Financial Ratios Analysis and its Importance

What are Financial Ratios?

Financial ratios are calculated relative ratios mostly derived from a company’s financial statements (see also the definition as per Wikipedia). They are required by management, financial analysts, investors, creditors, and other stakeholders to understand better and read financial statements. Also, calculating financial ratios puts the financial statements into perspective when comparing them with similar ratios serving as peer companies’ benchmarks.

We can identify five different types of financial ratios when analyzing financial statements: 

  • Liquidity ratios
  • Efficiency ratios
  • Profitability ratios
  • Growth Ratios
  • Leverage (or bank) ratios

These ratios have varied roles in interpreting the business’s financial condition and their financial ratios formulas use different aspects of the financial statements in their interpretations. The idea is to look at a company from different angles so that we can understand the full picture. For this, we will have to calculate a series of financial ratios.

Financial Ratios Cheat Sheet and Definitions

We have collected a comprehensive financial ratios list containing the financial ratios formulas which we recommend to calculate whenever analyzing a company and aiming to assess its financial situation. Our list – in form of an infographic – can be used as financial ratios cheat sheet as it contains the financial ratios definitions.

Why using Financial Ratios Analysis?

Financial ratios analysis is an invaluable tool in analyzing financial statements, evaluating business performance, and identifying company issues. With the financial ratios’ analysis, the business evaluation will become much more manageable and easier to compare to competitors and industry average.

Financial ratios are calculated for specified periods. It allows us to understand better how the financial ratios develop over time and identifying the right questions why this happened. It usually adds significant value in understanding financial statements. Therefore, financial ratios can be compared between periods and provide real information concerning a company’s financial performance.

The financial ratios’ importance is also given because financial ratios by industry are available and can be compared to. It allows us to better understand the company’s performance compared to benchmark competitors and the industry average. Furthermore, calculation financial ratios are also important to better estimate the company’s future performance.

It is essential to understand individual financial ratios and understand the full picture of a company. Therefore, it is required to calculate and analyze several financial ratios from the different groups (liquidity, efficiency, profitability, growth, and leverage) to get a full picture of what is going on with a company.

Financial ratios analysis becomes especially valuable when the ratios can be compared to its industry’s financial ratios or benchmark ratios derived from competitors or similar companies.

The Financial Ratios Importance for Forecasting

The importance of calculating financial ratios is also given that a proper analysis of a company’s situation is the prerequisite for preparing any meaningful budget and financial forecast. Only a thorough understanding of the financial situation of the company will lead to a meaningful budget. Also, any budget itself will heavily rely on Financial Ratios Importance as many times it will be easier to forecast a financial ratio than determining the forecast in another manner, which many times disregard if the financial ratios are in line with historic financials or not. To avoid this error, it is important that also a forecast includes the calculation of all the relevant financial ratios.

The most common financial ratios used in forecasting are profit margins. The below picture reveals that the company would expect that the current high EBITDA margin is expected to decrease over time while the Gross Profit margin appears to remain.

An Example: Analyzing Financial Statements of a Company

Below we present the Financial Statements – Income Statement, Balance Sheet, and Cash Flow statement of a manufacturing company.  In short, the company generates $5.5m in revenues at an EBITDA margin of 27.6%. Operating cash flow is positive while the company has to invest every year in the maintenance and upgrade of its machinery park. The company also uses Financial Debt which shows up on the Balance Sheet.

In order to better understand these financial statements, we now will calculate all the relevant financial ratios to get a better picture of the financial and performance situation of this example manufacturing company. Our analysis will follow the financial ratios list summarized in the financial ratios cheat sheet to calculate the financial ratios of each commonly used financial ratio category. Before we do that, we will also require the financial ratios by industry.

Financial Ratios Industry Average

Below we now have also collected the financial ratios by industry which reflect the industry average for the same kind of manufacturing operations as our company is involved. The financial ratios industry average can now serve as a benchmark and allows us to compare how our company performs in comparison to its average peers.

We are now all set to perform the calculation of all financial ratios as per the financial ratios definitions and interpret the results.

A Walkthrough of Financial Ratios Formulas as per our Financial Ratios List

We now will work through the financial ratios list presented above by using the financial ratios formulas mentioned in the cheat sheet and its definitions. This will be the prerequisite to assess the business’s financial performance from all the relevant angles and come up with a comprehensive understanding of the situation of the company. The five commonly used financial ratios categories are the liquidity ratios, efficiency ratios, profitability ratios, growth ratios, and leverage ratios.

1.            Liquidity Ratios

Liquidity ratios measure the capability of the business to pay its obligations whereas we focus on the current liabilities (liabilities which are due to be paid within one year). Businesses need a certain amount of cash and other current assets to finance the business operation. Liquidity ratios assess the company’s capacity to meet its current obligations without requiring additional capital.

a.            Cash Ratio

The cash ratio is computed by taking the cash and cash equivalents divided by the current liabilities. It measures the capacity of the business by using the most liquid assets in paying short-term obligations. Cash & cash equivalents are the business value in a worst-case scenario in case the other current assets could be converted into cash. Cash equivalents include marketable securities and money market holdings. The financial ratio formula is as follows:

Formula:  Cash Ratio = Cash & Cash Equivalents / Current Liabilities

In our example, the company has cash & cash equivalents amounted to $1.48 million for the latest year with current liabilities of $0.45 million. The cash ratio computed is 3.3x, which means that the company has more than enough cash & cash equivalent to fulfill the current financial obligation. It shows that the business has excess cash not utilized in operation, which going on since 2018 (when the cash ratio exceeded 1.0x). A minimum cash ratio depends on the industry but normally a cash ratio of 0.8x is a reasonable minimum target.

b.            Quick Ratio (Acid-Test Ratio)

The Quick Ratio or the Acid-Test ratio is computed by dividing the Cash & cash equivalents + Receivables (or current assets less inventory) by the current liabilities. Inventory is taken out since it takes more time to dispose of compared to receivables where they normally can be collected quicker. The Quick Ratio is a more conservative approach than the current ratio, and a minimum ratio of 1.0x is desirable to current obligations can be paid quickly from cash and receivables if needed. There are two financial ratio formulas which can be used:

Formula 1: Quick Ratio (Acid-Test) = (Cash + Receivables)/Current Liabilities

Formula 2: Quick Ratio (Acid-Test) = (Current Assets – Inventory) / Current Liabilities

On our Balance Sheet, the Company has cash & cash equivalent of $1.48 million in 2019, accounts receivable of $0.6 million, and an inventory amounting to $0.6 million for 2019. On the other hand, current liabilities are $0.45 million. It means that the computed Quick Ratio results in 4.6x, which implies that the business has more than enough quick assets to meet its current obligations. Having a high ratio is not a reasonable implication for the business since it does not efficiently utilize its assets and would indicate that the company lacks opportunities to find profitable investments in other ventures.

c.            Current Ratio

The current ratio measures the company’s capacity to meet its short-term liabilities (the liabilities which are due to be paid in one year). The current assets include cash & cash equivalents, accounts receivables, and inventory. The current ratio is computed by taking the current assets divided by the current liabilities. Benchmark ratios depend on the industry, and a manufacturing company’s standard ratio would be somewhere around 2.0x. It would mean there should be around two current assets to pay for one current liabilities. A lower than one current ratio could mean that the business will have difficulties to meet its short-term obligations and requires a cash injection (either from a bank or from shareholders). A higher than two or three current ratios suggest that the company has excess current assets that could be better invested in other ventures (since so many assets are not really needed). The financial ratio definition is as follows:

Formula : Current Ratio = Current Assets / Current Liabilities

Based on the balance sheet above, the company has current assets amounting to $2.68 million and current liabilities of $0.45 million in 2019. It means that the current ratio is 6.0x, which is much higher than the desired 2.0x. The business has high current ratios for the past three years. It does not invest the excess current assets and sits idly within the company.

2.            Efficiency Ratios

Efficiency ratios measure the efficiency of the business how to run its operations. The most common efficiency ratios focus on how networking capital is managed and how efficiently assets are being used.

a.            Days Inventory

The inventory days are derived by dividing the inventory by costs of goods sold (COGS), then multiplied by 365 (number of days in a year). This efficiency ratio is used to determine how long it takes for the inventory, including the works in progress, into sales. It also measures the company’s efficiency in terms of warehousing, distribution, and the timing of purchasing new inventory. The shorter the inventory days, the better since it implies that the business can produce another production cycle.  

Formula: Days in Inventory = Inventory / COGS   x 365

The average inventory amounts to $0.60 million, and the costs of goods sold amounted to $2.60 million in 2019. Both inventory and COGS are increasing throughout the years. Given the figures above, the computed days in inventory is 84 days, which can be considered a high ratio compared to the industry average of 50 days as calculated in the financial ratios by industry. It means that the company stock up inventory for almost three months before disposed of and turned into cash. The day’s inventory needs to be improved. As the Days Inventory was already reduced from 2018 (91 days) to 2019 (84 days), most likely efforts were initiated but most likely not enough to meet the standards of competitors.

b.            Days Receivables

The day’s receivables (or days sales outstanding) are the average number of days it takes for the accounts receivable to be collected. It depicts the company’s efficiency in collecting payment from its customers. The faster payment can be collected, the more cash is available to run day-to-day operations. The targeted day’s receivables vary from industry to industry but should be near to the average credit terms provided for the company’s customers. As per the financial ratio definition, days receivables are computed by dividing the accounts receivable over net sales, then multiplied by 365 days.

Formula: Days Receivables = Accounts Receivables / Net Sales x 365    

Given the accounts receivable of $0.60 million and net sales of $5.50 million for 2019, the calculated day’s sales outstanding is 40 days. The turnover is decreasing in the past three years, 58 days in 2017 and 45 days in 2018, respectively, suggesting that the collection system has become better. If we compare to the industry average (50 days), the company (40 days) by now actually manages receivables more efficiently than its peers. This would be a sign of good management.

c.            Days Payables

Days Payables is computed by dividing the accounts payable by COGS, then multiplied by 365 to get the length of time it takes for the company’s bills and financial obligations to be paid. Desirable days payable depends on industry standards and good relationships with creditors. A low ratio can indicate that the business applies shorter credit terms than its competitors, or it is not fully utilizing the term offered by creditors. On the other hand, the high ratio suggests that the company has better credit terms than its competitors or has limited ability to pay the current obligations on time. A high ratio can be beneficial, given that the company can use the cash for other activities such as investment. However, it can jeopardize the business’s credit rating and lead to higher purchasing costs when suppliers realize that their invoices do not get paid in time. 

Formula: Days Payables = Accounts Payable /COGS x 365

The accounts payable for 2019 is $0.45 million, and the COGS is $2.6 million, which translates to 63 days turnover. Days payable outstanding for 2017 and 2018 are 47 days and 55 days, respectively. Either the company is in a favorable position to demand longer credit terms or in some cases it would indicate the company using payables to finance its operation. Also, our analysis of financial ratios by industry shows that the days payable is longer than the industry average of 30 days.

d.            Cash Conversion Cycle (CCC)

The cash conversion cycle is the measure of how fast the inventory turns into cash. It includes the working capital accounts, which are the inventory, receivables, and payables. The days inventory and receivables are added, then deducting the days payable to compute the cash conversion cycle. The shorter the CCC, the better since more products can be sold in a particular time and then produce another production cycle.

Formula: Cash Conversion Cycle = Days Inventory + Days Receivable – Days Payable

As computed above for the year 2019, days inventory is 84 days, days receivable is 40 days, and the days payable is 63 days. It translates to 61 CCC, which means that it takes 61 days to purchase inventory, sell products on credit, collect cash, and pay outstanding payables. It is higher than the industry benchmark of 55, which means that the cash conversion cycle should be improved.

e.            Asset Turnover Ratio

Asset turnover is an indicator of how efficient the company is in utilizing assets to produce sales. It is computed by taking revenues then divided by the total assets. Higher ratios indicate that a company used its assets in more efficient ways to generate revenues. Conversely, lower ratios than competitors need further investigation and analysis on how the company can utilize the assets properly to produce more output that turns into sales. The financial ratio formula is very simple:

Formula: Asset Turnover = Revenues / Total Assets

For 2019, the company recorded net sales of $5.5 million and the value of the total assets of $4.98 million. It provides an asset turnover ratio of 1.1x, which means that per dollar of assets produces $1.1 in revenue can be generated. It is a good indicator that the business is appropriately utilizing its assets to provide more sales.

f.             Effective Interest Rate

The effective interest rate is the effective interest rate paid by the company’s interest-bearing debt taking into account all effects including eventual compounding. It means that the more frequent the compounding period, the higher the effective interest rate. A higher effective interest rate is profitable for the lender but more interest to pay on the debtor. The interest payment is divided by the average interest-bearing financial debt to compute the effective interest rate. 

Formula: Effective Interest Rate = Interest Payment / Average Interest-Bearing Financial Debt

In our example, the company has paid interest amounted to $48K for 2019, and financial debt of $2.5 million and $2.0 million for 2018 and 2019, respectively. With the given figures, the computed effective interest rate is 2.1%. A low-interest rate indicates that using debt financing benefits the company favorable as the interest is cheap. A high-interest rate would indicate that using debt financing adds significant stress on the company and therefore might require de-leveraging.

g.            Effective Tax Rate

The effective tax rate is the average tax rate paid by a company. It is computed by taking the tax paid divided by earnings before tax (EBT). Investors and analysts utilized this ratio to analyze business efficiency to generate income and how much is allocated from the earnings to pay for tax obligations.

Formula: Effective Tax Rate = Tax Expense / EBT

Considering that the company’s tax obligation for 2019 is $30K and the EBT is $1.25 million, this translates to a 2% effective tax rate of the corresponding year. It means that the tax obligation is only a small percentage of the business cash outlays and doesn’t affect the earnings.

3.            Profitability Ratios

Profitability ratios evaluate the company’s capacity to generate profits to its revenue, assets, cash flow, and equity. These ratios are the financial ratios formulas most looked at by investors since it tells them how much they can earn by investing in the company. The higher the ratios, the better.

a.            Gross Profit Margin

It is computed by taking the gross profit then divided by net sales. This ratio entails how effective the company is in earning profit after deducting the cost of goods sold; or the service industry’s revenue costs. A high gross profit margin shows that the business can sufficiently cover its direct costs (direct expenses when producing goods and services).

Formula: Gross Profit Margin = Gross Profit / Net Sales

The Company shows net sales of $5.5 million for 2019 and 2.9 million in gross profit. This results in a gross profit margin of 52.7% percent. It means that only 47.3% is spent on COGS. A 52.7% gross profit margin is considered a high margin compared to industry standard.

b.            EBITDA Margin

EBITDA is the earnings after deducting all the production costs and operating expenses, excluding interest, taxes, depreciation, and amortization. The EBITDA margin is derived by taking EBITDA then divided by the net sales. It is more comparable to use with the competitors since it only considers the operating costs on a cash basis, which can be similar to the competitors.

Formula: EBITDA Margin = EBITDA/ Net Sales

The company generates an EBITDA of $1.52 million for 2019 from a $5.50 million net sale. The EBITDA margin is computed at 27.6%. It can be considered a higher return compared to the industry average of 15% as per the financial ratios by industry analysis. Also, many other industries show EBITDA margins between 10% – 15%.

c.            Net Profit Margin

Production costs, general & administrative expenses, interest expenses, taxes, and depreciation are deducted to derive the net income. The net income is then divided by net sales. Though this ratio could be a valuable tool for internal use to assess how much left after removing all the costs, the net profit margin is not a fair comparison with the competitors since businesses have different financing structures. 

Formula: Net Profit Margin = Net Income / Net Sales

Considering a net income of $1.22 million for 2019 after deductions of all the expenses from the net sales of $5.50 million, the company’s net profit margin translates to 22.2%. The company’s net profit margin is increasing for the past three years, 14.1%, and 19.7% for 2017 and 2018, respectively. Increasing net profit margins show the stability of the business earnings.

d.            Return on Assets

The return on assets is derived by taking the net income + interest divided by the average assets. It is the measure of the business efficiency to generate profit by optimizing its assets. The return on assets is a valuable ratio in evaluating asset-intensive companies such as telecom and car manufacturers since it assesses if they are correctly utilizing their assets to generate more profit. The financial ratio definition is as follows:

Formula: Return on Assets = (Net Income + Interest) / Average Assets

In 2019, the Company has a $1.22 million net income with an interest obligation of $48K. Assets of 2019 ($4.98 million) and 2018 ($4.14 million) lead to an average asset position of $4.56 million. With these figures, the return on assets is computed at 27.9%. It can be assessed that the business is appropriately utilizing its assets to produce desired earnings.

e.            Return on Equity

The return on equity is looked at the shareholders’ point of view and is computed by dividing the net income over the average shareholders’ equity. The higher return, the better it is for the investors since profits can either be used to pay higher dividends or reinvested to grow the business. It also shows how effective the company is in utilizing its equity to produce earnings.

Formula: Return on Equity = Net Income / Average Shareholders’ Equity

The Company has a net income amounting to $1.22 million in 2019, while the shareholders’ equity is valued at $1.31 million and $2.53 million for 2018 and 2019, respectively. The computed return on equity is 63.7%, which means that every dollar of equity produces 64-dollar cents. Therefore, the Company is appropriately utilizing the investors’ money to pay back dividends.

f.             Return on Capital Employed

Return on capital employed measures how efficient the company uses the capital employed in its operations, including net debt and equity, to produce earnings. It is computed by taking the Net Operating Profit Less Adjusted Taxes (NOPLAT), which is the same as EBIT adjusted for Pro-forma taxes, divided by the average capital employed. Capital employed is the amount of total capital invested in the business to use for the business operation and generate profit. It is calculated by adding Net Working Capital minus Cash plus Fixed Assets which is the same as Net Debt + Equity.

The return on capital employed is a more meaningful profitability ratio to assess business performance since it considers both the capital invested by shareholders and debtors. The financial ratio formulas are the following:

Formulas:

NOPLAT = EBIT * (1- tax rate)

Capital Employed = (Current Assets – Cash) – (Current Liabilities + Other Non-Interest-Bearing Liabilities – Short Term Debt)

Capital Employed = Equity + Interest Bearing Debt – Cash

Return on Capital Employed = NOPLAT / Average Capital Employed

Considering 2019, the company shows a NOPLAT of $1.29 million ($1.30 million EBIT – 2% tax rate). Capital employed amounted up to $2.77 million (2018) and $3.05 million (2019), averaging at $2.91 million. The resulting return on capital employed (ROCE) lies at 43.6% for 2019. This is much higher than any reasonable opportunity costs on the invested capital and shows excellent operating profitability of the company.

4.            Growth Ratios

Growth ratios typically serve as an additional metric to determine the company’s success by measuring the ongoing growth rates. Successful companies usually keep growing while the company that is stagnating or not growing ends up in trouble. Therefore, as a financial analyst, you want to understand if a company keeps growing and why.

a.            Revenue Growth

Revenue growth, a metric presented as a percentage, is used to measure if the company is growing over time. An increasing trend means that the business is continually growing while a decreasing rate could suggest an operational problem related to the sales department or the industry it belongs is already slowing down. On the downside, this ratio excludes costs in the computation, which means it does not present the actual picture of the company’s operations and profits. To compute the revenue growth, divide the current revenue by the revenue of the previous period, and subtract one.

Formula: Revenue Growth = (Current Period Revenue/ Previous Period Revenue) -1

In our example, the Company’s revenue growth is increasing for the past three years, which recorded 18.4% and 22.2% for 2017-2018 and 2018-2019, respectively. It means that the company is continually growing and also clearly exceeds the 5.0% annual revenue growth as per the analysis of financial ratios by industry.

b.            EBITDA Growth

EBITDA growth is a good measure of profitability compared to its competitors and industry average as it takes into account the operating costs or cash flows in the analysis.  Increasing EBITDA shows that the effect of cost-cutting efforts done by the company is working. Interesting situations are when revenue keeps growing but not EBITDA. It means one has to analyze the costs better as it can be costly to achieve further growth. Important then is to understand if the costs spent are likely to lead to higher profits later on or not. To compute for the EBITDA growth, divide the current EBITDA by the EBITDA of the previous period, and subtract one.

Formula:  EBITDA Growth = (Current Period EBITDA / Previous Period EBITDA) -1

The Company’s EBITDA Growth decreased over the last two years, from 46.9% for 2017-2018 to 27.7% for 2018-2019. Maintaining continuous high growth in EBITDA is difficult, Still, the management needs to identify the reasons for the high growth and seek ways to maintain it.

c.            Net Income Growth

Net income growth measures a company’s growth using the earnings found from the income statement’s bottom level. By comparing net income to EBITDA and revenue growth rate, it can give indications where a company’s problem starts. However, this is not a fully fair comparison to competitors and industry average since companies across the industry have different financial structures that impact Net Income (but not EBITDA). To compute for the net income growth, divide the current Net Income by the Net Income of the previous period and subtract one.

Formula: Net Income Growth = (Current Period Net Income / Previous Period Net Income) – 1

For the last two years, the Company’s Net Income growth decreased from 65.4% to 37.7%. As EBITDA already decreases as per the same pattern, we conclude that the reason must lie above the EBITDA line. As the company uses debt financing which leads to interest costs, the effect impacts Net Income more heavily (as interest costs behave as fixed costs in this case).

d.            Asset Growth

Asset growth is a metric used to assess how much the assets grow for the evaluated years. Increasing growth can be an indication of a company’s growth and stability. However, decreased or fluctuation needs further analysis, for it does not necessarily mean a losing business since the timing of assets sales or purchase can affect the result. To compute the asset growth, divide the current period’s Total Assets by the Total Assets of the previous period, and subtract one.

Formula: Asset growth = (Current Period Total Assets– Previous Period Total Assets) – 1

Asset Growth decreased during the past two years from 31.3% to 20.4%. The Asset Growth rate declined a bit as the Asset Turnover ratio became less efficient (1.1x instead of 1.2x). The reason lies also in the company’s cash balance which was steadily increasing over the last years and leading to a higher base to measure asset growth.

e.            Equity Growth

Equity growth is used to measure how much growth in the company’s equity position is recorded for the evaluated period. This metric is utilized by investors to know if there is growth in the company’s total equity and if the growth can be maintained. To compute the equity growth rate, divide the current period’s Equity value by the Equity book value of the previous period, and subtract one.

Formula:  Equity Growth = (Current Period Equity– Previous Period Equity) -1

The equity growth rate was decreasing over the past two years. Equity growth for 2017-2018 was 211.3% but then decreases to 93.5% for 2018-2019. This is due to the fact that the equity position at the beginning was very thin, so it is easy to grow and afterward, no Dividends are paid leaving all income earned inside the company.  

5.            Leverage Financial Ratios (or Bank Ratios)

Leverage or Bank ratios are used to evaluate the capacity of a business to pay its debt. It is evaluated by banks and other creditors to ensure that the company asking for a loan will meet its obligations when due.

Financial ratios leverage shows the company’s capital structure by assessing its total assets, liability, and shareholders’ equity. It also examines how heavily it is funded by debt or a mixed debt and shareholders’ equity. Using a high amount of leverage makes a company vulnerable to economic risks. A certain business volume is required to service its financial debt, as any business turmoil can put the company in severe difficulties.

a.            Debt/EBITDA Ratio

The financial ratio formula is computed by considering the company’s interest-bearing debt (or financial debt which only includes debt with interest and financing character but not payables or provisions even despite the term debt is used) which is then divided by the EBITDA (the Earnings before Interest, Tax, Depreciation, and Amortization). The Debt/EBITDA ratio is used to measure the capability of paying financial debt out of the cash earnings available to the company. A low Debt/EBITDA ratio less than 1.5x normally means that the company can easily cover its financial debt obligations and it would take only 1.5x years to repay the debt based on its EBITDA. As with any other ratio of relevance to the bank, this impacts the company’s credit score. In contrast, a high Debt/EBITDA ratio > 3.0x implies that the business in the worst case will require more than 3 years to repay the financial debt from EBITDA. Such high ratios normally will serve as a warning sign to lenders as they might start to question the company’s abilities to repay its debt. Below is the financial ratio definition:

Formula:  Debt / EBITDA Ratio = Financial Debt / EBITDA

For 2019, the company’s interest-bearing debt amounts to $2.0 million, with an EBITDA of $1.52 million, which translates into a 1.3x Debt/EBITDA ratio. It portrays that the business uses only a modest amount of financial debt which is also lower than the industry average of 2.0x.

b.            Net Debt/EBITDA Ratio

The Net Debt/EBITDA ratio is computed by taking the interest-bearing debt less cash and divide this number by EBITDA. It is a bank ratio that measures how many years it takes for the company to pay its debt giving that the net debt and EBITDA are constant. Having more cash, however, would render the ratio negative. A high ratio indicates that the business will not be able to pay all its financial obligations.

Formula: Net Debt/EBITDA Ratio = (Debt – Cash & Cash Equivalents) / EBITDA

As mentioned above, the company’s interest-bearing debt amounts up to $2.0 million for 2019, cash & cash equivalents of $1.48 million, and EBITDA of $1.52 million. It means that the business has a net debt ratio of 0.3x. The Net Debt/EBITDA ratio normally is lower than the Debt/EBITDA ratios due to the assumption that the cash on the Balance Sheet could be used to repay some of the debt.

c.            Interest Coverage Ratio

The interest coverage ratio is a metric of how capable the company is in paying its interest obligation. This leverage ratio is closely looked at by bankers and other creditors to examine how much they can lend to the company. The interest coverage ratio calculation is derived by dividing EBIT by the interest expense.  

Formula:  Interest Coverage Ratio = EBIT / Interest Expense

Based on the income statement for 2019 above, EBIT is $1.3 million and the interest expenses amount to $48K. The computed interest coverage ratio is 27.1x, which is significantly higher than a minimum threshold such as 1.5x or 3.0x which could be required by a bank. This ratio is consistent with the view that our example company only uses a modest amount of financial debt financing.

d.            Debt Service Coverage Ratio

The debt service coverage ratio is computed by taking the free cash flow to the firm (FCFF) then divided by the debt repayment + interest. FCFF is the operating cash flows after accounting for taxes, change in working capital, and CAPEX. A high debt service ratio means there is enough available FCFF to service the loan’s interest payment and principal repayment obligations. The financial ratio formula is as follows:

Formula:   Debt Service Coverage Ratio = Free Cash Flow to Firm / (Debt Repayments + Interest)

Considering that FCFF available in 2019 is $0.77 million, and the debt service amounted to $0.55 million. The company has a Debt Service Coverage Ratio (DSCR) of 1.4x. This might come dangerously close to any reasonable threshold expected by a bank of 1.25x or 1.50x. However, the current year’s debt repayment component seems abnormally high, and also the company has still significant cash on the Balance Sheet. Another reason could be that the CAPEX (which impacts FCFF heavily) is influenced by one-time costs. Nevertheless, the company will have to investigate this and ensure a next year’s DSCR ratio increases either by repaying less or producing more Free Cash Flows to the Firm.

e.            Debt Ratio

The debt ratio measures how much of the total assets are financed through debt and indicates the financial ratios leverage effect. It is computed by taking the total liabilities, then divided by the total assets. A high debt ratio suggests that the business is mostly funded by debt and is using high financial leverage.

Formula: Debt Ratio = Total Liabilities / Total Assets

For 2019, the current liabilities are $0.45 million and non-current liabilities of $2 million, while the total assets amounted to $4.98 million. It shows that the debt ratio is only 0.5x, which depicts that the company is not highly leveraged. The debt ratios have also gradually decreased for the past three years, which portrays that total assets are financed less and less by liabilities.

f.             Debt/Equity Ratio

The debt/equity ratio aims to determine the % of debt financing used in a company’s financing sources. It is computed by taking the interest-bearing debt and divided by the total shareholders’ equity. It is a calculation of how much is the borrowed capital to the investment. Also, it entails the capacity of the company to cover its debt through the owner’s equity. The financial ratio formula is defined as follows:

Formula: Debt/Equity Ratio = Interest-bearing debt / Equity

The company borrowed a total of $2.0 million for 2019, and its total equity in the same year amounted to $2.53 million. The Debt/Equity ratio for the company of 79.1% is low, and the equity can cover the debt. It can also suggest that the business is not in the capital-intensive industry since this industry can have as high as two hundred percent debt/equity ratios. Also, the company can be maintaining low borrowing which should allow avoiding adverse effects during business turmoil.

What does our Financial Ratios Analysis tell us?

As we worked through the financial ratios list to perform a comprehensive financial ratios analysis of our company’s situation, we now can obtain the full picture of what is going on. Here the conclusion based on our analysis of the calculated financial ratios:

  • Liquidity: For liquidity ratios, the Current Ratio (6.0x), Quick Ratio (4.6x), and Cash ratio (3.3x), all the results show that the company has more than the required current assets to cover its current liabilities. Current obligations can be easily met with the available current assets. The ratios would even indicate that there are excess funds available that could be invested outside the business to gain additional income in order to avoid sitting idle in the business.
  • Efficiency: Days inventory (84 days) indicates a long period of goods that have to remain in inventory. When comparing to industry benchmarks of 50 days, the company has to work things out to lower the inventory turnover to the level of benchmark or near it. Days sales outstanding (40 days) seem to be close to the benchmark of 35 days, but there is some attention required as the ratio exceeds the benchmark.  On the opposite, days payables (63 days) increased over the last three years, these entail low turnover ratios, which can be interpreted as abusing the goodwill of the company’s suppliers and most likely will not be sustainable in the future. However, at the moment low turnover for days payables can be beneficial for the business since the resources can still be utilized for the operation and prospective investment. Overall, there is some work to do here as our company needs to assess how to improve and lessen its working capital turnover.
  • Profitability: In terms of profitability ratios, the gross profit margin is computed at 52.7%, the EBITDA margin is 27.6%, and the net profit margin is 22.2%. All these margins indicate exceptionally high profitability and strong value capture ability by the company. The company must sell something very valuable as the EBITDA margins clearly outrank the available industry average of 15.0%. Also, this is reflected in other profitability ratios such as the return on assets (27.9%), return on equity (63.7%), and return on capital employed (43.6%). Important to note here is, the main reason the last three ratios are so high, are the high-profit margins as clearly the company is not operating as efficiently as its peers in terms of managing its working capital.
  • Growth: Revenue growth even increased from 18.4% (2018) to 22.2% (2019). However, EBITDA growth slowed down (46.9% to 27.7%) and the same is true for net income growth (65.4% to 37.7%) as it is more difficult to grow a larger starting base than a lower starting base. The same is true for asset growth from 31.3% (2018) to 20.4% (2019), and equity growth of 211.3 (2018) to 93.5% have a decreasing trend for the last three years. Overall, the point is that the company is continuing to experience strong growth and most likely will continue to grow strongly in the future exceeding the growth rates in the financial ratios industry average.
  • Leverage:  Several financial leverage ratios including Debt/EBITDA ratio (1.3x), Net Debt/EBITDA ratio (0.3x), interest coverage ratio (27.1x), Debt ratio (0.5x), and the Debt/Equity ratio (79.1%) would argue that the company uses a modest degree of bank financing and cannot be considered as highly leveraged. The financial ratios leverage appears modest. There is one question mark with respect to the Debt Service Coverage Ratio (1.4x) which becomes dangerously low compared to expected bank covenants which normally lie at around 1.25x-1.50x. The reason there was a large repayment of $500,000 or eventually a large one-time investment which leads to high CAPEX in the last years. This will require further analysis with respect to the reasons why, and also one needs to determine how the ratio will result in the next year to avoid any surprises. 

Important to note is also that the financial ratios by industry are very helpful to better analyze and interpret the company’s financial situation. The financial ratios industry average helps to put the calculated financial ratios in perspective and allow conclusions whether there exist ways to do things better or if where a company actually operates at a better level than its competitors.

By utilizing all these financial ratios in the analysis, these provide a more comprehensive and reliable evaluation of the company that can help make more solid decisions to optimize the operations of a business and serve as a basis to develop a meaningful budget.

Please refer also to our rich collection of financial model templates which include comprehensive financial ratio analysis and financial ratios lists ready to be used. Feel free to check out again our financial ratios cheat sheet as it can serve as a reference to all financial ratios’ definitions.