Understanding Financial Ratios: Investor Junkie’s Beginner Guide
From time to time, a company will share figures about itself that can provide insight into how well it’s functioning from a financial standpoint.
The company sometimes includes these ratios in their financial statements. Analysts also report them.
In this article, we’ll discuss some of the less common financial ratios designed to measure liquidity, solvency and efficiency. We’ll also show how the ratios are calculated based on a major corporation’s financial statements.
The debt-to-equity ratio shows how much debt a company has. Simply using a certain dollar amount to determine the level of debt is not good enough. For example, a $50 billion company with a $2 billion in debt can hardly be considered overleveraged. But a $1 billion company with the same level of debt is clearly in more than a little bit of trouble. The debt-to-equity ratio is the only effective way to compare leverage between companies in the same industry but of different sizes.
The debt-to-equity ratio is calculated by dividing the company’s total liabilities by shareholder equity. For example, a company with $2 billion in total liabilities and $5 billion in shareholder equity has a debt-to-equity ratio of 40%.
2 / 5 = 0.40 = 40%
Is 40% a good number? Only if it’s consistent with debt-to-equity ratios of companies engaged in the same industry. 40% is a good number if the average debt-to-equity ratio for the industry is 50%. But if the industry standard is 20%, it could be an indication the company has financial problems.
The ratio is commonly disclosed on the balance sheet portion of the issuing company’s financial statements. But the debt-to-equity ratio is too broad in scope. For example, it doesn’t isolate long-term debt, which is generally a higher risk than short-term debt. Think of it as a starting point for evaluating a company’s debt status.
Debt Interest Coverage Ratio
Sometimes referred to simply as the interest coverage ratio, it’s used to measure a company’s ability to pay interest on its debts. It’s calculated by dividing the company’s earnings before interest and taxes — abbreviated as EBIT — by the dollar amount of the interest payments due within the fiscal year.
So, if a company’s EBIT is $900 million and its interest expense is $300 million, its debt interest coverage ratio is 3.
900 / 300 = 3
In most cases, a debt/interest ratio of 3 is one sign of well-managed debt.
The ratio shows how well a company is able to manage their current debt obligations. It indicates how many times a company is able to cover its interest payments with its present earnings. A low ratio suggests the company may be struggling to meet its debt payments. As a rule of thumb, a ratio of 1.5 or lower is considered risky.
Since debt is a fact of life for companies, they need to maintain the ability to cover the interest on that debt fairly easily. Companies often use debt to grow. But if the debt interest coverage ratio is too low, it can be a hint the company is overleveraged and heading for trouble.
Asset Turnover Ratio
Asset turnover ratio is calculated by dividing a company’s total sales by the average of its total assets over the course of the fiscal year. It’s calculated as follows:
total sales for the year—————————————————(beginning assets + ending assets) / 2
The sub-calculation of beginning assets plus ending assets, divided by two, is the average assets. It produces a more accurate picture of a company’s assets over the course of a full year.
The asset turnover ratio shows how well a company is leveraging its assets to produce revenue. A higher asset turnover ratio suggests the company is managing its assets more efficiently. Basically, it measures how many dollars of revenue are being produced from each dollar in asset value.
Since the asset turnover ratio can vary dramatically from one industry to another, it needs to be measured against the same ratio of competing companies. For example, utilities have large asset bases and will have a low asset turnover ratio. On the other hand, retailers typically have smaller asset bases and will reflect a higher asset turnover ratio due to much higher sales volume.
Inventory Turnover Ratio
As the name implies, inventory turnover ratio is the number of times a company sells off its inventory during this fiscal year. It’s calculated as follows:
total sales for the year—————————————————(beginning inventory + ending inventory) / 2
Much like the asset turnover ratio, average inventory is calculated by taking the inventory at the beginning of the period plus the inventory at the end of the period and dividing the total by two.
If a company has $1 billion in sales and an average inventory of $200 million ($0.2 billion), its inventory turnover ratio is five.
1 / 0.2 = 5
The ratio shows how fast the company sells its inventory. As always, compare this to its competitors. If the ratio is lower than industry standard, it could indicate either poor sales or excess inventory. And that could indicate a lack of desirability of the company’s product line, insufficient marketing efforts or simply overstocking of inventory.
One of the darker issues inventory turnover ratio can reveal is an excess of dead stock. That’s inventory that the company can’t sell. It can include perishable items that spoiled or exceeded their maximum shelf life, or inventory that simply isn’t selling due to obsolescence or undesirability.
A company may keep such inventory on their books longer than they should in order to maintain the appearance of a stronger asset position than really exists.
Once again, the ratio will vary based on the industry. For example, in the grocery industry, the ratio is high because products sell quickly. But for manufacturers of oil drilling equipment, the ratio will be lower due to a longer cycle of sales and production.
Analyzing Ratio Demo With a Real Company: Value and Profit Ratios
For the purposes of this demo, we’re going to rely on the financial statements for Apple, Inc., for the fiscal year ended September 29, 2018. Due to the length of such statements, we are unable to produce legible screenshots, so you’ll need to verify the numbers on the statement itself. Or you can take our word for it. Just remember this is a demo only and not a claim of an official financial analysis of Apple, Inc.
Also note that the company’s stock price closed at $222.29 per share on September 28, 2018. For our purposes and for simplicity sake we’re going to call that $222.
Price to Earnings (P/E)
P/E is the share price divided by earnings per share. If the stock is trading at $100 and earnings per share is $4, the P/E is 25.
Apple’s earnings per share was $12.01. Dividing the stock price of 222 by $12.01, the P/E was 18.48.
222 / 12.01 = 18.48
Price-to-earnings Growth (PEG)
This is the P/E of a stock divided by its earnings-per-share growth. Now, earnings-per-share growth isn’t necessarily a hard number. It uses analysts’ estimates provided by third-party financial sources. A PEG of 1 is considered optimal, with the P/E equaling the earnings-per-share growth rate. If the PEG exceeds 1, the company is overvalued. If it’s less than 1, it’s considered undervalued. A company with a P/E of 25 and an earnings-per-share growth rate of 25% has a PEG of 1 and is considered fairly valued.
With a P/E of 18.48 and a rough earnings-per-share growth rate of 30%, the PEG for Apple was 0.62.
18.48 / 30 = 0.62
P/S shows how much investors are willing to pay per dollar of sales generated by the company. It is calculated by dividing the share price by sales per share. Sales per share is calculated by dividing company sales by the number of outstanding shares. If a company has $1 billion in sales and 10 million (0.01 billion) shares of stock outstanding, the sales per share will be 100. If the stock is trading at $50, the P/S will be 0.5.
Apple had $265.6 billion in sales for the fiscal year. The number of shares outstanding was 4,955,377,000. By dividing sales by the number of outstanding shares, sales per share is 53.6. By dividing the share price of $222 by 53.6, the P/S was 4.14.
222 / (265.6 / 4.955) = 4.14
P/B is calculated by dividing a company’s stock price by its book value per share. (Book value per share is the company’s total assets minus intangible assets and liabilities divided by the number of shares outstanding.) A low P/B can suggest a company is undervalued. For example, if its share price is $75 and its book value per share is $100, the P/B would be 0.75; the company’s intrinsic value is higher than its stock price.
For Apple, total shareholder equity was $107.1 billon. Divided by 4,955,377,000 shares, the book value per share is $21.61. With the stock price of $222, the P/B was 10.27.
222 / (107.1 / 4.955) = 10.27
This is a company’s annual dividend divided by its share price. For example, if the company has an annual dividend of $5 and a share price of $100, the dividend yield is 5%.
Apple’s cash dividend for the year was $2.72. Dividing that by the share price of $222 gives a dividend yield of 1.22%.
2.72 / 222 = 0.122 = 1.22%
This is the total amount of dividends paid on all the company’s stock divided by the company’s net income. If a company has $1 billion in net income and pays out $350 million in dividends, the dividend payout ratio is 35%. The rest of net income is invested in either expanding operations, buying back stock or paying off debt.
Apple paid $13.7 billion in dividends. Dividing that by net income of $59.5 billion gives a dividend payout ratio of 23%.
13.7 / 59.5 = 0.23 = 23%
Return on Assets (ROA).
This ratio is calculated by dividing a company’s net income by its total assets. The higher the ratio, the more profitable the company is on its asset base. If a company has $1 billion in net income and $10 billion in assets, it’s ROA is 10%.
With a net income of $59.5 billion and total assets of $365.7 billion, Apple’s ROA was 16.27%.
59.5 / 365.7 = 0.1627 = 16.27%
Return on Equity (ROE)
This ratio is calculated by dividing a company’s net income by shareholder equity. If the company’s net income is $10 billion and it has total outstanding equity of $100 billion, the ROE is 10%.
With a net income of $59.5 billion divided by shareholder equity of 107.1 billion, the ROE was 55.6%. (We’re ignoring payments to preferred stockholders and interest to lenders, since they’re not presented on the consolidated financial statements.)
59.5 / 107.1 = 0.556 = 55.6%
There are various types of profit margin calculations, but for our purposes we’re going to use gross profit margin. That’s basically total sales minus the cost of goods sold divided by net sales. If a company has total sales of $1 billion and $600 million in cost of goods sold, its gross profit is $400 million. The gross profit margin then is 40%, or $400 million divided by $1 billion.
With the gross margin of $101.8 billion and net sales of $265.6 billion, Apple’s gross profit margin was 38.3%.
101.8 / 265.6 = 0.383 = 38.3%
Analyzing Ratio Demo: Liquidity, Solvency and Efficiency Ratios
Each of the ratios below have been explained at the beginning of this article. We’ll calculate the ratios for the demo company below, based on those explanations.
Debt to Equity
Apple’s shareholder equity was $107.1 billion. Total liabilities were $258.6 billion. Dividing total liabilities by shareholder equity produces a debt-to-equity ratio of 241.6%.
258.6 / 107.1 = 2.416 = 241.6%
Debt Interest Coverage
Apple’s earnings before interest and taxes totaled $70.9 billion. Its total interest expense for the year was $3.24 billion. Dividing earnings by interest expense, the debt interest coverage ratio was 21.9.
70.9 / 3.24 = 21.9
Total sales were $265.6 billion. Total assets were $375.3 billion at the start of the year and $365.7 billion at year’s end. Dividing sales by average assets, the asset turnover ratio is 71.7%.
265.6 / ((375.3 + 365.7) / 2) = 265.6 / 370.5 = 0.717 = 71.7%
As mentioned, annual sales were $265.6 billion. Inventory at the beginning of the year was $4.855 billion and at year’s end, $3.956 billion. So, Apple’s inventory turnover ratio was 60.3.
265.6 / ((4.855 + 3.956) / 2) = 265.6 / 4.406 = 60.3
Liquid Current Ratio (Solvency)
Usually referred to as the quick ratio, it’s determined by adding cash and cash equivalents, marketable securities and accounts receivable, and dividing them by current liabilities.
In Apple’s case, the company had cash and cash equivalents of $25.9 billion, marketable securities of $40.4 billion, and net accounts receivable of $23.2 billion. Collectively, these “quick assets” totaled $89.5 billion. Dividing that by current liabilities of $116.9 billion, the company’s liquid current ratio was 76.6%.
(25.9 + 40.4 + 23.2) / 116.9 = 0.766 = 76.6%
Final Thoughts on Financial Ratios
Once again, let’s emphasize that this analysis is for demonstration purposes only. This is not an official analysis of any sort and will likely result in different numbers than those of the analysts.
And we also need to emphasize that while financial ratios measure the financial strength of a company, as well as its competitive position within its industry, they aren’t the be-all and end-all of determining whether you will purchase stock in a given company. You’ll also need to look closely at the qualitative aspects of the company in making your decision.
For example, P/E is a common measure of the desirability of a stock. Yet investors will pile into one stock with a P/E of 50 but turn their noses up at one with the P/E of 15. It’s because the answers aren’t always in the numbers.
In order to know the financial integrity of the company you’re buying into, you need to know these numbers. But at the same time, you need to pay close attention to the big picture. You need to know the company’s position in the industry. And you need to know the future prospects for the industry in general. Ratio analysis is just one more measure of a company’s desirability — or the lack of it.