Profitability ratios

These measures evaluate a company’s level of profitability by expressing sales and profits as a percentage of various other items.

• Return on assets (ROA). ROA provides a quantitative description of how well a company has invested in its assets.

  To calculate ROA, divide net income by total assets.

• Return on equity (ROE). ROE shows the return on the portion of the company’s financing that is provided by owners.

  To calculate ROE, divide net income by owners’ equity.

• Return on sales (ROS). Also known as net profit margin, ROS is a way to measure how sales translate into bottom-line profit. For example, if a company makes a profit of $10 for every $100 in sales, the ROS is 10/100, or 10 percent.

  To calculate ROS, divide net income by the revenue.

• Gross profit margin. A ratio that measures the percentage of gross profit relative to revenue, gross margin reflects the profitability of the company’s products or services.

  To calculate gross margin, divide gross profit by revenue.

• Earnings before interest and taxes (EBIT) margin. Many analysts use this indicator, also known as operating margin, to see how profitable a company’s operating activities are.

  To calculate EBIT margin, divide operating profit by revenue.

Operating ratios

By linking various income statement and balance sheet figures, these measures provide an assessment of a company’s operating efficiency.

• Asset turnover. This shows how efficiently a company uses its assets.

  Tip: To calculate asset turnover, divide revenue by total assets. The higher the number, the better.

• Days receivables. It’s best to collect on receivables promptly. This measure tells you in concrete terms how long it actually takes a company to collect what it’s owed. A company that takes forty-five days to collect its receivables will need significantly more working capital than one that takes four days to collect.

  There are different methods to calculate days receivables. One way is to divide ending accounts receivable by revenue per day.

• Days payables. This measure tells you how many days it takes a company to pay its suppliers. The more days it takes, the longer a company has the cash to work with.

  There are different methods to calculate days payables. One way is to divide ending accounts payable by cost of goods sold per day.

• Days inventory. This is a measure of how long it takes a company to sell the average amount of inventory on hand during a given period of time. The longer it takes to sell the inventory, the more the company’s cash gets tied up and the greater the likelihood that the inventory will not be sold at full value.

  To calculate days inventory, divide average inventory by cost of goods sold per day.

Liquidity ratios

Liquidity ratios tell you about a company’s ability to meet its financial obligations, including debt, payroll, vendor payments, and so on.

• Current ratio. This is a prime measure of how solvent a company is. It’s so popular with lenders that it’s sometimes called the banker’s ratio. Generally speaking, the higher the ratio, the better financial condition a company is in. A company that has $3.2 million in current assets and $1.2 million in current liabilities would have a current ratio of 2.7 to 1. That company would be generally healthier than one with a current ratio of 2.2 to 1.

  To calculate the current ratio, divide total current assets by total current liabilities.

• Quick ratio. This ratio isn’t faster to compute than any other—it simply measures the ratio of a company’s assets that can be quickly liquidated and used to pay debts. Thus, it ignores inventory, which can be hard to liquidate (and if you do have to liquidate inventory quickly, you typically get less for it than you would otherwise). This ratio is sometimes called the acid-test ratio because it measures a company’s ability to deal instantly with its liabilities.

  To calculate the quick ratio, divide current assets minus inventory by current liabilities.

Leverage ratios

Leverage ratios tell you how, and how extensively, a company uses debt. In the world of finance, the word leverage is used for debt.

• Interest coverage. This measures a company’s margin of safety: how many times over the company can make its interest payments.

  To calculate interest coverage, divide income before interest and taxes by interest expense.

• Debt to equity. This measure provides a description of how well the company is making use of borrowed money to enhance the return on owners’ equity.

  To calculate the debt-to-equity ratio, divide total liabilities by owners’ equity.

Other ways to measure financial health

Beyond profitability, operating, and leverage ratios, other ways of evaluating the financial health of a company include valuation, Economic Value Added (EVA), and assessing growth and productivity. Like the ratios described above, all these measures are most meaningful when compared against the same measures for other companies in that particular industry.

Valuation. Valuation often refers to the process by which people determine the total value of a company for the purpose of selling it. This type of valuation is an uncertain science. For example, a firm that is considering acquiring another firm might rely heavily on estimates of future cash flows to come up with a value for the potential acquisition. Another firm might rely on different data. Also, a company is worth different amounts to different parties. For instance, a small, high-tech company may be valued more by a potential acquirer that wants the acquired firm’s unique technology to leverage its other operations.

Valuation also refers to the process that Wall Street investors and stock analysts use to scrutinize a company’s financial statements and stock performance carefully in order to arrive at what they believe to be a realistic estimate of that company’s value. Since a share of stock denotes ownership of a part of the company, analysts are interested in knowing whether the market price of that share is a good deal, relative to the underlying value of the piece of the company the share represents.

Wall Street uses various means of valuation—that is, of assessing a company’s financial performance in relation to its stock price.

• The earnings per share (EPS) equals net income divided by the number of shares outstanding. This is one of the most commonly watched indicators of a company’s financial performance. If it falls, it will likely take the stock’s price down with it.
• The price-to-earnings ratio (P/E) is the current price of a share of stock divided by the previous twelve months’ earnings per share. It is a common measure of how cheap or expensive a stock is, relative to earnings.
• Growth indicators. Growth measures can tell a great deal about financial health. A company’s growth allows it to provide increasing returns to its shareholders and to provide opportunities for new and existing employees. The number of years over which you should measure growth will depend on the business cycle of the industry the company is in. A one-year growth figure for an oil company—an industry that typically has long business cycles—probably doesn’t tell you very much. But a strong one-year growth figure for an Internet company would be significant. Common measures of growth include sales growth, profitability growth, and growth in earnings per share.

Economic Value Added. This concept was introduced as a way to induce employees to think like shareholders and owners. It is the profit left over after the company has met the expectations of those who provided the capital.

Productivity measures. Sales-per-employee and net-income-per-employee measures link revenue and profit generation information to workforce data. Watching the trends of these numbers adds to your understanding of what is occurring in the company.