The Financial Ratios Used in Practice

There are many financial ratios used in business. These are used as part of assessing own strengths and weaknesses as well as demonstrating a safe and potentially lucrative return to investors. Use these to analyse a company or a portfolio in terms of overall performance. Many MBAs use ratios in daily practice and these do give an accurate and often reliable overview of the company. However, ratios are not industry specific. Therefore a new, trending and emergent sector may not be truly reflected in the ratios of the companies in that sector. Also many industries rely on a customer base rather than tangible assets such as stock, machinery, property, patients, brands and other intellectual property. Use ratios; they are very indicative in the majority of cases. However, smart investors look at more once ratios have highlighted potentials.

The main ratios are:

Profitability Ratios

The Fundamental Accounting Equation

Assets = Liability + Owners Equity

Use the abbreviation Aloe to remember this. This is the equation that is the basiss of all accountiung and is the sum of both sides of the Balance Sheet (see information about financial statements).

Gross Profit

Gross Profit = Turnover / Cost of Goods Sold

Gross Profit Margin = Gross Profit / Cost of Goods Sold

Gross Profit Margin = (Turnover – Cost of Goods Sold) / Revenue

Net Profit

Net Income = Gross Profit – Cost of Operations – Tax

Net Profit Margin = Net Income / Sales

Return on Equity (ROE)

ROE = (Net Income / Assets) x (Assets / Equity)

This is the return on the owners’ equity (shareholders’ funds) for the period in question. The period used is the financial year. Remember that in different counties financial years run from and to different months. For example US financial year begins 1st January whereas the UK financial year traditionally begins 1st April.

DuPont Analysis

The DuPont Analysis also determines ROE, but uses the equation below:

ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Equity)

Return on Capital Employed (ROCE)

The Return on Capital Employed (ROCE) expands on ROE by analyzing the return on all capital, including debts. ROCE is expressed as a percentage.

ROCE (%) = Net Profit / Capital Employed

The net profit here is specifically the operating profit i.e. the earnings before interest and tax (EBIT). In many industries EBIT is used as the fundamental valuation of a company.

Liquidity Ratios

Current Ratio

Current Ratio = Current Assets / Current Liabilities

This ratio tests a corporation’s liquidity. Liquidity means how quickly liquid capital (cash within the year) can be generated. The more liquid a company is the more chance it has of covering costs of its operations. A company can have high gross profits, but if it is not liquid enough to have the cash flow to cover daily operations, it will cease to function before profit is realized.

Quick Ratio aka Acid Test

The Current Ratio above gives the total ratio for current assets. Current assets are usually defines as assets that can be converted into cash or cash equivalents within a year. The Quick Ratio (often called the Acid Test) looks more deeply at the most liquid assets i.e. the assets that are most quickly turned into ‘free flowing’ cash.

Quick Ratio =

Cash +Accounts Receivable + Investments Payable Immanently
Current Liabilities

Cash Conversion Cycle

The Cash Conversion Cycle (CCC) is the cycle at which cash is generated as a result of expenditure. This is given in days. The CCC shows the number of days that a company’s liquid cash is tied up in operations before it is realised again (the cycle then begins again, hopefully getting bigger or more numerous as the company grows). For example, a basic sports retail company buys a batch of training shoes. The batch is bought rather than individual pairs due to bulk discount. The batch contains 100 pairs of shoes. The retail outlet sells 4 shoes per day. Therefore the Cash Conversion Cycle for this basic example is 25 days. In reality, the CCC is more complex and there are a lot of other factors to consider, but as long as the company has enough cash to survive all the cash cycles operating, it should continue to have liquid funds and be viable. Note that this does not relate to profitability directly, but obviously faster CCCs of higher margin products are better.

The CCC equation is:

CCC = DIO + DSO – DPO

DIO = days inventory outstanding, DSO = days sales outstanding, DPO = days payable outstanding

As you can see, this is more complicated than the simple retail example. Retail sales realise cash immediately. B2B sales and sales on account realize cash after the agreed (contracted) invoice payable period. Inventory does not always arrive when it is paid for. Much is produced (or shipped long-distance) to order. Also some inventory may be components of the final saleable item and until all inventories are received, none has value because it cannot be directly utilized and the DIO part of the CCC increases and the cycle ‘spins more slowly’, thus CCC days increase.