Financial Ratios

A firm's performance can be evaluated using financial ratios. Referencing these ratios to those of other firms allows a comparison to be made. The following is a listing of some useful ratios.

Leverage : Assets / Shareholder's Equity

Gross Margin = Gross Profit / Sales.
Gross margin measures the profitability considering only variable costs and is a measure of the percentage of revenue that goes to fixed costs and profit.

Net Profit Margin = Net Income / Sales

Total Asset Turnover = defined as Sales / Total Assets

Return on Assets (ROA) = Net Income / Assets
ROA is a measure of the return on money provided by both owners and creditors, and is a measure of how efficiently all resources are managed.

Return on Equity (ROE) = defined as Net Income / Equity
where the equity value is the shareholder's equity at the end of the period in which the income was earned. ROE is a measure of the return on money provided by the firm's owners.

ROE can be calculated indirectly as:

ROE = ( Net Income / Total Assets ) ( Total Assets / Equity )
ROE also can be calculated using DuPont analysis : ROE = (Net Income / Sales)(Sales / Total Assets)(Total Assets / Equity)

This states that ROE is determined by multiplication of three levers:

ROE = (net profit margin) (total asset turnover) (leverage)

These levers are readily viewed on the company's financial statements. While ROE's may be similar among firms, the levers may differ significantly.

Liquidity

The term working capital is used to describe the current items of the balance sheet. Working capital includes current assets such as cash, accounts receivable, and inventory, and current liabilities such as accounts payable and other short term liabilities. Net working capital is defined as non-cash current operating assets minus non-debt current operating liabilities. Cash, short-term debt, and current portion of long-term debt are excluded from the net working capital calculation because they are related to financing and not to operations.

Two commonly used liquidity ratios are the current ratio and the quick ratio.

Current Ratio : defined as Current Assets / Current Liabilities.
The current ratio is a measure of the firm's ability to pay off current liabilities as they become due.

Quick Ratio : defined as Quick Assets / Current Liabilities.

The quick ratio also is known as the acid test. Quick assets are defined as cash, accounts receivable, and notes receivable - essentially current assets minus inventory.

Recommended Reading

Mulford, Charles W., Comiskey, Eugene E. The Financial Numbers Game: Detecting Creative Accounting Practices