KEY FINANCIAL RATIOS
Ratio analysis has a role to play and can be helpful in interpreting the financial position of any
business. Ratios can be used to set targets and to measure performance, though they should
not be seen as the sole means of performance measurement. Many people find it difficult to
look at a profit and loss account or a balance sheet and derive a full picture. As a result, ratios
are often used to interpret accounts. They indicate how a business is performing and provide
indications of trends and patterns. They can be compared to the same ratios in previous years'
accounts and the accounts of other businesses operating in a similar environment. Ratios are
published for many business sectors which can be used as a comparison (these are sometimes
referred to as Industry Norms). The dozens of ratios that can be computed fall in four
categories: Profitability ratios, Liquidity ratios, Leverage ratios and Activity ratios.
Profitability Ratios
The most important objectives for the business and, arguably therefore, the most important
ratios, are those concerned with profitability. The gross profit needs to be sufficient to cover all
the overhead costs, including drawings for the self employed, and generate an additional profit
to retain within the business to reinvest and to provide additional working capital. The business
will also need to generate sufficient cash to repay outstanding loans.
1. Gross Profit Margin
A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw
materials and manufacturing overhead involved in its production process. This expense is
deducted from the company's net sales/revenue, which results in a company's first level of
profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is
using its raw materials, labor and manufacturing-related fixed assets to generate profits. A
higher margin percentage is a favorable profit indicator. Industry characteristics of raw material
costs, particularly as these relate to the stability or lack thereof, have a major effect on a
company's gross margin. Generally, management cannot exercise complete control over such
costs. Companies without a production process (ex., retailers and service businesses) don't
have a cost of sales exactly. In these instances, the expense is recorded as a "cost of
merchandise" and a "cost of services", respectively. With this type of company, the gross profit
margin does not carry the same weight as a producer-type company.
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Formula:
Example:
(Refer to Table A)
Gross profit margin = RM 296,500 – RM 142,400
RM 296,500
= RM 154,100
RM 296,500
= 52%
2. Operating Profit Margin
By subtracting selling, general and administrative (SG&A), or operating, expenses from a
company's gross profit number, we get operating income. Management has much more control
over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the
operating profit margin carefully. Positive and negative trends in this ratio are, for the most
part, directly attributable to management decisions.
Formula:
Example:
(Refer to Table A)
Operating profit margin = RM 296,500 – RM 59,200
RM 296,500
= RM 237,300
RM 296,500
= 80%
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3. Net Profit Margin
Often referred to simply as a company's profit margin, the so-called bottom line is the most
often mentioned when discussing a company's profitability. While undeniably an important
number, investors can easily see from a complete profit margin analysis that there are several
income and expense operating elements in an income statement that determine a net profit
margin. It behooves investors to take a comprehensive look at a company's profit margins on a
systematic basis.
Formula:
Example:
(Refer to Table A)
Net profit margin = RM 75,000
RM 296,500
= 25%
4. Return on Total Assets
Return on total assets measure the return on total investment in the enterprise. Interest is
added to after-tax profits to form the numerator, since total assets are financed by creditors as
well as by stockholders. Higher is better, and the trend should be upward.
Formula:
Return on total assets = Profits after taxes + interest
Total assets
Example:
(Refer to Table A and Table B)
Return on total assets = RM 75,000 + RM 2,600
RM 338,370
= 25%
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5. Return on Stockholder’s Equity
This shows the return stockholders are earning on their investment in the enterprise. A return
in 12 – 15 percent range is average, and the trend should be upward.
Formula:
Return on stockholder’s equity = Profits after taxes
Total stockholders’ equity
Example:
(Refer to Table A and Table B)
Return on stockholders’ equity = RM 75,000
RM 218,570
= 34%
6. Earning Per Share
It shows the earning for each share of common stock outstanding. The trend should be
upward, and the bigger the annual percentage gains, the better.
Formula:
Earning per share = Profit after taxes
Number of shares of common stock outstanding
Example:
(Refer to Table A and Table B)
Earning per Share = RM 75,000
150,000 shares
= RM 0.50
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Liquidity ratios
Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick
ratio.
1. Current Ratio
Current ratio, expresses a company's ability to repay short-term creditors out of its total current
assets. The current ratio is the result of dividing the total of current assets (incl. stocks) by
short-term borrowings. It shows the number of times short-term liabilities are covered by
current assets. If the value is greater than 1.00, it means fully covered.
Formula:
Current ratio = Current assets
Current liabilities
Example:
(Refer to Table B)
Current ratio = RM 188,910
RM 67,800
= 2.8:1
2. Quick Ratio
Quick ratio (or Acid Test), expresses a company's ability to repay short-term creditors out of its
most liquid assets. The quick ratio is the result of dividing the total of current assets, other than
stocks, by short-term borrowings. It shows the number of times short-term liabilities are
covered by quick assets. If the value is greater than 1.00, it means fully covered.
Formula:
Quick ratio = Current assets – Inventory
Current Liabilities
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Example:
(Refer to Table B)
Quick ratio = RM 188,910 – RM 105,400 – RM 5,210
RM 67,800
= 1.15:1
3. Working Capital
Bigger amounts are better because the company has more internal funds available to;
A) Pay its current liabilities on a timely basis
B) Finance inventory expansion, additional accounts receivable, and a larger base of
operations without resorting to borrowing or raising more equity capital.
Formula:
Working capital = Current assets – Current liabilities
Example:
(Refer to Table B)
Working capital = RM 188,910 – RM 67,800
= RM 121,110
Leverage Ratios
These measure solvency, the extent to which the firm is using its long term debt. These are
prevalent among banks and lenders since it indicate how much of the business is financed by
the lenders and how much of it comes from the ownerships. When the ratio results more than
100% it shows that the lenders gave in more of the capital than that of the owners which is
mostly preferred by the owners since they will have more capital to invest that subsequently
gives more opportunity to earn more and would mean more money for their pocket.. On the
other hand, banks and lenders usually go for a lower ratio because it means that the company
has the ability to pay its debt and provides lesser risk for default.
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1. Debt-to-assets ratio
This ratio is used to gain a general idea as to the amount of leverage being used by a company.
A low percentage means that the company is less dependent on leverage, i.e., money borrowed
from and/or owed to others. The lower the percentage, the less leverage a company is using
and the stronger its equity position. In general, the higher the ratio, the more risk that
company is considered to have taken on.
Formula:
Debt-to-assets ratio = Total debt
Total assets
Example:
(Refer to Table B)
Debt-to-assets ratio = RM 119,800
RM 338,370
= 35%
2. Long-term debt-to-capital ratio
The long-term debt-to-capital ratio measures the debt component of a company's capital
structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity)
to support a company's operations and growth. Long-term debt is divided by the sum of long-
term debt and shareholders' equity. This ratio is considered to be one of the more meaningful
of the "debt" ratios - it delivers the key insight into a company's use of leverage. There is no
right amount of debt. Leverage varies according to industries, a company's line of business and
its stage of development. Nevertheless, common sense tells us that low debt and high equity
levels in the capitalization ratio indicate investment quality.
Formula:
Long-term debt-to-capital ratio = Long-term debt
Long-term debt + Total stockholders’ equity
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Example:
(Refer to Table B)
Long-term debt-to-capital ratio = RM 52,000
RM 52,000 + RM 218,570
= 19%
3. Debt-to-equity Ratio
The debt-equity ratio is another leverage ratio that compares a company's total liabilities to its
total shareholders' equity. This is a measurement of how much suppliers, lenders, creditors and
obligors have committed to the company versus what the shareholders have committed. To a
large degree, the debt-equity ratio provides another vantage point on a company's leverage
position, in this case, comparing total liabilities to shareholders' equity, as opposed to total
assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that a company
is using less leverage and has a stronger equity position.
Formula:
Debt-to-equity ratio = Total debt
Total stockholders’ equity
Example:
(Refer to Table B)
Debt-to-equity ratio = RM 119,800
RM 218,570
= 55%
4. Long-term debt-to-equity Ratio
This ratio shows the balance between debt and equity in the firm’s long-term capital structure.
Low ratios indicate greater capacity to borrow additional funds if needed.
Formula:
Long-term debt-to-equity ratio = Long-term debt
Total stockholders’ equity
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Example:
(Refer to Table B)
Long-term debt-to-equity ratio = RM 52,000
RM 218,570
= 24%
5. Times-interest-earned (or Coverage) Ratio
The coverage ratio is used to determine how easily a company can pay interest expenses on
outstanding debt. The ratio is calculated by dividing a company's earnings before interest and
taxes (EBIT) or operating income by the company's interest expenses for the same period. The
lower the ratio, the more the company is burdened by debt expense. When a company's
interest coverage ratio is only 1.5 or lower, its ability to meet interest expenses may be
questionable.
Formula:
Coverage ratio = Operating income
Interest expenses
Example:
(Refer to Table A)
Coverage ratio = RM 94,900
RM 2,600
= 36 times
Activity Ratios
These ratios measure the speed with which various accounts are converted into sales or cash.
1. Days of Inventory
This measures inventory management efficiency. Fewer days of inventory are usually better.
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Formula:
Days of inventory = Inventory
Cost of goods sold /365
Example:
(Refer to Table A and Table B)
Days of inventory = RM 105,400
RM 142,400 ÷ 365 days
= 270 days
2. Inventory Turnover
It measures the number of inventory turns per year. Higher is better.
Formula:
Inventory turnover = Cost of goods sold
Inventory
Example:
(Refer to Table B)
Inventory turnover = RM 142,400
RM 105,400
= 1.35 times
3. Average Collection Period
This indicates the average length of time the firm must wait after making a sale to receive cash
payment. A shorter collection time is better.
Formula:
Average collection period = Accounts receivable = Account receivable
Total sales/365 Average daily sales
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Example:
(Refer to Table A and Table B)
Average collection period = RM 61,500
RM 296,500 ÷ 365 days
= 75 days
Other Important Financial Measures
1. Dividend yield on common stock
A stock's dividend yield is expressed as an annual percentage and is calculated as the
company's annual cash dividend per share divided by the current price of the stock. The
dividend yield is found in the stock quotes of dividend-paying companies. Investors should note
that stock quotes record the per share dollar amount of a company's latest quarterly declared
dividend. This quarterly dollar amount is annualized and compared to the current stock price to
generate the per annum dividend yield, which represents an expected return. Income investors
value a dividend-paying stock, while growth investors have little interest in dividends, preferring
to capture large capital gains. Whatever your investing style, it is a matter of historical record
that dividend-paying stocks have performed better than non-paying-dividend stocks over the
long term.
Formula:
Dividend yield on common stock = Annual dividend per share
Current market price per share
Example:
(Refer to Table A)
Dividend yield on common stock = RM 0.014
RM 1
= 1.4%
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2. Price/earning (P/E) Ratio
The price/earnings ratio (P/E) is the best known of the investment valuation indicators. The P/E
ratio has its imperfections, but it is nevertheless the most widely reported and used valuation
by investment professionals and the investing public. The financial reporting of both companies
and investment research services use a basic earnings per share (EPS) figure divided into the
current stock price to calculate the P/E multiple (i.e. how many times a stock is trading (its
price) per each dollar of EPS). It's not surprising that estimated EPS figures are often very
optimistic during bull markets, while reflecting pessimism during bear markets. Also, as a
matter of historical record, it's no secret that the accuracy of stock analyst earnings estimates
should be looked at skeptically by investors. Nevertheless, analyst estimates and opinions based
on forward-looking projections of a company's earnings do play a role in Wall Street's stock-
pricing considerations. Historically, the average P/E ratio for the broad market has been around
15, although it can fluctuate significantly depending on economic and market conditions. The
ratio will also vary widely among different companies and industries.
Formula:
P/E ratio = Current market price per share
Earning per share
Example:
(Refer to Table A)
P/E ratio = RM 1
RM 0.5
= 2 times
3. Dividend payout ratio
Indicates the percentage of after-tax profits paid out as dividends.
Formula:
Dividend payout ratio = Annual dividends per share
Earnings per share
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Example:
(Refer to Table A)
Dividend payout ratio = RM 0.014
RM 0.5
= 2.8%
4. Internal cash flow
It is a quick and rough estimate of the cash a company’s business is generating after payment
of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or
funding capital expenditures.
Formula:
Internal cash flow = After-tax profits + Depreciation
Example:
(Refer to Table A and Table B)
Internal cash flow = RM 75,000 + RM 79,740
= RM 154,740
Bibliography
Brigham, E. F. & Houston, J. F. (2007). Essentials of Financial Management . Thomson Learning.
Singapore.
Fred, L. F. & Stoner C. R. (1995). Strategic Planning for the New and Small Business . Upstart
Publishing Company, Inc. United States of America.
Gabriel, V. (1996). Management 2nd Edition. Longman Singapore Publishers (Pte) Limited.
Singapore.
Isa, S. (2008). Accounting Principles 2nd Edition. Pearson Prentice Hall. Kuala Lumpur.
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APPENDIX
TABLE A
Hati Enterprise Bhd.
Income Statement
For the Year Ended 31 December 2001
RM RM
2001 2000
Net Sales 296,500 282,800
Cost of Good Sold (142,400) (136,350)
Gross Profit 154,100 146,450
Operating Expenses:
Sales Expenses (50,010) (48,430)
General and Administrative Expenses (9,190) (8,960)
Total Operating Expenses (59,200) (57,390)
Other Income and Expenses:
Dividend Income 2,100 2,100
Interest Expense (2,600) (2,750)
Other Income and Expenses (500) (650)
Income before Income Tax 94,400 88,410
Income Tax Expense (19,400) (18,110)
Net Income 75,000 70,300
Earning per Share RM0.50 RM0.48
Current market price per share = RM 1
Dividend per share = RM 0.014
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TABLE B
Hati Enterprise Bhd.
Balance Sheet
31 December 2001
RM RM
2001 2000
Current Assets
Cash 10,600 32,100
Current Investment 6,200 3,120
Accounts Receivable 61,500 93,100
Inventories 105,400 33,200
Prepaid Expenses 5,210 4,960
Total Current Assets 188,910 166,480
Investment
Investment in Shares 21,000 21,000
Property Plant and Equipment
Land 11,000 11,000
Building 154,000 154,000
Less: Accumulated Depreciation (61,200) (58,200)
Equipment 43,200 37,500
Less: Accumulated Depreciation (18,540) (17,900)
Total Property, Plant and Equipment 128,460 126,400
Total Assets 338,370 313,880
Current Liabilities
Accounts Payable 51,200 61,020
Salaries Payable 12,100 8,400
Tax Payable 4,500 4,500
Total Current Liabilities 67,800 74,100
Long-term Liabilities
10% Bonds Payable 52,000 55,000
Total Long-Term Liabilities 52,000 55,000
Total Liabilities 119,800 129,100
Shareholders’ Equity
Ordinary Shares (RM 1 at par) 150,000 145,000
Retained Earning 68,570 39,780
Total Shareholders’ Equity 218,570 184,780
Total Liabilities and Shareholders’ Equity 338,370 313,880
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