ratio analysis

profitability ratios

assess how well a company generates profits relative to resources used

• operating return on assets

• return on assets

• return on equity

• return on investment

operating return on assets

indicates how efficiently management uses assets to generate operating income

return on assets

shows how effectively assets are used to generate net income

return on equity

indicates how efficiently the company generates profit from equity investment

return on investment

helps assess whether an investment is worthwhile

liquidity ratios

show a company’s ability to meet short-term obligations

• current ratio

• acid-test ratio

• working capital

current ratio

measures shot-term liquidity; values > 1 suggest the firm can cover current liabilities with current assets

acid-test ratio

measures liquidity excluding inventory; stricter than the current ratio; useful when inventory is not easily converted to cash

working capital

measures short-term financial health; positive this indicates ability to pay off short-term debts

efficiency ratios

measure how effectively assets are managed

• turnover (asset turnover)

• accounts receivable turnover

• days sales in AR

• inventory turnover

• days sales of inventory

(asset) turnover

measures efficiency in using assets to generate sales; higher values suggest better asset utilization

accounts receivable turnover

measures efficiency in collecting receivables; higher turnover means quicker collections

days sales in accounts receivable

measures average number of days to collect receivables; lower values indicate faster collections

inventory turnover

measures efficiency of inventory management; higher turnover suggests strong sales or efficient inventory handling

days sales of inventory

measures average days inventory is held; lower values suggest better inventory control

leverage ratios

assess long-term financial stability and risk

• debt ratio

• debt/equity ratio

• times interest earned

debt ratio

measures proportion of assets financed by debt; higher ratios indicate grater financial risk

debt/equity ratio

measures leverage level; high ratio shows reliance on debt over equity, which may be risky

times interest earned

measures ability to meet interest payments; higher ratios imply more income available to cover interest obligations

market value ratios

relate financial performance to stock market performance

• price-earnings ratio

• dividend yield

• dividend payout ratio

price-earings ratio

measures investor expectations and valuation; high this suggests expected growth, low this could indicate undervaluation or risk

dividend yield

measures return on investment from dividends; attractive to income-focused investors

dividend payout ratio

measures proportion of earnings paid out as dividends; helps evaluate sustainability of dividend payments

high operating return on assets

strong operating efficiency; company is generating good return from assets before financing

low operating return on assets

inefficient use of assets in core operations

high ROA

company is generating solid net profit from assets (often >5-10%)

low ROA

poor asset utilization; may indicate low profit margins or inefficient operations

high ROE

indicates strong returns to shareholders (>15% is generally good)

low ROE

weak shareholder value creation; may signal problems in profitability or over-reliance on equity

high ROI

profitable investment; returns exceed cost (20%+ is strong)

low ROI

investment may not be worth it; possibly a loss or minimal gain

high current ratio

>2 suggests strong liquidity (can easily buy or sell an investment), but too high may indicate excess idle assets (resources owned by a business that are not being actively used to generate income)

low current ratio

<1 indicates risk of not meeting short-term obligations

acid-test ratio

>1 suggests ability to meet obligations without selling inventory

low acid-test ratio

<1 indicates potential liquidity issues

high working capital

positive (especially significantly so) shows financial flexibility

low working capital

negative means liabilities exceed assets — potential cash flow problems

high asset turnover

indicates efficient use of assets (varies by industry)

low asset turnover

assets may be underutilized or sales are low

high AR turnover

fast collections; efficient credit management

low AR turnover

slow collections; risk of bad debts

high days sales in AR

suggests slow collections or weak credit policies

low days says in AR

means quick cash flow (e.g. <30 days)

high inventory turnover

fast-moving inventory, less storage cost (high is good)

low inventory turnover

excess stock or weak sales

days sales of inventory

suggests overstocking or poor sales

low days sales of inventory

means quick inventory turnover

high debt ratio

higher risk (>60%); company is heavily leveraged

low debt ratio

lower risk; company is less dependent on debt

high debt/equity ratio

more aggressive financing (>2 is often high risk)

low debt/equity ratio

more conservative financing (may miss out on growth leverage)

high times interest earned

safer (e.g. >5); company can easily cover interest

low times interest earned

risky (<2 or negative); possible difficulty meeting debt payments

high price earnings ratio

high growth expectations, but possibly overvalued (>25-30)

low price earnings ratio

low expectations; possibly undervalued or in decline (<10)

high dividend yield

attractive to income investors; high yield (>3-5%) appealing

low dividend yield

(<1%) may signal reinvestment strategy or low profitability

high dividend payout ratio

>60% may show mature company with limited reinvestment needs

low dividend payout ratio

suggests retention of earnings for growth or financial stress