How does financial ratio analysis work?

Let’s discuss ten of the most popular financial ratios that can help you find the story behind

the numbers.

What do you need to get started on a financial ratio analysis?

You need an income statement,

the overview of how much profit a company made during a year.

You also need a balance sheet, an overview of what a company owns and what a company

owes at a specific point in time.

We will start off with financial ratios that only focus on the income statement, then look

at financial ratios that only focus on the balance sheet, and end with powerful financial

ratios that combine information from the income statement and the balance sheet.

Performing a financial ratio analysis has a scientific element to it (finding data and

putting it into formulas), as well as an artistic element (assigning meaning to the outcome

of the calculations, and seeing the big picture).

Part 1: financial ratios that only focus on the income statement,

or profit and loss statement (P&L).

Let’s compare the income statements of two fictitious companies, which unlike real life

companies have nice round numbers in their financial statements.

The first step in financial ratio analysis of the income statement,

is to make everything relative.

Relative to sales that is.

Each of the cost line items and profit subtotals is expressed as a percentage of revenue.

Let’s see what the financial ratios tell us.

Company A has a Gross Profit margin of 50%, company B of 30%, so the Gross Profit margin

is 20%-points higher for company A. Company A makes far more margin than company B on

the products or services it sells.

Company A has an Operating Margin of 21%,

while company B has an Operating Margin of 14%.

So the 20%-point difference (50% versus 30%) on the Gross Profit level has shrunk to 7%-points

(21% versus 14%) on the Operating Margin level.

Net income as percentage of sales (often called “Return On Sales”) is 16% for company

A, and 8% for company B. What do we zoom in on for further analysis?

Let’s investigate the difference between Gross Profit and Operating Margin.

This is mainly driven by selling, general and administrative expenses: 20% of revenue

in company A, 10% of revenue in company B. The non-manufacturing costs for functional

departments like sales, marketing, finance, HR, sourcing, legal and IT are far higher

for company A than for company B.

This could be related to the industry each company is in, the company’s strategy, or

the level of efficiency that it has achieved.

Could company A be overspending in SG&A, or is company B underspending?

Hard to say just from these numbers, but worth investigating!

On the Research and Development line, company A is spending more than company B.

This is usually seen as a good thing, as today’s Research and Development expenses hopefully

lead to high margin innovative products and services to sell in the future.

Part 2: financial ratios that only focus on the balance sheet.

The first question that I always ask myself is: how is the company doing on liquidity,

is it likely to be able to pay its bills in the short term?

Let’s look at the current assets (cash plus items that are likely to convert to cash within

a year) versus the current liabilities (items that need to be paid with cash within a year).

A useful financial ratio in this area is the current ratio: simply divide the current assets

by the current liabilities.

For company A, 400 divided by 200 is 2.

For every dollar of current liabilities, there are two dollars of current assets, a “safe”

position (from the perspective of business continuity).

For company B, 200 divided by 400 is 0.5.

For every dollar of current liabilities, there is only 50 cents of current assets, a “more

risky” position (for a supplier that is hoping to get paid).

While on the topic of current assets and current liabilities, let’s calculate the amount

of working capital utilized by the companies: accounts receivable plus inventories minus

accounts payable.

For company A, this is 150 plus 200 minus 200, in total 150.

For company B, this is 50 plus 100 minus 300, in total negative 150.

Company B seems to be getting paid by customers before they have to pay suppliers, and holds

a low level of stock.

The next financial ratio is all about the companies’ financing strategy: does it primarily

borrow money to finance operations, or rely on capital provided by the shareholders?

The debt-to-equity ratio can help you put that in perspective.

For company A, 100 in borrowings, 700 in equity, so a debt-to-equity ratio of 1 to 7.

You could call this a conservative and robust way of financing, with a big buffer of equity

that helps defend the business continuity of the company in case of future losses.

For company B, 400 in borrowings, 100 in equity, so a debt-to-equity ratio of 4 to 1.

For every dollar of shareholder capital (equity), there are four dollars borrowed, which is

possibly more fragile.

A related financial ratio is equity as percentage of the balance sheet total.

70% for company A, 12.5% for company B. Based on the debt-to-equity ratio, and equity as

percentage of total, you could say that company A has a low leverage, while company B has

a high leverage.

Part 3: financial ratios that combine information

from the income statement and the balance sheet.

This is where you might see new storylines and connections, on top of what you discovered

in analyzing the income statement individually and the balance sheet individually.

Let’s start with a “big picture” financial ratio called Return On Equity, which is Net

Income divided by Equity.

For company A, 160 divided by 700, which is 22.9%.

For company B, 80 divided by 100, which is 80%.

On the Return On Equity metric, company B far outperforms company A.

What is driving that?

While company A has higher profit margins (as we saw in the income statement analysis),

company B has a much higher financial leverage (as we saw in the balance sheet analysis).

There is a third component to the Return OnEquity calculation:

the financial ratio called asset turnover.

Asset turnover looks at how much revenue is generated by the company

with the assets it has.

For company A, asset turnover is 1.

1000 in assets on the balance sheet generates 1000 in revenue in the income statement.

For company B, asset turnover is 1.25.

Let’s dig a little deeper into two key subsets of this asset turnover ratio.

The first one is receivables turnover: the number of times per year that a business collects

its average accounts receivable, the ratio between revenue in the income statement and

accounts receivable on the balance sheet.

6.67 for company A, 20 for company B. Receivables turnover might be a bit abstract for a lot

of people, so let’s turn it into a more tangible related metric called Days Sales

Outstanding: how many days does a company need to wait before a customer pays.

55 days for company A, and just 18 days for company B.

The second subset of the asset turnover ratio is inventory turnover:

the number of times per year that a business turns

its inventory, the ratio between revenue in the income statement

and inventory on the balance sheet.

5 inventory turns for company A, 10 inventory turns for company B.

So what do financial ratios tell us?

Can we say, based on calculating these financial ratios that company A is in better financial

shape, or company B is in better financial shape?

Not necessarily.

Financial ratios do provide us with clear information about the financial footprint

of a company, and deepen your understanding of the strategic and operational story behind

the financial numbers.

In this video on financial ratio analysis, we covered ten financial ratios:

On the income statement: gross profit %, operating margin %, return on sales %

On the balance sheet: current ratio, debt-to-equity, equity as % of total

When linking the P&L and the balance sheet: return on equity, asset turnover, receivables

turnover, inventory turnover Financial ratio analysis is as much an art

as it is a science!

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