Financial Ratios eBook - Corporate Finance Institute

The Corporate Finance Institute

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Financial Ratios eBook

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Corporate Finance Institute

Financial Ratios

Table of Contents

Financial Ratio Analysis Overview ............................................................................................... 3

What is Ratio Analysis?.......................................................................................................................................................................................................3 Why use Ratio Analysis?.....................................................................................................................................................................................................3 Types of Ratios?...................................................................................................................................................................................................................3

Profitability Ratio .......................................................................................................................... 4

Return on Equity .................................................................................................................................................................................................................5 Return on Assets .................................................................................................................................................................................................................6 Return on Capital Employed.............................................................................................................................................................................................7 Gross Margin Ratio .............................................................................................................................................................................................................8 Operating Profit Margin.....................................................................................................................................................................................................9 Net Profit Margin.............................................................................................................................................................................................................. 10

Leverage Ratios........................................................................................................................... 11

Debt-to-Equity Ratio ........................................................................................................................................................................................................ 12 Equity Ratio........................................................................................................................................................................................................................ 13 Debt Ratio .......................................................................................................................................................................................................................... 14

Efficiency Ratios .......................................................................................................................... 15

Accounts Receivable Turnover Ratio ........................................................................................................................................................................... 16 Accounts Receivable Days.............................................................................................................................................................................................. 17 Asset Turnover Ratio ....................................................................................................................................................................................................... 18 Inventory Turnover Ratio................................................................................................................................................................................................ 19 Inventory Turnover Days ................................................................................................................................................................................................ 20

Liquidity Ratios............................................................................................................................ 21

Current Ratio..................................................................................................................................................................................................................... 22 Quick Ratio......................................................................................................................................................................................................................... 23 Cash Ratio .......................................................................................................................................................................................................................... 24 Defensive Interval Ratio.................................................................................................................................................................................................. 25 Times Interest Earned Ratio .......................................................................................................................................................................................... 26 Times Interest Earned (Cash-Basis) Ratio................................................................................................................................................................... 27 CAPEX to Operating Cash Ratio .................................................................................................................................................................................... 28 Operating Cash Flow Ratio............................................................................................................................................................................................. 29

Pyramid of Ratios........................................................................................................................ 30

Multiples Valuation Ratios ......................................................................................................... 31

Price-to-Earnings (P/E) Ratio.......................................................................................................................................................................................... 32 EV/EBITDA Ratio ............................................................................................................................................................................................................... 33 EV/EBIT Ratio..................................................................................................................................................................................................................... 34 EV/Revenue Ratio............................................................................................................................................................................................................. 35 Valuation Ratios Comparison........................................................................................................................................................................................ 36



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Corporate Finance Institute

Financial Ratios

Financial Ratio Analysis Overview

What is Ratio Analysis?

Corporate finance ratios are quantitative measures that are used to assess businesses. These ratios are used by financial analysts, equity research analysts, investors, and asset managers to evaluate the overall financial health of businesses, with the end goal of making better investment decisions. Corporate finance ratios are also heavily used by financial managers and C-suite officers to get a better understanding of how their businesses are performing.

Why use Ratio Analysis?

Ratio analysis is a great way to compare two companies that are different in size operations and management style. It also is a great way to quantify how efficient a company's operations are and how profitable the business is set up to be. Solvency ratios, for example, can be used to analyze how well a company will be able to meet their financial obligations.

Types of Ratios?

Corporate finance ratios can be broken down into four categories that measure different types of financial metrics for a business: liquidity ratios, operational risk ratios, profitability ratios, and efficiency ratios:



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Corporate Finance Institute

Financial Ratios

Profitability Ratio

Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets, operating costs, and shareholders' equity during a specific period of time. They show how well a company utilizes its assets to produce profit and value to shareholders.

A. Return Ratios Return ratios represent the company's ability to generate returns for its shareholders. It typically compares a return metric versus certain balance sheet items.

Return on Equity Return on Assets Return on Capital Employed

B. Margin Ratios Margin ratios represent the company's ability to convert sales into profits at various degrees of measurement. Margin ratios typically look at certain returns when compared to the top line (revenue). Typically, it compares income statement items.

Gross Margin Ratio Operating Profit Margin Net Profit Margin



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Corporate Finance Institute

Financial Ratios

Return on Equity

Overview

Return on equity is a measure of a company's annual return (net income) divided by the value of its total shareholders' equity, expressed as a percentage (e.g. 10%). Alternatively, ROE can also be derived by dividing the firm's dividend growth rate by its earnings retention rate (1-dividend payout ratio). There are several ROE drivers, and we will further breakdown the ratio.

Formula

Interpretation

ROE provides a simple metric for evaluating returns. By comparing a company's ROE to the industry's average, it is possible to pinpoint a company's competitive advantage (or lack of competitive advantage). As it uses net income as the numerator, return on equity (ROE) looks at the firm's bottom line to gauge overall profitability for the firm's owners and investors.

As an investor, this is an essential ratio to look at as it ultimately determines how attractive an investment is. Return on equity is a product of asset efficiency, profitability, and financial leverage.



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