Financial Ratios

ABOUT THIS CONTENT

Financial ratios are the fundamental tools of financial analysis.
Subject: Finance

Financial ratios are the fundamental tools of financial analysis. A calculation of profitability, asset utilization and financial leverage ratios can result in key insights about a company’s operations.

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Methodology

  1. Obtain information. Use the income statement, balance sheet, and cash flow statement from annual reports to obtain data required to calculate the ratios for the company as a whole. Access databases such as Excel, Bloomberg, Datastream, and World Equities to obtain supporting data and information. Obtain information about divisions from management.
  2. Calculate key ratios. Calculate the most relevant ratios and margins, such as profitability, asset turnover, and financial leverage ratios. The ratios of importance will vary by industry. Assess the capital structure, operating efficiency, free cash flow, and returns to shareholders.
  3. Compare against competitors’ ratios. Compare the ratios to those of key competitors and determine the reasons for discrepancies.

Notes

  • Operating expense (%): exclude extraordinary charges (e.g., restructuring charge) and depreciation
  • Interest expense (%): use gross interest expense, not net of interest income
  • Income tax (%): use provision for income taxes and exclude deferred taxes
  • Balance sheet: long-term debt includes all interest bearing liabilities (e.g., post-retirement benefits and other long-term liabilities); capital = total assets less BIBLs; book equity = total shareholder equity less preferred stock

Strengths

  • Key ratios will define areas of concern and make it possible to direct analyses

Weaknesses

  • Hard to find “pure plays”, i.e., it is hard to compare companies unless they have a very similar business portfolio (apples must be compared to applies)
  • Be careful that your definitions of ratios match the company’s definitions

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