Explained 4 Types of Financial Ratios for Financial Analysts

9. Case Examples

Example 1: Retail Company

A large retail company had good liquidity ratios which enabled it to negotiate favourable credit terms with suppliers. These terms allowed the company to sustain competitive pricing, to support its higher market share.

Example 2: Manufacturer

A manufacturing company had moderately high net income however, they struggled to pay key suppliers on time due to low liquidity. This resulted in a downgrade on their credit rating. This shows how important liquidity is to sustainability.

10. Suggestions for Analysing Liquidity Ratios

• Do always compare ratios to an industry average.
• Do compare trends over several years vs. one year.
• Do review liquidity ratios along with profitability ratios, and solvency ratios to enable a thorough investigation.
• Do consider seasonal cycles as found within industries such as retail or agriculture.
• Do understand cash management policies before interpreting liquidity ratios and their context.

2. Solvency Ratios: Measuring Long-Term Financial Stability

Every company has to contend not only with its short-term accountability, but with its long-term potential claims. While liquidity potentially deals with obligations of the future, solvency deals with present limitations to a company's long-term future.

Having solvency spells out whether a company can satisfy its debt obligations in total and also operate without a real risk of financial distress. A set called solvency ratios has been developed by analysts and rating agencies to assess this question.

Solvency ratios look at how much debt a company has, along with how much equity and assets. These ratios look at the relationship between the company's capital structure and long-term financial position. Solvency ratios provide a continuing basis for investors, creditors, and managers to assess a company's ability to pay its long-term liabilities.

In this blog, we will look at the types of solvency ratios, why they are significant, what they mean, advantages and limitations, which industries its irrelevant in, and best practices for analysis.

1. What are Solvency Ratios?

Solvency ratios are metrics used to assess a company's ability for fulfil long-term debts and financial obligations. Solvency ratios measure the long-term endurance of a business, whereas liquidity ratios give attention to the short term.

Specifically, solvency ratios help to answer the essential question:
"Does this company have the financial capacity to fulfill its obligations and stay in business over an extended period of time?"

Solvency ratios help determine debt burden, equity position, and level of financial flexibility of the firm.

2. The Role of Solvency Ratios

Many different parties care about solvency ratios:

Investors will use solvency ratios to evaluate if the company will be a secure long term investment.

Creditors and Banks review solvency ratios before sanctioning any large loans or extending credit.

Management will review solvency ratios to ensure that its debt doesn't exceed a reasonable level.

Regulators may determine solvency ratios as part of the analysis of systemic risks, in businesses like banks and insurers.

3. Types of Solvency Ratios

Solvency ratios can be arranged into different types of solvency ratios, with each type providing a different perspective on financial stability:

• 3.1 Debt-to-Equity Ratio – This ratio compares the company's total debt to shareholder equity and indicates how much of an organization's financing comes from creditors versus owners.
• 3.2 Debt-to-Asset Ratio – This ratio evaluates the total amount of assets that are financed by debt and indicates the company's degree of financial leverage.
• 3.3 Interest Coverage Ratio – The interest coverage ratio determines how easily a business can pay interest on outstanding debt with its earnings. This ratio is especially important when thinking about how risky a business is from a financing standpoint.
• 3.4 Equity Ratio – The equity ratio describes the proportion of total assets financed by shareholders' equity, or owners' equity. This ratio indicates the degree an organization relies on internal versus external financing.
• 3.5 Proprietary Ratio – The proprietary ratio describes the amount of total assets financed by owners. This ratio emphasizes internal financing, and those using it may want to assess how strong the internal financing is in its capital structure.

4. Significance of Solvency Ratios to Business Decision-Making

Solvency ratios provide a useful part of the picture:

• Indicators of Financial Risk – They show how susceptible a company is to financial risk resulting from borrowing money.
• Indicators of Capital Structure – Solvency ratios show the extent to which a company finances operations using debt versus equity.
• Informed Investment Decisions – Solvency ratios assist investors to identify whether it is better to hold onto, buy, or sell their investment.
• Indicators of Creditworthiness – Needed when lenders are determining a borrower's ability to repay.

5. Industry-Specific Perspectives

Interpretations of solvency ratios can vary across industries:

• Capital-Intensive Industries (Infrastructure, Telecom): More common to have higher debt levels due to the capital demands of the industry. Solvency ratios may be lower everything considered, but risk levels and investor psychology would expect it, i.e higher debt levels would be normal for the industry.
• Technology companies are likely to have a higher reliance on equity and retained earnings, meaning more cash and definitely better solvency ratios.
• Publicly-owned banks and financial services firms are regulated closely regarding solvency as systemic risk is a concern for regulator, not the owner.
• Retail and FMCG firms generally have moderate debt levels to avoid risk during periods of expansion.

So, solvency ratios should always be considered against industry standards.

6. Benefits of Solvency Ratios

• Long-term Perspective. Solvency ratios augment liquidity measurements to offer a forward-thinking view rather than a short-run view (like income statement).
• A Lending Tool. Basically it lets creditors measure risk before extending a significant amount of credit.
• Assurance for Investors. A solvency ratio gives investors assurance that the company should be able to stay in operation, for at least the next year.
• Capital Structure Examination. Solvency ratios tell you whether a company has a good mix of debt and equity.
• Good Strategic Planning Tool. Suitable for management decisions relating to financing and investment.

7. Disadvantages of Solvency Ratio

Overall solvency ratios are helpful; they can also limit decision making:

• Represent a "Static" picture. It captures risks based on the financial statements provided but does not account for future risks as well.
• Accounting Considerations. Records may vary, especially with regards to accountant's decisions not to readily market value or misstated present value of vehicles - even when an asset is properly valued.
• Acceptances can differ from one industry to another. Acceptable levels of solvency vary widely from industry to industry.
• So what if a company is solvent even when liquidity is an issue! A company could be solvent next quarter and run into liquidity issues over the next 12 months after that.
• Not account for "non-financial" factors. Market conditions, technological changes, shifts in regulation, etc. could all have a drastic impact on ongoing evolution down the line.

8. Practical Applications of Solvency Ratios

Solvency ratios can be viewed in the context of many real-world decision-making environments as follows:

• Credit Rating Agencies: Solvency ratios are an important aspect of how credit rating agencies assign credit ratings to corporations. For example, a corporate borrower will demand lower borrowing costs based on a better rating assignment.
• Mergers and Acquisitions: Solvency is a relevant consideration for a corporation in deciding whether companies will be attractive as acquisition targets.
• Corporate Governance: Long-term solvency reflects effective management and responsible fiduciary management of financial resources.
• Investor Relations: Communicating solvency increases transparency and can help develop trust capital with investors.

9. Case Studies

• Case 1: Infrastructure Company
  A significant emerging infrastructure company (a public company) was able to grow larger than all its competitors in revenues, but had very poor solvency ratios. At the same time, it was able to maintain credibility, by it was then faced with excessive borrowing cost, or interest rates affected by the designation of multiple credit downgrades by ratings agencies.
• Case 2: Technology Start-Up
  A quickly growing technology start-up relied on equity financing primarily. The growth of its solvency ratios, particularly when the company was able to attract institutional investor interest also improved the market value and added growth value of the company.

10. Best Practices for Using Solvency Ratios

• Be sure to always compare solvency ratios against industry benchmarks.
• Look for trends over a multi-year period rather than just looking at a point in time.
• When analyzing solvency ratios, you will want to include liquidity ratios and profitability ratios for a complete picture.
• Consider management's policies regarding debt to get insight into management's strategic intentions.
• Be sure to consider the external economic environment and any considerations which may impact long-term solvency.

3. Profitability Ratios: Measuring Business Performance and Value Creation

Introduction

The ultimate goal of any company is to make a profit and provide value to its stakeholders. A company may be fully solvent and liquid, but the question is whether or not it can make money sustainable over time. Many investors will prefer to have shares in the company with profits, versus a company without profits. Multi-national corporations are dependent on profit by shareholders being rewarded for allocating capital to the business. Profits drive shareholder wealth, attract investors, and allow for reinvestment and growth within the company, as opposed to representing all profits as dividends.

To assess profits, analysts use models or set of tools called profitability ratios. Profitability ratios assess a company’s ability to generate earnings, relative to sales, assets, equity, and other financial metrics. Profitability ratios give insights into:

1. Efficiency of operations, management of costs and
2. Cost of capital
3. Overall effectiveness of the organization's business strategies.

This blog post will provide step by step details about: profitability ratios, their meaning, significance, types, pros, cons and best practice of profitability ratios - helping you understand profitability ratios and their importance for business analysis and decision making.

1. Profitability Ratios Defined

Profitability ratios are financial measures that assess how well a company earns profit from juggling its resources. That is, they are financial measures that assess management´s ability to perform and efficiently manage resources. This is different from liquidity and solvency ratios which have focused more on financial strength.

Profitability ratios help answer important questions like:

• How much profit is the company making from its sales?
• Is it using assets and equity efficiently?
• What does the company create as long-term value, and does it have a sustainable business model to create it?

Profitability ratios are valuable for investors, managers, creditors, and analyst, as they denote the true earning power of a business.

2. Relevance Of Profitability Ratios

Profitability ratios are highly relevant for a variety of interest groups:

• Investors: Profitability ratios tell the investor whether the company is able to make a return on their investment.
• Creditors: Profitability ratios reveal the ability to pay back debt since profits drive cash flow.
• Management: Profitability ratios reveal the strengths and weaknesses of operations to help with future performance.
• Regulators: Profitability ratios provide an overview of the trends in profitability to help assess the health of an industry and the contribution of that industry to the economy.

In summary, profitability ratios show the pulse of a business in terms of its performance relative to the resources put towards that performance.

3. Types of Profitability Ratios

Profitability ratios are generally classified into two areas: Margin ratios and Return ratios.

3.1 Margin Ratios

Margin ratios indicate the amount of profit a company is extracting from sales.

• Gross Profit Margin: This is the profit that is left after the costs of its direct production costs have been paid.
• Operating Profit Margin: This is the profit that is left afte direct production costs and its operating expenses have been accounted for.
• Net Profit Margin: This is the profitability of the bottom line after all expenses, taxes and interest have been paid or accounted for.

3.2 Return Ratios

Return ratios help indicate how successfully the company is using its resources to generate profit. ROA (return on assets) measures profitability according to total assets; ROE (return on equity) measures how much profit the firm is creating for its shareholders; ROCE (return on capital employed) measures profitability according to the capital employed in the business. Return ratios provide insight on internal efficiency (ex: controllables like cost and productivity) and external operating performance (ex: earnings available to shareholders).

4. Use of Profitability Ratios

Profitability ratios are used for a variety of purposes in business financial analysis, for example:

• Performance: Profitability ratios convey whether the business is using successful strategies to generate earnings.
• Cost control: Profitability ratios help management to better control or manage costs by looking for areas of inefficiency or cost that is too high.
• Investment / Stock purchases: Investors heavily look at profitability metrics when evaluating stocks for purchase or investment.
• Credit analysis: Positive profitability ratios provide creditor's a measure of comfort regarding the firm’s ability to repay loans.
• Arguments when analysing trends: Comparing profitability ratios over years is a great way to identify if growth can be sustained.

5. Industry-Based Perspectives

Profits differ across industries:

• Retail: Low margin but high turnover
• Technology: High margin based on intellectual property and scale model
• Manufacturing: Moderate margin, depending on raw materials, scale
• Banking/Finance: Profitability is determined by interest spreads, asset quality and cost efficiency
• Healthcare/Pharma: High profitability based on innovation, patents and premium pricing

Therefore, profitability ratios should always be interpreted within the context of industry norms.

6. Benefits of Profitability Ratios

• A Full Picture of Performance: Gives you a good idea of the company's overall efficiency.
• Decision-Making Aid: Helps the manager analyse the company's strategies and operations.
• Investor Confidence: good profitability signals both institutional and retail investors.
• Rewards: Benchmarking against peers-and/or industry leaders.
• Long-term value creation: Build the companies power to maintain the growth and to create shareholder wealth.

7. Profitability Ratios Limitations

Although profitability ratios provide significant value, they do have some limitations:

• Variations in accounting practice: Different depreciation techniques and revenue recognition practices can distort results.
• Inflation effects: Higher costs can make profit ratios less favorable, but ratios may not reflect the true purchasing power of future cash inflows.
• Differences across industries: Ratios may create misleading impressions when comparing companies across industries.
• Ignores cash flows: Profitability might be positive, but, cash flows could be weak.
• Focus on short-term results: Growth may be limited, as ratios may not speak to all positive long-term growth prospects.

8. Profitability Ratios in the Real World

Profitability ratios are broadly useful in the real world:

• Stock Valuation: as an analyst’s basis to justify stock valuations and price targets.
• Loan approval: banks will assess profitability ratios before approving loans to businesses.
• Mergers and Acquisitions: Companies that have positive profitability ratios with real-world insights.ll be attractive merger targets, or attractive acquisitions.
• Corporate governance: Managers’ efficiency, and ethical practices are demonstrated through their ability to consistently generate positive profitability ratios.
• Strategic planning: Investments in expansion plans, diversification plans, and entering markets are often evaluated using profitability ratios.

9. Case Studies

• Case 1: Technology Sector
  A worldwide technology firm has consistently reported strong profitability ratios, as it benefits from high levels of intellectual property and scalable business models. This has created an exponential growth of market capitalization.
• Case 2: Traditional Manufacturing Firm
  A manufacturing firm that faced stagnant profitability despite high sales. A further analysis found that the firm had high operating costs, leading management to reorganize and invest in automation to enhance margins.

10. Best Practice for Profitability Ratio Analysis

• Always compare with industry-average ratios, ratios on their own can often be misleading.
• Compare profitability ratios over multiple years in order to assess the sustainability of the profitability ratio.
• Overall profitability ratios should be assessed in conjunction with liquidity ratios and solvency ratios, as together they create a complete picture of a firm's performance and strength.
• Look beyond the profitability ratios and consider the industries qualitative figures (e.g, innovation, market share, management strategy and stability).
• Adjust out any extraordinary items (i.e., gains or losses that are considered one-time events) that may have distorted a firm's profitability.

5. Market Valuation Ratios: Measuring Investment Worth and Shareholder Value

Introduction

Within the financial world, there is really only one question that matters - “What’s the company worth?” While liquidity, solvency, profits, and efficiency ratios provide a deeper level of information on a company’s operational strength and financial performance, what investors and financiers really want to know is how the company is valued in the marketplace.

This is the purpose of market valuation ratios, as they provide a measure of a company’s financial performance in relation to its share price, allowing investors and analysts to determine whether the company remains undervalued, is reasonably valued or, overvalued.

For businesses, market valuation ratios reflect the company’s financial strength, investor confidence in the market, and potential for future growth. This blog post will discuss in detail what market valuation ratios mean, their importance, types, strengths and limitations, along with market valuation ratios and a brief business application.

1. What Are Market Valuation Ratios?

Market valuation ratios are indicators that help assess firm value in consideration of specific financial performance indicators such as earnings, book value, or sales with the company’s stock price. They provide an answer to these important questions:

• Is the company price in respect of its earnings valued fairly?
• How much are investors paying for the company’s resources?
• What does the market think of the company’s future growth?

In a sense, they provide a connection between a company’s internal performance and its external market perception.

2. Importance of Market Valuation Ratios

Market valuation ratios are important to different parties:

• Investors: to measure whether they should buy, hold, or sell their stock.
• Analysts: as a measure of comparison against other companies in the same sector.
• Management: to see if investors actually have confidence in the management strategies in both their performance and their strategies.
• Regulators: as an assessment of whether the markets tend towards being overvalued or undervalued.

Market valuation ratios are valuable because they combine financial indicators with investor perception to create a very powerful and dynamic tool for assessing a company and its future potential.

3. Different market valuation ratios

Market valuation ratios come in a variety of types with a different focus:

3.1 Price-to-Earnings ratio (P/E ratio)

This measure shows how much an investor is willing to pay for a unit of earnings. It shows growth expectations, and investor enthusiasm with respect to what investors as a group collectively think going forward.

3.2 Price-to-book ratio (P/B ratio)

This ratio compares the market value of equity with its book value. It shows whether you are valued above or below your net worth based on your assets.

3.3 Price-to-sales ratio (P/S ratio)

This ratio shows how much an investor is willing to pay for a unit of revenue. It is used more so to evaluate companies that have inconsistent or negative earnings.

3.4 Dividend yield ratio

This ratio shows what return the investor is receiving based on dividends relative to the price they bought the stock for. It shows income generation of the investment.

3.5 Earnings yield

This is the inverse of the P/E ratio. It shows the percentage return on the investment based solely on the currently earned earnings.

3.6 Market-to-book ratio

This ratio assesses how much the market is valuing the equities based on its book value and is often useful in valuing equities in a corporate situation.

4. The Significance of Market Valuation Ratios in Investment Analysis

Market valuation ratios have a vital role in investment analysis:

• Valuation Benchmark: To determine whether stocks are undervalued or overvalued.
• Growth Expectations: To reflect the expectations that investors have on future earnings.
• Comparative Analysis: Useful comparison index to compare business with other companies not only in similar businesses, but across industries.
• Portfolio Decisions: to help investors deploy capital across sectors as well as stocks.
• Market Sentiment: These ratios capture how the market perceives the operating performance of the business.

5. Industry Perspectives

Market valuation ratios have different meanings depending on the type of industry based on several factors:

• Technology Companies: are typically traded at high P/E ratios based on potential for growth;
• Banking and Financial Services: P/B ratios are more important as the business model of these firms primarily is based on assets and equities.
• Retail or Fast Moving Consumer Goods: Valuations are based on relatively stable revenues and dividends.
• New Start Ups or Emerging Companies: Often, these businesses are valued on their P/S ratio as the earnings may be negative as they first start building sales.
• Utilities: Dividend yield ratios are more important because utilities provide steady revenue but low growth.

6. Benefits of Market Valuation Ratios

• Decision-Making Support: Assist investors in making decisions about whether to buy or sell a stock.
• Sentiment Indicator: Measure the level of confidence that investors have in the company's prospects.
• Benchmarking: Compare with other companies, sectors, and markets.
• Examining Growth: Explore investor expectations about both future earnings and future performance.
• Management Assessment: Implied belief of investor confidence in management based on strong valuation ratios.

7. Disadvantages of Market Valuation Ratios

Although these ratios can be very useful, they have several drawbacks:

• Market Volatility: Investors can react to market sentiment in between periodic valuations, causing share prices to move throughout the year and affecting the ratios.
• Industry Variability: Sector-to-sector differences can be confounding; historically, a high ratio in one sector could indicate a totally overvalued company in another sector.
• Concept of "Time": Ratios can frequently indicate investor sentiment on a short-term focus and may not incorporate underlying fundamentals.
• Accounts Variability: Variations in the way companies derive earnings or book values will affect the ratios.
• Qualitative Factors: Ratios can ignore things like brand value, innovation, and leadership.

8. Practical Applications of Market Valuation Ratios

Market Valuation Ratios have a number of practical applications in the real world:

• Equity Research: Generally, analysts use market valuation ratios for developing price targets on stocks
• Initial Public Offerings (IPOs): Newly public firms are typically valued based on valuation ratios.
• Mergers and Acquisitions: The ratios support their calculation of fair value for acquisition targets
• Portfolio Management: Fund managers utilize market valuation ratios for stock selection
• Investor Relations: Firms find these ratios useful as they measure investor trust and confidence.

9. Case Studies

Case 1: Tech Company Valuation

A tech company sold its stock trading at three times industry averages on P/E ratios. Investors were confident based on positive forecasts of revenues and earnings growth. This megastock offers a case-in-point of an investable asset with average earnings but high valuation based on future earnings, which may or may not happen.

Case 2: Banking Sector Analyze

A bank was shown to be trading at a market valuation ratio of below 1 on P/B ratios, suggesting the market was dubious about the quality of its asset values. This warranted further analysis into the loan book and risks involved with those loans as part of the analysis in substantiating the market valuation under the circumstances.

10. Guidelines for Using Market Valuation Ratios

• Consider the market valuation ratios in conjunction with market averages to avoid misinterpretation
• Study past trends over time to assess why ratio changes to market conditions exist
• Using in conjunction with profitability, liquidity, and solvency ratios provides insights into capital depreciation risks
• Adjust for market cycles, because whether the market is bullish or bearish can impact market valuation ratios distorting company adaptability to match valuations
• Incorporate qualitative aspects of firms, such as brand value, innovations, and leadership of market.

Financial Modeling Certification

The Financial Modeling Certification program is designed to provide you with in-demand industry knowledge, hands-on practice, and confidence to stand out and become a world-class financial analyst.

Enroll Now