FM - ratios

Gross Margin

• Purpose: Measures a firm's ability to sell products for more than the direct costs of production.

• Advantage: Highlights core pricing power and direct production efficiency without operational overhead.

• Limitations: Excludes operating expenses, administrative costs, R&D, interest, and taxes.

Operating Margin

• Purpose: Measures how much a company earns from each dollar of sales before interest and taxes.

• Advantage: Assesses the operational efficiency of the core business.

• Limitations: Ignores capital structure differences (interest expenses) and tax burdens.

Net Profit Margin

• Purpose: Shows the fraction of each revenue dollar remaining for equity holders after all expenses, interest, and taxes.

• Advantage: Provides a comprehensive view of overall bottom-line profitability.

• Limitations: Can be distorted by differences in financial leverage (interest) and accounting assumptions.

Current Ratio

• Purpose: Assesses short-term solvency and liquidity.

• Advantage: Simple indicator of whether short-term assets can cover short-term debts.

• Limitations: Includes inventory and other assets that may not be easily convertible to cash quickly.

Quick Ratio

• Purpose: Evaluates short-term liquidity by excluding less liquid inventory.

• Advantage: More stringent and realistic liquidity test than the current ratio.

• Limitations: Accounts receivable included in the numerator may still be slow to collect during credit crunches.

Cash Ratio

• Purpose: Measures the most liquid assets against current liabilities.

• Advantage: The most stringent and conservative liquidity test.

• Limitations: Excessively conservative; operating firms rarely need enough cash on hand to cover 100% of current liabilities instantly.

Accounts Receivable Days

• Purpose: Evaluates the average speed at which a company collects payment from customers.

• Advantage: Highlights credit policy efficiency and collection performance.

• Limitations: Can fluctuate seasonally or be distorted if the firm offers loose credit terms to temporarily boost sales.

Accounts Payable Days

• Purpose: Measures how long a firm takes to pay its suppliers.

• Advantage: Indicates how effectively the firm utilizes short-term trade credit financing.

• Limitations: Excessively stretching payables can signal cash flow distress and damage supplier relationships.

Inventory Days & Turnover

• Purpose: Measures how rapidly inventory is sold and replaced.

• Advantage: Evaluates inventory management and operational efficiency.

• Limitations: Varies drastically across different industries (e.g., wine aging vs. grocery retail), making cross-industry comparisons misleading.

Interest Coverage Ratios (EBIT or EBITDA to Interest)

• Purpose: Assesses a firm's ability to meet its debt interest obligations from earnings.

• Advantage: Directly indicates financial safety regarding debt servicing.

• Limitations: EBIT deducts non-cash depreciation, while EBITDA ignores necessary capital expenditures required to replace depreciating assets.

Debt-Equity Ratio (Book or Market)

• Purpose: Measures the extent of a firm's reliance on debt financing relative to equity.

• Advantage: Market value D/E accurately reflects true economic leverage.

• Limitations: Book D/E can be distorted or rendered meaningless if the book value of equity is negative due to heavy borrowing.

Debt-to-Capital Ratio

• Purpose: Measures the proportion of total capital structure financed by debt.

• Advantage: Standardizes leverage relative to total capital.

• Limitations: Subject to distortions depending on whether book or market values are used.

Debt-to-Enterprise Value Ratio

• Purpose: Measures the proportion of the underlying business enterprise financed by net debt.

• Advantage: Accounts for cash reserves and reflects true operational leverage.

• Limitations: Sensitive to fluctuating market capitalizations.

Equity Multiplier (Book or Market)

• Purpose: Indicates the amount of assets held per dollar of equity, measuring financial leverage amplification.

• Advantage: Serves as a vital component of the DuPont identity to analyze ROE.

• Limitations: High leverage magnifies both upside returns and downside financial risk.

Price-Earnings (P/E) Ratio

• Purpose: Assesses whether a stock is over- or undervalued based on earnings.

• Advantage: Universally understood metric for pricing relative to earnings.

• Limitations: Sensitive to capital structure (leverage) differences and useless when earnings are negative.

Enterprise Value Multiples (EV to Sales, EBIT, or EBITDA)

• Purpose: Compares the total value of the business to its sales, operating profits, or cash flow.

• Advantage: Avoids distortions caused by differing leverage levels when comparing firms.

• Limitations: Still influenced by differing industry growth rates and risk profiles.

Return on Equity (ROE)

• Purpose: Measures the return earned on past equity investments.

• Advantage: Directly reflects profitability from the common stockholder's perspective.

• Limitations: Can be artificially inflated via high financial leverage rather than operational excellence.

Return on Assets (ROA)

• Purpose: Measures the return generated by assets funded by both debt and equity investors.

• Advantage: Less sensitive to leverage variations than ROE.

• Limitations: Sensitive to working capital changes (e.g., fluctuations in accounts receivable or payable).

Return on Invested Capital (ROIC)

• Purpose: Measures after-tax profit generated by core operations relative to capital actively deployed.

• Advantage: The most robust indicator of fundamental business performance, excluding interest and idle cash.

• Limitations: Requires adjustments for tax rates and identification of operating vs. non-operating assets.

Asset Turnover

• Purpose: Measures how efficiently a firm utilizes its total assets to generate revenue.

  • Advantage: Highlights operational asset productivity.

  • Limitations: Varies widely due to capital intensity differences across distinct industries.

Market-to-Book Ratio

• Purpose: Compares the market valuation of equity to its historical accounting book value.

• Advantage: Helps classify growth stocks versus value stocks and measures management-added value.

• Limitations: Book value ignores unrecorded intangible assets like brand reputation and employee expertise