Our prior post about the price earnings ratio has generated some interest in other ratios that may also be used for investment and credit analysis. In this post, I will try to respond to this request by discussing a few simple and helpful financial ratios together with caveats or limitations in using and interpreting them.
In a nutshell, financial ratios are indicators of a firm's financial health and are ultimately used to evaluate a firm's future prospects. By themselves, these numbers mean very little--people who insist on "unbendable" rules (i.e., minimum or maximum values) for these ratios simply don't know what they are talking about (unfortunately, one can find a handful of these so-called experts in even the most prestigious universities in the country, but I won't mention names). To make sense of financial ratios, one must perform ratio analysis either by comparing a firm's ratio to the same ratio of its competitor(s) or to the industry average (cross-sectional analysis) or by analyzing how a particular ratio behaves over time (time series analysis).
Financial ratios may be loosely classified into the following categories:
Liquidity ratios - reflects the firm's ability to meet short-term financial obligations (i.e., those that are due within one year)
Asset management ratios - reflects how well the firm is able to use assets to generate sales
Debt management ratios - reflects the firm's capacity to meet its long-term financial obligations
Profitability ratios - reflects how well the firm is able to generate earnings from investments
Since eleven ratios are too long for one post and also because these two categories are very much related, we will just focus on liquidity and management ratios in this post.
Liquidity ratios
1. Current ratio = current assets / current liabilities
Technically, current assets (e.g., cash, accounts receivable, inventories, etc.) are those that are liquid--that is, those that may be converted into cash "quickly" (technically, within a year) at a level that is close to their fair values. Similarly, current liabilities (e.g., accounts payable, accrued expenses, etc.) are those which need to be paid within the year. So ideally, a firm should have enough current assets to cover its current liabilities--in other words, a current ratio of at least 1.
Caveat: While a current ratio that is greater than one may seem healthy, a current ratio that is high relative to an appropriate benchmark is often not good. A very high current ratio would mean one of two things: current assets are high relative to a certain amount of current liabilities, which is usually not good since this is an indication of an over investment in idle assets (remember, receivables are only good when they are collected and inventories when they are sold); or, that current liabilities are low given a level of current assets, which may mean that the firm is passing over possibly less expensive trade credit.
2. Quick or acid-test ratio = (cash + accounts receivable + other liquid current liabilities) / current liabilities
The quick ratio is based on the same principles (and is covered by the same limitations) as the current ratio, but is a more conservative measure since it excludes the least liquid current assets from the numerator (like inventories for many businesses).
Asset management ratios
3. Inventory turnover ratio = sales / inventories*
(*When comparing income statement items like sales to balance sheet items like assets, it's better to use the average value of the latter instead of the same-year figure, especially if year-on-year amounts vary greatly. For simplicity, though, we stick with using the same-year balance sheet amount.)
The inventory management ratio reflect's the firm's efficiency in converting raw materials to finished goods (for manufacturing firms) to sales. Generally, it is good to have a high inventory turnover ratio.
Caveat: A high inventory turnover ratio may mean that the firm is underinvesting in inventories, which may lead to higher inventory costs and lost sales.
4. Accounts receivable (A/R) turnover ratio = credit sales / accounts receivable
The accounts receivable turnover ratio is an indicator of how well the firm is able to collect receivables. A high A/R turnover ratio would often mean less cash tied to credit sales and therefore more cash-at-hand.
Caveat: One may be tempted to boost A/R turnover by not offering credit sales to customers and not accumulate receivables. But businesses offer credit terms to customers for one very important reason: to increase sales, since generally, more people would buy more if they have an option to buy on credit. So trying to increase the A/R turnover this way may actually hurt the company instead of help it.
Since the inventory turnover ratio and the accounts receivable turnover ratio also reflect the firm's ability to generate cash from the use of current assets, these ratios are sometimes also considered liquidity ratios.
5. Fixed asset turnover ratio = sales / net fixed assets
The fixed asset turnover ratio shows how efficiently the firm is able to generate sales from the use of fixed or long-term assets like real property, production facilities, and equipment, which may be considered direct capital inputs of production. A high fixed asset turnover ratio is generally considered a positive sign of the firm's financial health.
Caveat: The denominator--net fixed assets--is total fixed assets less accumulated depreciation. Therefore, a high fixed asset turnover ratio may just mean that the firm is using highly depreciated and inefficient equipment and that the firm's production is not as efficient as the ratio indicates.
6. Total asset turnover ratio = sales / total assets
The total asset turnover ratio is just the aggregate of the three asset management ratios above: it reflects the firm's efficiency in using all of its resources--its assets--to generate sales. Just like the fixed asset turnover ratio, a high total asset turnover ratio would generally mean highly efficient operations; however, this ratio also suffers from the same caveat that results from the inclusion of depreciation in the denominator.
Liquidity and asset management ratios go hand in hand in that they reflect the efficiency of the firm's operations--specifically its ability to generate sales from using its resources--and its capacity to use the resulting asset inflows to meet short-term financial obligations. In Part 2, we will take a look at other aspects of the firm's financial well-being when we discuss debt management and profitability ratios.