Financial ratios are very
common in financial analysis but also in investing and are used to help us
reveal information about a company, like its liquidity. Of course since we are
talking about ratios that means that we have to deal with a division in math
(in most cases), with a numerator and a denominator.
The first ratio is working
capital which is the capital used in the company on a daily basis –
operations. The formula is current assets less current liabilities. Current
assets are found on the left side of the balance sheet, and current liabilities
on the right side. The basic accounting equation is Assets = Liabilities +
Owners’ Equity.
Working capital is the
relationship between a company’s short term assets and its short term
liabilities. In accounting short term usually means within one year. Current
assets are assets that can quickly be converted to cash, and short term
liabilities are what a company owes within one year. The working capital ratio
is expressed as a ratio, so if the ratio is 2:1, it means that a company has
current assets twice as much as current liabilities.
The next ratio is the Quick
ratio and since this is also a liquidity ratio, it compares liquid assets,
like cash, marketable securities, and accounts receivables, divided by current
liabilities. A quick ratio of 1.5 means that the company has $1.50 of liquid
assets available to cover $1 of current liabilities. We often hear of the term
liquidity and a company been liquid or illiquid. Liquidity is a term that
refers to a company being able to pay its bills using its most liquid form of
assets, or those that can be quickly converted to cash.
A reminder that on the
company’s balance sheet, the asset side lists the assets of the company in
decreasing liquidity. Thus cash would be the most liquid form of asset and land
the least liquid.
Another ratio is the Earnings
per share, or EPS, and measures a company’s profit. It is calculated by profit
less dividends and dividing by the number of shares outstanding. EPS measures
net income earned on each share of a company’s common stock. There are situations where you have two
companies with one having a higher EPS but lower net income, and the other a
lower EPS but higher net income. In that situation it is not enough to make an
investment decision.
The next ratio is the Debt
to Equity ratio which is calculated by total liabilities divided by
shareholders’ equity. The debt to equity ratio or D/E, is how much dependent is
a company to debt. It’s an indication of the relative proportion of
shareholders’ equity and debt used to finance a company’s assets. Each industry has a different D/E ratio since
some industries tend to use a higher levered ratio than others.
In the cases where a
company has debt another useful indicator to see if a company meets its
interest payments on the debt is the times interest earned ratio, or TIE. The
formula is TIE = EBIT or EBITDA/ interest charges. When the interest coverage
ratio is <1, that means that the company is not generating enough cash from
operations (EBIT) to cover its interest obligations.
Capital structure is a
term that is used and indicates how a company is financed, that is, with debt,
equity (common stock), preferred stock. A company with a lower leverage ratio is
financed with more equity that debt, thus has a conservative capital structure.
