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March 20, 2019

Using Financial Ratios to Evaluate Financial Strength (or Weakness) – Part 2

financialratiosDetermining a company’s successful performance or identifying its risks involves more than just examining the cash balance in the checkbook or “the bottom line” on the Income Statement.  While analyzing complex financial information can be challenging, financial ratios can provide business owners with excellent tools and useful indicators of their company’s financial strength (or weakness).

Financial ratios are the most common and widespread tools used to analyze a business’ financial standing.  They are easy to understand, simple to compute, and are used to compare performance from year to year as well as to industry averages.  This monitoring of how a specific ratio is trending over time is what brings financial ratios its value as a financial statement evaluation tool.

Financial ratios are mathematical comparisons of financial statement accounts or categories and are classified according to the information they provide.  There are six main groups of ratios:

  1. Liquidity
  2. Solvency (or Leverage)
  3. Efficiency
  4. Profitability
  5. Market Prospect
  6. Coverage

In the last article, we examined the first three groups.  This time, we will review the last three groups.

PROFITABILITY RATIOS

Profitability ratios compare income statement accounts and categories to show a company’s ability to generate profits from its operations.  Profitability ratios focus on a company’s return on investment in inventory and other assets.  Financial statement analysts can use profitability ratios to judge whether companies are making enough operational profit from their assets.  Profitability is also important to the concept of solvency and going concern.

Here are the most common profitability ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Gross Margin Ratio

Gross Margin[1] divided by Net Sales

This ratio measures how profitable a company sells its job cost (self-performed labor, construction materials purchased, subcontracted work, equipment rented, etc.).  Also look at this ratio as job profit as a percentage of the job’s revised contract value.

Return on Assets

Net Income divided by Average Total Assets[2]

Measures how profitable a company’s assets are and how efficiently a company can convert the money used to purchase assets into net income or profits.

Return on Equity (“ROE”)

Net Income minus preferred dividends divided by Stockholders’ Equity

Shows how effective management is at using equity financing to fund operations and grow the company.

 

 

MARKET PROSPECT RATIOS

Market Prospect ratios are used to compare publicly traded companies’ stock prices with other financial measures like earnings and dividend rates.  Investors use market prospect ratios to analyze stock price trends and help figure out a stock’s current and future market value.  In other words, market prospect ratios show investors what they should expect to receive from their investment.  These ratios are helpful for investors to predict how much stock prices will be in the future based on current earnings and dividend measurements.  For example, a downward trend in earnings per share and dividend yield point to profitability problems and could even raise going concern issues.

Here are the most common market prospect ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Earnings Per Share (“EPS”)

Net Income minus preferred dividends divided by Weighted Average Common Shares Outstanding

This ratio measures the amount of net income earned per share of common stock outstanding.  In other words, this is the amount of money each share of common stock would receive if all of the profits were distributed to the outstanding shares.

Price Earnings (“P/E”)

Market Value Price Per Share divided by Earnings Per Share

Calculates the market value of a stock relative to its earnings and shows what the market is willing to pay for a stock based on its current earnings.  Investors often use this ratio to evaluate what a stock’s fair market value should be by predicting future earnings per share.

Dividend Payout Ratio

Total Dividends divided by Net Income

The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form of dividends during the year.  In other words, this ratio shows the portion of profits the company decides to keep to fund operations and the portion of profits that is given to its shareholders.  A consistent trend in this ratio is usually more important than a high or low ratio.

Dividend Yield

Cash Dividends Per Share divided by Market Value Per Share

This measures the amount of cash dividends distributed to common shareholders relative to the market value per share.  The dividend yield is used by investors to show how their investment in stock is generating either cash flows in the form of dividends or increases in asset value by stock appreciation.

 

COVERAGE RATIOS

Coverage ratios are comparisons designed to measure a company’s ability to pay its liabilities.  On the surface, coverage ratios might sound a lot like liquidity and solvency ratios, but there is a distinct difference:  Coverage ratios analyze a company’s ability to service its debt and other obligations.

 

Here are the most common coverage ratios, how they are calculated, and their definitions.

Name

Calculated as

Definition

Times Interest Earned

EBIT[3] divided be Interest Expense

Measures the proportionate amount of income that can be used to cover interest expenses in the future. 

In some respects the Times Interest Earned ratio is considered a solvency ratio because it measures a firm’s ability to make interest and debt service payments.

Fixed Charge Coverage

EBIT plus Fixed Charges Before Income Taxes divided by Fixed Charges Before Income Taxes plus Interest Expense

The fixed charge coverage ratio measures a firm’s ability to pay all of its fixed charges or expenses with its income before interest and income taxes.  The fixed charge coverage ratio is basically an expanded version of the times interest earned ratio.  The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like lease payments, insurance payments, and preferred dividend payments can be built into the calculation.

Debt Service Coverage

Operating Income divided by Total Debt Service Cost

Indicates a company’s ability to service its current debts by comparing its net operating income.

To summarize, ratio analysis is a tool that was developed to perform quantitative analysis on numbers found on financial statements.  Ratios help link the three financial statements together (Balance Sheet, Income Statement, Cash Flow) and offer figures that are comparable between companies and across industries and sectors.  Ratio analysis is one of the most widely used fundamental analysis techniques.  Ratio analyses can identify your company’s strengths and weaknesses, especially after you calculate results for your last two or three fiscal years.  Look for trends and then implement processes/procedures to fix the weaknesses.

[1] Defined as Sales (or Contract Revenue) less Cost of Sales (or Cost of Contract Revenue)

[2] Defined as the sum of Total Assets at the beginning of the year (period) plus Total Assets at the end of the year (period), excluding accumulated depreciation, divided by 2.

[3] Earnings (income) before interest expense and income taxes.

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