make projections about future performance. This forward-looking
analysis is essential for gaining insights into the company's prospects. Ultimately, this process
captures the essence of horizontal or trend analysis.
Now, let’s look at the same data presented visually in the four graphs below. The trends are
clearly visible. We see the addition of two features that make the trend analysis even easier to
read. The lightest line in the graphs below are the averages over 5 years, while the dotted line
represents a trend line, which is helpful when a trend may be hard to see otherwise.
Benchmarking
As we have already seen, financial ratios are valuable tools for assessing a company's
performance. Still, their true significance lies in the context they provide.
Benchmarking allows us to compare a company's ratios against those of its peers operating in
the same sector. By doing so, we gain insights into how the company performs relative to its
competitors and the industry as a whole. Benchmarking is typically done against a small peer
group or an industry benchmark.
Benchmarking against a small peer group provides a focused comparison among direct
competitors, offering specific and actionable insights.
On the other hand, benchmarking against the industry at large provides a broader context,
capturing overall industry trends and performance expectations.
Each approach has its merits, and both approaches are often used in combination to gain a
comprehensive understanding of a company's performance and competitiveness.
Industry Benchmarking
Benchmarking against the industry at large involves comparing a company's financial ratios
and performance metrics to those of a wide range of companies operating within the same
sector. This approach considers companies of varying sizes, market positions, and
operational models. Industry benchmarks are formulated by aggregating data from a
diverse set of companies within the sector.
With industry benchmarking, companies can gain a broader context that helps them
identify overall industry trends, challenges, and opportunities. This context enables them to
understand their relative position within the industry and how their performance stacks up
against the larger market. Such a perspective is invaluable for strategic decision-making,
such as long-term goal setting and identifying potential areas for growth or diversification.
Peer Benchmarking
In peer benchmarking, the focus is on comparing financial ratios and performance metrics
with a select group of companies that are similar in size, market position, and operational
characteristics.
A typical peer group includes direct competitors or companies operating within the same
industry niche.
Benchmarking against a small peer group allows for a more granular analysis and
comparison. It provides a focused view of how a company is performing relative to its
closest competitors. This level of detail can uncover specific strengths, weaknesses, and
competitive advantages within a specific market segment.
Realistically picking peers is the most important part of a peer group analysis and where
you should spend the bulk of your time, unless you are already a specific-industry expert.
Again, the goal is to find peers with similar risk factors as the company you are analyzing.
If there are no good peers, then you may want to look at companies in different industries
that have similar characteristics as the company in question.
But this should be done very rarely and carefully; straying outside a particular sector is rare
in practice.
Ultimately, your benchmarking should be determined based on the closest and best peers.
Business Finance
Characteristics Characteristics
Return, profitability, and expense ratios are financial metrics used to measure and
evaluate the ability of a business to generate income (profit) relative to revenue,
assets, operating costs, and shareholders’ equity during a specific period.
Return Ratios
Return ratios represent the company’s ability to generate returns for its shareholders
and other capital providers. It typically compares a return metric to certain balance
sheet items
Return on Equit
Return on Asset
Return on Invested Capital
Profitability Ratios
Profitability ratios, or margin ratios, represent the company’s ability to convert sales
into profits at various degrees of measurement. Profitability ratios take different
profit metrics from the income statement and compare them to revenue
Gross Profit Margi
Operating Profit Margi
Net Profit Margin
Expense Ratios
Expense ratios represent how much of a company’s revenue is absorbed by specific
expense categories such as cost of goods sold, selling, general and administrative
costs (SG&A), interest, and tax. Like profitability ratios, expense ratios take different
expense metrics from the income statement and compare them to revenue
Effective Interest Rat
Interest Burde
Effective Tax Rat
Tax Burden
INTERPRETATION
ROE measures the profitability and efficiency of a company in generating returns for its
shareholders' equity investment. It shows how effectively a company utilizes its shareholders'
capital to generate profits. A higher ROE generally indicates better financial performance. It
suggests the company generates higher profits relative to its shareholders' equity investment. A
higher ROE is often preferred as it signifies efficient utilization of capital.
EXAMPLE
Here are ROE ratios for small, medium,
and large retailers selling similar
merchandise, as well as an industry
benchmark. These ratios are based on
the financial results of real companies
with names removed for learning
purposes.
It's important to note that different industries typically have different ROAs. Industries that require
substantial investments in fixed assets and have capital-intensive operations tend to have lower
ROAs. A lower ROA occurs because the larger asset base increases the denominator of the ROA
formula. Ultimately, the interpretation of ROA should be relative and consider the specific industry
and company circumstances.
EXAMPLE
Here are ROA ratios for the same
retailers with an industry benchmark
ROA of 5.00%. All three of these
retailers have significant amounts of
property, plant, and equipment (such as
stores and distribution centers) and are
required to hold large inventories. These
factors help explain a lower ROA on
average.
INTERPRETATION
Let's discuss a fundamental principle that should always be at the forefront of your mind when
conducting financial analysis: the principle of comparing apples to apples and oranges to oranges.
This principle emphasizes the importance of ensuring that you compare metrics of the same nature
and relevance.
Take a closer look at the return on equity (ROE) ratio. Since the profit that belongs to shareholders
is net income, we calculate ROE by dividing net income by equity. This ratio specifically focuses on
the returns generated for equity investors.
Now, let's shift our attention to ROIC. Here, we need to incorporate a profit metric that considers
both shareholders and debtholders. Therefore, we calculate a profit figure that excludes interest
expenses, representing the returns to debtholders.
EXAMPLE
Here are ROIC ratios for the same three
retailers. The mid-sized retailer has the
highest average ROIC at 19.90%, almost
8.00% higher than the industry average.
Again, the small retailer has the lowest
average ROIC at 4.57%. ROIC and ROE
commonly move in line with each other
as we see here.
INTERPRETATION
A low gross margin ratio does not necessarily indicate a poorly performing company. It is important
to compare gross margins between companies in the same industry rather than across industries.
For example, a legal service company reports a high gross margin because it operates in a service
industry with low production costs. In contrast, the ratio will be lower for a car manufacturing
company because that industry has a high direct operating cost of goods.
This ratio is an example of vertical analysis where each line item on the income statement is
compared to revenue. In contrast, the term horizontal analysis is used to describe comparing
periods with each other (i.e., quarters, years, etc.).
EXAMPLE
Here are gross profit margin ratios for
the same three retailers. We see a wide
range of performance, which is
somewhat uncommon within an
industry and suggests very different
retail strategies. The mid-sized retailer’s
gross margins are about half those of
the small and large retailers and 6.00%
on average lower than the industry
average. This metric suggests the mid-
sized retailer may operate on much
lower profit margins by selling at lower
prices, or it has a problem controlling its
direct operating costs.
INTERPRETATION
The operating profit margin calculation is the percentage of operating profit derived from each
currency unit of revenue. For example, if the company’s reporting currency is dollars, you can
interpret a 15% operating profit margin as follows: for every $1 of revenue, the company generates
15 cents of profit after covering all its operating costs.
Some analysts prefer to calculate this ratio with EBITDA (Earnings Before Interest, Tax, Depreciation
and Amortization) rather than EBIT as depreciation and amortization are non-cash operating
expenses. If in doubt, calculate both. In most instances the EBIT and EBITDA versions of these ratios
will be highly correlated. A large difference between the two could mean very different asset
structures and/or asset useful lives.
EXAMPLE
Here are operating profit margin ratios
for the same three retailers. Unlike the
wide range of gross margins among the
retailers, all the retailers’ operating
profit margin ratios range between 3%
and 4%. Recall the mid-sized retailer’s
gross margins were significantly lower
than the rest.
EXAMPLE
Here are net profit margin ratios for the
same three retailers. The net profit
margins amongst the retailers have now
much more closely converged with all
retailers delivering around the industry
average of 2.25%. General retailers
typically deliver very low margins
compared to other industries.
INTERPRETATION
It’s really important to use gross interest expense in this ratio. Sometimes companies show only net
interest expense on the income statement (which is where interest income is netted off against
interest expense). If you can’t see interest expense presented separately on the income statement,
it can be found in the notes to the financial statements.
Also know that another name for interest expense and income that many companies use is finance
expense and income.
EXAMPLE
Here are the effective interest rates the
three retailers paid on their debt
financing / debt capital. Overall, they are
relatively stable and in line with the
industry overall. The exception is the
mid-sized retailer whose effective
interest rate is half the others.
Generally, this ratio moves in the opposite direction to the effective interest rate. The higher the
effective interest rate, the more EBIT interest expenses will consume.
EXAMPLE
Recall that the mid-sized retailer has the
lowest effective interest rate of the
three retailers. Here it has the lowest
interest burden (i.e., highest ratio).
Conversely, the small retailer has the
highest interest burden as more of its
EBIT is consumed by interest expenses.
Total Taxes The effective tax rate looks at the relationship between total
taxes and earnings before tax. In general, this ratio shows
Earnings Before Tax how well a company manages its taxes.
INTERPRETATION
Generally, from a shareholder perspective, the lower the effective tax rate, the better, as this means
more profits remain for shareholders. You can also compare the effective tax rate to corporate tax
rates in the jurisdiction(s) in which the company operates. Typically, a company’s effective tax rate
ratio should trend towards the corporate tax rate.
EXAMPLE
The average effective tax rates for the
three retailers show very little
difference. At the same time, all three
retailers paid more tax on average than
the industry as a whole. Here we see the
corporate tax rates for all three retailers
very close together when we look at the
averages. The small retailer has the
widest swings in its effective tax rate
with year 4 at a low of 20.41% and, in
year 5, rising to 45.52%. This large
difference may be the result of one-off
items that you should investigate
further.
INTERPRETATION
If you see a percentage like 70%, it means shareholders receive 70% of earnings before tax.
Alternatively, it means 30% of a company’s earnings before tax go to taxes. If you have already
calculated the effective tax rate, you can quickly calculate a tax burden ratio by taking 100% and
subtracting the effective tax rate.
One-off items in a company’s financial statements can sometimes bring volatility to single year tax
burdens. As a result, financial analysts often prefer to look at averages rather than single years.
EXAMPLE
Here we see the average tax burdens for
the three retailers are all very close. We
also see the tax burden is higher
(represented by a lower number) for the
three retailers than the industry overall.
The retailers’ shareholders are all
receiving around 67% of earnings before
tax while the industry overall retains
69% of earnings before tax for
shareholders.
Asset utilization ratios measure how well a company is utilizing its assets and
resources. These ratios are sometimes referred to as efficiency ratios. These ratios
compare revenue and cost of goods sold to various assets and liabilities on the
balance sheet. Typically, most financial analysts focus on what we call the “top 6”
Total Asset Turnove
Property, Plant & Equipment Turnove
Cash Turnover/ Cash Day
Accounts Receivable Turnover / Accounts Receivable Day
Inventory Turnover / Inventory Day
Accounts Payable Turnover / Accounts Payable Days
When pulling numbers from the balance sheet, some financial analysts prefer to
calculate averages over two years or periods rather than using the current year.
Although this is more correct academically and more accurate, it is rarely done in
practice. Instead, most analysts use only the current year as it is quicker and easier to
do.
Asset Turnover
Revenues The asset turnover ratio, also known as the total asset
turnover ratio, measures how efficient a company uses its
Total Assets assets to generate sales. This ratio looks at how many dollars
in sales are generated per dollar of total assets that the
company owns. The asset turnover ratio divides revenues by
total assets.
INTERPRETATION
Asset turnover ratios are typically greater than 100%, so it is convention to quote them as a multiple
rather than as a percentage. Let’s imagine the asset turnover ratio was 1.27. We would say the ratio
is 1.27 times (marked by an x) rather than 127%.
For these ratios, the larger, the better. To make these ratios more understandable, it is often helpful
to talk using currency language. For example, assume an asset turnover ratio is 1.27 times. You can
interpret this as, for every dollar invested in assets, the business gets $1.27 of annual revenue.
EXAMPLE
Here we see the same three retailers,
and we can see a clear difference
between the three. The mid-sized
retailer has the highest asset turnover,
followed by the large retailer and then
the small retailer. The quality and
location of the three retailers’ stores can
explain a large part of the differences.
The mid-sized retailer’s stores are large,
warehouse-style buildings located in
suburban areas where real estate is less
expensive. In contrast, the large retailer
operates stores in both urban and
suburban areas, and its stores have a
more traditional retail layout. The small
retailer operates primarily in urban areas
with the most expensive real estate, and
it's stores have more expensive fixtures
and fittings. Asset turnover is very
stable for all three retailers.
INTERPRETATION
Like the asset turnover ratio, the PP&E turnover ratio is typically greater than 100%, so it is
convention to quote them as a multiple rather than as a percent. Let’s imagine the PP&E turnover
ratio was 3.75. We would say the ratio is 3.75 times (marked by an x) rather than 37550%.
For these ratios, the larger, the better. While PP&E represents a large part of total assets, typically
total asset turnover and PP&E turnover will be highly correlated – in other words, moving in line with
each other.
EXAMPLE
Our three retailers have significant
amounts of PP&E, so it should not be
surprising that their PP&E ratios move
very similarly to total asset turnover.
Again, we see the impact of the mid-
sized retailer having spent less on its
stores and real estate by building
warehouse-like stores in suburban areas.
The mid-sized retailer gets double the
average revenue out of its PP&E (6.96x)
when compared with the large retailer
(3.42x). The mid-sized retailer gets four
times the average revenue out of its
PP&E compared with the small retailer.
Recall the small retailer operates in
expensive urban areas with high quality
fixtures and fittings to enhance the
shopping experience and draw in
customers.
INTERPRETATION
For the next four turnover ratios, you'll encounter two versions: a turnover version and a days version.
Let's consider an example where we calculate a cash turnover ratio of 40 times. This implies that for
every dollar we hold in cash, we generate $40 in revenue. An alternative interpretation is that our
current cash balance cycles through 40 times in a single year.
Understanding the cash turnover rate can help you understand the concept of the cash days ratio. If the
cash turns over 40 times in a year, and there are 365 days in a year, then dividing 365 by 40 yields 9.125
days. In simpler terms, our current cash balance turns over approximately every 9.125 days.
To put it another way, if our company generated no revenue for 9.125 days, our existing cash reserves
would sustain us. Generally, a lower number is preferable because idle cash, or cash in the bank, isn't
being utilized to expand the business.
However, it's important to note that industry-specific factors can influence cash days . For instance,
seasonal businesses may require larger cash reserves to continue operating during off-peak periods.
Similarly, tech startups often need substantial cash reserves to sustain them until their revenues begin
to grow significantly.
EXAMPLE
Overall, the cash days for our three
retailers and the industry may be
surprisingly very low. That said, all these
retailers sell necessities which means
cash walks in the door every day. This
constant influx of cash allows these
retailers to operate with low cash
reserves and deploy their cash into the
business instead.
INTERPRETATION
Suppose we have an A/R turnover ratio of 12. This means that for every dollar in accounts
receivable, we generate $12 in revenue. This ratio indicates that our accounts receivable turns over
12 times a year.
To understand how long it takes to collect payment, we can calculate the A/R days ratio. We do this
by dividing 365 by the turnover ratio of 12, which gives us just over 30 days. This means that it takes
about 30 days on average to collect payment after a sale.
Generally, a higher turnover ratio or fewer days to collect payment is better for a business.
However, it's important to note that different industries have varying standard credit terms. For
example, grocery stores typically require immediate payment, resulting in low A/R days. In contrast,
some industries may have standard credit terms of 30 days, leading to a longer collection period.
EXAMPLE
It should be no surprise that A/R days
are low for a retailer because general
merchandise retailers require immediate
payment and generally don’t give
customers credit terms. You will rarely,
if ever, see A/R days for a retailer
exactly at zero because retailers may
extend credit to a few clients (e.g., large
corporate accounts). The small retailer
has the lowest A/R days, which suggests
that they are the least likely of the three
retailers to provide credit to customers.
Cost of Inventory
business sells and replaces its stock of goods in a given
Goods Sold x 365 period of time. Unlike the previous turnover ratios, the
Inventory Cost of inventory turnover ratio uses cost of goods sold (COGS)
Goods Sold rather than revenue. The rationale is that the COGS more
closely aligns with inventory as it is the cost of inventory. To
get to the inventory days ratio, you simply take the
inventory turnover ratio and divide it by 365 or use the
formula.
INTERPRETATION
One of the key principles in effective ratio analysis is to make like-for-like comparisons—compare
apples to apples and oranges to oranges. When calculating the inventory turnover ratio, some analysts
use revenue as the numerator to maintain consistency. However, using the COGS is more accurate
because COGS reflects the actual cost of the inventory, providing a more precise measure of how
frequently the inventory turns over.
Let's say the inventory turnover ratio is 4. This means the inventory turns over four times a year. To
convert this into a "days ratio," divide 365 by 4, resulting in 91.25 days. In general, businesses aim for a
higher inventory turnover or fewer days in inventory, similar to the accounts receivable (A/R) ratio.
However, it's crucial to remember that different industries have varying norms for how long they hold
inventory. To revisit the grocery store example, you would expect a high inventory turnover (or low
inventory days) because many of the items sold are perishable.
EXAMPLE
Here are the inventory days for our
three retailers. All the retailers’ inventory
days are relatively stable over this five-
year period except the small retailer in
year 5. Although all three retailers sell
general merchandise (food, clothes,
household items, etc.), their different
merchandise mixes might be driving
these different days ratios. For example,
the mid-sized retailer focuses on food/
grocery the most while the small retailer
focuses on food/grocery the least.
Cost of Accounts many times a business pays off its creditors. Like the
Goods Sold Payable x365 inventory turnover ratio, the A/P turnover ratio uses cost of
Accounts Cost of goods sold rather than revenue. Again, the rationale is that
Payable Goods Sold COGS more closely aligns with A/P. To get the A/P days
ratio, you simply take the A/P turnover ratio and divide it by
365 or use the formula.
INTERPRETATION
Like the inventory turnover ratio, some analysts use revenue as the numerator to maintain the
consistency of the A/P turnover ratios with the other turnover ratios. However, using COGS is more
precise.
If A/P turnover is 12 times, we say A/P turns over 12 times in a period. This means accounts payable
days are about 30 days.
Generally, a lower A/P turnover ratio or a higher A/P days ratio is better for a business. However, it's
important to note that different industries and geographies have varying standard credit terms.
EXAMPLE
We can see that the industry standard of
A/P days is 45 days. Both the small and
mid-sized retailers have A/P days
around the industry average. The large
retailer has significantly more A/P days
which is likely due to the company’s
ability to negotiate better terms with its
suppliers because of its size and scale.
Financial leverage ratios look at both solvency and liquidity. Solvency ratios focus on
a company's long-term financial health and ability to meet long-term obligations.
Liquidity ratios assess the company's short-term cash position and ability to handle
immediate financial needs and obligations. Both solvency and liquidity are important
considerations when evaluating a company's financial well-being.
When we talk about financial leverage, we are really talking about how much
interest-bearing debt funding a business has relative to its equity funding. We say
that financial leverage increases when a company takes on more debt financing
relative to its equity financing.
Another name for financial leverage is financial gearing. The terms "financial gearing"
and "financial leverage" are often used interchangeably to refer to the practice of
using borrowed funds (debt) to finance a company's operations or investments. Both
terms describe the concept of amplifying the company's returns and risks through
the use of borrowed capital.
This section explores the following financial leverage and solvency ratios
Total Assets to Equit
Debt to Equit
Debt to Tangible Net Wort
Debt to EBITDA
INTERPRETATION
We typically express all financial leverage ratios as multiples rather than percentages. Let’s imagine
a company’s asset to equity ratio is 2.5. We would say the ratio is 2.5 times (marked by an x) equity
rather than 250% of equity.
Generally, the smaller the number, the better. As a financial analyst, you need to make sure that a
business hasn’t taken on too much debt, which would increase the risk of it becoming insolvent and
potentially declaring bankruptcy.
That said, a company can have too little debt as well. Optimal capital structures are typically based
on the industry. It’s useful to know the industry standard capital structures first so you can better
evaluate this ratio.
EXAMPLE
Here are total assets to equity ratios for
our three general merchandise retailers.
The mid-sized retailer has the most
financial leverage of the three. The
challenge with this ratio is that we don’t
necessarily get a clear picture of how
much debt financing a company has
because it infers the size of total
liabilities versus total interest-bearing
liabilities.
Debt to Equity
Interest Bearing The debt to equity ratio focuses on interest-bearing
Liabilities liabilities, which excludes liabilities such as accounts payable
and unearned/deferred revenue. Note that interest-bearing
Total Shareholders’
Equity liabilities can be current, non-current, or both. Include all
interest-bearing liabilities, wherever they appear, when
calculating this ratio.
INTERPRETATION
The debt to equity ratio is the most commonly used by financial analysts to measure financial
leverage because it allows you to compare debt and equity financing precisely.
As before, the smaller the number, the better. You want to make sure a company hasn’t taken on
too much debt, which increases risk of insolvency and bankruptcy.
That said, a company can have too little debt as well. Optimal capital structures are typically based
on the specific industry. It’s useful to know industry standard capital structures first so you can
better evaluate this ratio.
EXAMPLE
Here are the debt to equity ratios for our
three retailers. The mid-sized retailer
has the least leverage and the small
retailer has the most. Given that the
industry has a typical debt to equity
split of 1 to 1, one could argue the mid-
sized retailer is potentially under-
leveraged. That said, all three retailers
have conservative amounts of debt
financing.
Interest Bearing The debt to tangible net worth is a very conservative version
Liabilities of the debt to equity ratio. Debt to tangible net worth
compares all interest-bearing liabilities to total shareholders’
Total Shareholders’
Equity
equity after subtracting intangible assets.
- Intangible Assets
INTERPRETATION
Businesses and commercial bankers often use this conservative debt to equity ratio when
evaluating a corporate borrower. They want to look at the business through a very conservative
lens.
Deducting intangible assets from equity to calculate tangible net worth provides a clearer picture of
a company's financial strength and the tangible value of its assets. Tangible net worth focuses on a
company’s tangible assets, meaning the physical assets with clear market value, such as property,
plant, and equipment (PP&E), inventory, and cash.
Intangible assets, such as patents, trademarks, copyrights, and goodwill, are non-physical assets
that derive their value from intellectual or legal rights rather than physical properties. Since these
assets do not have readily ascertainable market values, or can be difficult to sell or monetize, we
exclude them when calculating tangible net worth.
By deducting intangible assets from equity, investors and analysts can evaluate a company's
financial position by considering only the assets that have a more tangible and measurable value.
EXAMPLE
Here we see debt to tangible net worth
for our three retailers. By deducting
intangible assets from equity, all the
retailers have seen their debt to equity
ratio increase (as the denominator has
decreased). Nevertheless, the ratios are
still very much in line with our standard
debt to equity ratios suggesting all the
retailers have similar amounts of
intangible assets.
Debt to EBITDA
Interest Bearing
The debt to EBITDA ratio compares only the interest-bearing
Debt liabilities on a company’s balance sheet with its EBITDA.
EBITDA Some analysts adjust the numerator of this ratio by
deducting cash from interest-bearing debt to get net debt
divided by EBITDA. The assumption is that the company can
use cash to pay down interest-bearing debt.
INTERPRETATION
Whether we use gross interest-bearing debt or net debt, a high debt to EBITDA ratio may indicate
higher financial risk, while a lower ratio suggests lower risk and better debt repayment capacity.
Investors and lenders frequently use this specific ratio to evaluate a company's ability to generate
sufficient earnings (EBITDA) to cover its debt payments.
These ratios are also very popular with M&A professionals who typically talk in EBITDA multiples
when they are valuing a business.
EXAMPLE
Here are gross debt to EBITDA multiples
for our three retailers. The mid-sized
retailer operates with a capital structure
using the least amount of financial
leverage. The large retailer is in line with
industry averages. The small retailer has
the most leverage, but there is a clear
downward trend from 7.60x in year 1 to
3.60x in year 5.
Financial analysts use liquidity ratios to evaluate the short-term financial soundness
of a company. These ratios assess the company’s short-term cash position and its
ability to handle immediate financial needs and obligations. In this section, we look at
three commonly used liquidity ratios
Current Rati
Quick Ratio
EBITDA to Interest
Current Ratio
Current Assets The current ratio, also known as the working capital ratio,
measures a business’s ability to meet its short-term
Current Liabilities obligations that are due within a year. This ratio compares
total current assets to total current liabilities. It also looks at
how a company can maximize the liquidity of its current
assets to settle its debt obligations.
INTERPRETATION
The current ratio is more comprehensive than other liquidity ratios, such as the quick ratio, as it
considers all current assets, including cash marketable securities, accounts receivable, and
inventory.
If a business has current assets of $60 million and current liabilities of $30 million, then it has a
current ratio of 2. You can interpret this ratio of 2 as indicating the business can pay off its current
liabilities, such as accounts payable, twice with its current assets.
Typically, a current ratio greater than 1 suggests financial well-being for a company. However, a
very high current ratio could suggest the company is leaving too much excess cash unused instead
of investing it into company growth initiatives.
EXAMPLE
Here are the current ratios for the same
three retailers. Recall that, typically, a
current ratio greater than 1 suggests
satisfactory liquidity. However, for our
three retailers, only the mid-sized
retailer hits the target of 1 on average.
Quick Ratio
Current Assets - The quick ratio, also known as the acid-test ratio, measures
Inventory the ability of a business to pay its short-term liabilities by
having assets that are readily convertible into cash. These
Current Liabilities
assets are cash, marketable securities, and accounts
receivable. These assets are considered “quick” assets
because converting them into cash is quick and easy.
INTERPRETATION
Compared to the current ratio, the quick ratio only looks at the most liquid assets. The quick ratio
evaluates a company’s ability to pay its short-term liabilities with only assets that can quickly be
converted into cash. Therefore, the quick ratio excludes accounts like inventories and prepaid
expenses.
Suppose a company has cash of $20 million, marketable securities of $10 million, accounts
receivable of $18 million, and current liabilities of $25 million. Its quick ratio is 1.52, which means the
business can pay off 1.52 times its current liabilities using its most liquid assets.
A quick ratio greater than 1 implies strong financial well-being for the company as it shows that the
company can repay its short-term debt obligations with only its liquid assets. However, like the
current ratio, a very high quick ratio suggests that the company leaves too much excess cash
instead of investing it in growth or to generate returns.
EXAMPLE
The quick ratios for our three retailers
are significantly less than 1. The industry
average suggests that retailers can
succeed with an average quick ratio of
0.30x. It should come as no surprise that
this ratio is much lower than the current
ratio because retailers typically need to
hold significant amounts of inventory.
Many different versions of this ratio exist. Some analysts use EBIT in place of EBITDA. Other
analysts use EBITDA but deduct capex. The logic of this approach is to take out depreciation and
amortization, which are non-cash expenses, and replace them with CAPEX, which is an actual cash
expense.
Another version of this ratio, the fixed charge coverage ratio, uses EBITDA minus CAPEX in the
numerator, while the denominator is the interest expense and the current portion of long-term debt
owed in the current year. This version is more comprehensive as it measures a company’s ability to
service all required, short-term financing obligations.
EXAMPLE
Here, only the small-retailer’s EBITDA to
interest ratio falls below the industry
average. The large retailer’s EBITDA to
interest is comfortably above the
industry average. The mid-size retailer’s
EBITDA to interest is a real outlier, which
suggests the mid-size retailer may hold
too little debt.
The DuPont pyramid of ratios, also known as the DuPont analysis, is an advanced
technique that uses ratio analysis to assess a company’s financial performance. The
DuPont pyramid framework was developed by the DuPont Corporation in the 1920s.
This analysis aims to assess a company's return on equity (ROE) by breaking it down
into its key components. It provides a structured approach to understand the factors
driving a company's profitability and efficiency.
Two-Lever Pyramid
Return on Assets Financial Leverage
Net Income Total Assets
X
Total Assets Equity
The standard DuPont pyramid has three levers, but we start by breaking ROE into two ratios.
Importantly, you need to make sure that when you multiply these two ratios, you get the ROE.
The first ratio is the return on assets (ROA) ratio. The ROA ratio measures a company's
profitability in relation to its total assets. It provides insight into how effectively a company
utilizes its assets to generate profit.
The second ratio is the equity multiplier, more commonly referred to as financial leverage. It
measures the extent to which a company relies on debt financing. Financial leverage is
calculated by dividing total assets by shareholders' equity. As you can see here, multiplying
these two ratios produces ROE. The total assets in both ratios cancel each other out.
Three-Lever Pyramid
Net Profit Margin Total Asset Turnover Financial Leverage
Net Income Revenues Total Assets
X X
Revenue Total Assets Equity
You can move from the two-lever pyramid to a three-lever pyramid by breaking down the ROA
ratio into net profit margin and total asset turnover. As mentioned, the three-lever pyramid is
the most commonly used pyramid. Breaking down ROE into three levers allows you to see if
changes in ROE are due to changing profit margins, asset utilization, or financial leverage.
Five-Lever Pyramid
Most financial analysts stop with the three-lever approach. However, the five-lever approach
takes net profit margin and breaks it down into three component ratios.
Tax Burden Interest Burden Operating Profit Margin
As we covered in an earlier section, tax burden measures the percentage of pre-tax earnings
that are retained as net income after accounting for taxes. A tax burden ratio closer to 1
indicates that the company retains a larger portion of its pre-tax earnings, leading to a higher
ROE.
Next comes interest burden, which is the ratio of EBT to EBIT. An interest burden ratio closer to
1 indicates the company has little debt.
Finally, operating profit margin tells us what’s left from revenue after accounting for operating
expenses.
A five-lever pyramid replaces the net profit margin ratio with the three ratios above.
Tax Burden Interest Burden EBIT Margin Total Asset Turnover Financial Leverage
Net Income Earnings Before Tax Earnings Before
Revenues Total Assets
Interest and Tax
Earnings Before
Earnings Before
Total Assets Equity
Tax Interest and Tax Revenue
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