Financial Ratios. Part 1: Liquidity and Asset Management Ratios

PERSONAL FINANCE 101

Our prior post about the price earnings ratio has generated some interest in other ratios that may also be used for investment and credit analysis. In this post, I will try to respond to this request by discussing a few simple and helpful financial ratios together with caveats or limitations in using and interpreting them.

In a nutshell, financial ratios are indicators of a firm's financial health and are ultimately used to evaluate a firm's future prospects. By themselves, these numbers mean very little--people who insist on "unbendable" rules (i.e., minimum or maximum values) for these ratios simply don't know what they are talking about (unfortunately, one can find a handful of these so-called experts in even the most prestigious universities in the country, but I won't mention names). To make sense of financial ratios, one must perform ratio analysis either by comparing a firm's ratio to the same ratio of its competitor(s) or to the industry average (cross-sectional analysis) or by analyzing how a particular ratio behaves over time (time series analysis).

Financial ratios may be loosely classified into the following categories:

Liquidity ratios - reflects the firm's ability to meet short-term financial obligations (i.e., those that are due within one year)

Asset management ratios - reflects how well the firm is able to use assets to generate sales

Debt management ratios - reflects the firm's capacity to meet its long-term financial obligations

Profitability ratios - reflects how well the firm is able to generate earnings from investments

Since eleven ratios are too long for one post and also because these two categories are very much related, we will just focus on liquidity and management ratios in this post.

Liquidity ratios

1. Current ratio = current assets / current liabilities

Technically, current assets (e.g., cash, accounts receivable, inventories, etc.) are those that are liquid--that is, those that may be converted into cash "quickly" (technically, within a year) at a level that is close to their fair values. Similarly, current liabilities (e.g., accounts payable, accrued expenses, etc.) are those which need to be paid within the year. So ideally, a firm should have enough current assets to cover its current liabilities--in other words, a current ratio of at least 1.

Caveat: While a current ratio that is greater than one may seem healthy, a current ratio that is high relative to an appropriate benchmark is often not good. A very high current ratio would mean one of two things: current assets are high relative to a certain amount of current liabilities, which is usually not good since this is an indication of an over investment in idle assets (remember, receivables are only good when they are collected and inventories when they are sold); or, that current liabilities are low given a level of current assets, which may mean that the firm is passing over possibly less expensive trade credit.

2. Quick or acid-test ratio = (cash + accounts receivable + other liquid current liabilities) / current liabilities

The quick ratio is based on the same principles (and is covered by the same limitations) as the current ratio, but is a more conservative measure since it excludes the least liquid current assets from the numerator (like inventories for many businesses).

Asset management ratios

3. Inventory turnover ratio = sales / inventories*

(*When comparing income statement items like sales to balance sheet items like assets, it's better to use the average value of the latter instead of the same-year figure, especially if year-on-year amounts vary greatly. For simplicity, though, we stick with

using the same-year balance sheet amount.)

The inventory management ratio reflect's the firm's efficiency in converting raw materials to finished goods (for manufacturing firms) to sales. Generally, it is good to have a high inventory turnover ratio.

Caveat: A high inventory turnover ratio may mean that the firm is underinvesting in inventories, which may lead to higher inventory costs and lost sales.

4. Accounts receivable (A/R) turnover ratio = credit sales / accounts receivable

The accounts receivable turnover ratio is an indicator of how well the firm is able to collect receivables. A high A/R turnover ratio would often mean less cash tied to credit sales and therefore more cash-at-hand.

Caveat: One may be tempted to boost A/R turnover by not offering credit sales to customers and not accumulate receivables. But businesses offer credit terms to customers for one very important reason: to increase sales, since generally, more people would buy more if they have an option to buy on credit. So trying to increase the A/R turnover this way may actually hurt the company instead of help it.

Since the inventory turnover ratio and the accounts receivable turnover ratio also reflect the firm's ability to generate cash from the use of current assets, these ratios are sometimes also considered liquidity ratios.

5. Fixed asset turnover ratio = sales / net fixed assets

The fixed asset turnover ratio shows how efficiently the firm is able to generate sales from the use of fixed or long-term assets like real property, production facilities, and equipment, which may be considered direct capital inputs of production. A high fixed asset turnover ratio is generally considered a positive sign of the firm's financial health.

Caveat: The denominator--net fixed assets--is total fixed assets less accumulated depreciation. Therefore, a high fixed asset turnover ratio may just mean that the firm is using highly depreciated and inefficient equipment and that the firm's production is not as efficient as the ratio indicates.

6. Total asset turnover ratio = sales / total assets

The total asset turnover ratio is just the aggregate of the three asset management ratios above: it reflects the firm's efficiency in using all of its resources--its assets--to generate sales. Just like the fixed asset turnover ratio, a high total asset turnover ratio would generally mean highly efficient operations; however, this ratio also suffers from the same caveat that results from the inclusion of depreciation in the denominator.

Liquidity and asset management ratios go hand in hand in that they reflect the efficiency of the firm's operations--specifically its ability to generate sales from using its resources--and its capacity to use the resulting asset inflows to meet short-term financial obligations. In Part 2, we will take a look at other aspects of the firm's financial well-being when we discuss debt management and profitability ratios.

Part 2: Debt Management and Profitability RatiosPERSONAL FINANCE 101

In Part 1, we took a look at financial ratios that we can use to assess the capacity of a firm to meet its short-term obligations and its ability to use its resources to generate revenues. In this post, we will discuss ratios that we can use to evaluate the firm's ability to meet long-term financial obligations and earn returns from investments.

Debt management ratios

7. Debt ratio = total liabilities / total assets OR total long-term debt / total assets

The debt ratio, also often referred to as financial leverage, is simply a measure of how the firm's assets are financed. If you recall from our post about the balance sheet, a business has two main sources of long-term financing: debt and shareholders' equity (i.e., capital provided by the firm's owners). A high debt ratio indicates that a big portion of the firm's assets is financed by debt--which is really neither "good" nor "bad". To a great extent, a firm's debt level depends on its industry as some business models do well on little debt while others thrive on a higher financial leverage. Also, according to financial theory, having too little and too much debt both involve significant risks and

costs. But if we want to just focus on the firm's capacity to service long-term debt, then we would want to make sure that its debt ratio is not significantly higher than that of its competitors or the industry average.

8. Times interest earned = earnings before interest and taxes / interest expense

Times interest earned or TIE, sometimes also referred to as interest coverage ratio, reflects the firm's ability to meet interest payments on debt. In the income statement, earnings before interest and taxes (EBIT) is the item from which interest expense is deducted, so a TIE of at least 1 meas that the firm has interest "fully covered."

Caveat: We should however remember that interest is not the only obligation that arises from borrowing money. Often, the firm also needs to make periodic principal payments, particularly for amortized loans or bond issues with sinking fund provisions, so we should also consider these in our analysis.

Profitability ratios

9. Net profit margin = net profit / sales

Essentially, the net profit margin is a measure of how well a firm is able to control costs to maximize profitability, so typically, a firm with a consistently high net profit margin is a sign of good financial management.

Caveat: However, we must take care not to focus too much on costs at the expense of other aspects of the business. For example, some managers may be tempted to use cheaper, sub-standard materials in production or forego "costly" human resource development programs in an effort to boost profitability, but in the long run these actions may actually do more harm than good to the firm.

10. Return on total assets = net profit / total assets

Return on total assets or ROA measures the profitability of the firm's investments in assets regardless of how these assets were finance. Businesses of course work to improve their ROAs through the efficient use of resources (i.e., by improving the total asset turnover ratio) and/or by controlling costs (i.e., by improving the net profit margin). A relatively high ROA reflects efficient operations and a sound business model.

Caveat: Because "total assets" is in the denominator, the ROA suffers from the same limitations as other similar ratios in that firms with highly depreciated assets would have superficially high ROAs.

11. Return on common equity = net profit / shareholder's equity

Unlike ROA which does not take the source of the business' capital into consideration, return on common equity or ROE focuses on the profitability of the owners' investment in the business. Naturally, firms target a high ROE or a higher "bang for the buck" for common shareholders. Incidentally, ROE and "return on investment" or ROI are basically the same thing: the percentage of an investment that investors earn as profit. However, if many business persons and enthusiasts refer to ROI as the time it takes for

an investment to be recovered; this quantity is actually not ROI but a commonly-usedcapital budgeting criteria called payback period.

Caveat: One way to mathematically or artificially get a higher ROE is by getting more debt. While "leveraging," to a certain extent, can amplify returns to the firm's owners, some costs like "financial distress" are not reflected by the numbers. Also, many cite ROE's limitations as an end-all measure of profitability, foremost of which is that it does not account for important factors like risk and time value of money.

There you have it, 11 financial ratios that you can use to evaluate the financial health of a business. Remember, these ratios only mean something when used in comparison with an appropriate benchmark. If you have time, you can download annual reports from the PSE website and try to perform your own analysis using these ratios.