Types of financial ratios:
a., liquidity: how easily a company can turn some of its assets into cash
b., solvency: whether a company has enough cash to pay short-term debts, or whether it could go bankrupt
c., efficiency: how well a company uses its resources
- Liquidity ratios: these measure ability to turn assets into cash to pay short-term debts
Working capital (current ratio) = Current assets / Current liabilities
Video 1: Working capital
Quick ratio / acid test: = Liquid assets / Current liabilities
- Profitability ratios: these measure ability to generate proftis
Gross profit margin = Gross profit / Sales
Net profit margin = Net income before taxes / Net sales
Return on assets = Net profit / Total assets
Return on equity (ROE) = Net income after tax / Total owners’ equity
- Case study: GM vs Toyota: Still recovering from a tsunami and floods, Toyota achieved an ROE of 3.9 percent in 2012. Rival General Motors (GM), unaffected by the natural disasters, managed 16.7 percent. Based on its ROE, GM appeared to be four to five times better at generating profit from shareholders’ investment.
As an indicator of investment potential, ROE can be problematic. The percentage outcome is a function of two things: how high the profit is, and how low the shareholders’ equity is. Toyota and GM both made a similar pretax profit in 2012, but the amount of shareholders’ equity in the two companies creates a misleading picture. Toyota has a huge balance sheet with high shareholder equity, bolstered by decades of high profits. GM’s bankruptcy in 2009 had wiped out its reserves, leaving it with a small equity base. GM’s high ROE was largely due to its collapse and US government bailout. In the 2000s, many banks cut their balance sheets through “share buybacks.” Cash was used to buy shares back from shareholders, reducing the equity at the bottom of the formula. This increased the ROE, but led to a risky capital structure. By maximizing ROE, the banks left too little cash to deal with the 2007–08 financial crash.
Earnings per share (EPS) = Net income after tax / Number of shares issued
Price / earnings ratio: = The market price of an ordinary share / The past year’s EPS
Dividend cover (times dividend cover) = Ordinary share dividend / Net profit
- Leverage (debt) ratios: these measure the degree to which a company relies on borrowed funds
Debt to owners’ equity (gearing BrE / leverage AmE) = Total liabilities / Total owners’ equity
Interest cover / Times interest earned = EBIT / Interest charges
- Activity ratios: these measure the effectiveness of the use of resources from an operational point of view
Inventory turnover = Cost of goods sold / Average inventory
(mid point between inventory at beginning and ending of accounting period)