Financial analysis techniques

Return on equity (ROE)

A profitability ratio calculated as net income divided by average shareholders' equity.

Price to earnings ratio

(P/E ratio or P/E) The ratio of share price to earnings per share. The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. In other words, the P/E ratio tells us how much an investor in common stock pays per dollar of earnings. The P/E ratio measures the "multiple" that the stock market places on a company's EPS.

Return on assets (ROA)

A profitability ratio calculated as net income divided by average total assets; indicates a company's net profit generated per dollar invested in total assets.

Total asset turnover ratio

An indicator of efficiency: how much revenue a company generates per one money unit of assets. =Revenue/Average total assets

Liquidity ratios

Financial ratios measuring the company's ability to meet its short-term obligations. Major liquidity ratios include the current ratio, quick ratio, cash ratio, and defensive interval ratio.

Profitability ratios

Ratios that measure a company's ability to generate profitable sales from its resources (assets). Major profitability ratios include return on sales ratios (including gross profit margin, operating profit margin, pretax margin, and net profit margin) and return on investment ratios (including operating ROA, ROA, return on total capital, ROE, and return on common equity).

Valuation

Ratios that measure the quantity of an asset or flow (e.g., earnings) in relation to the price associated with a specified claim (e.g., a share or ownership of the enterprise).

Defensive interval ratio

The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. A defensive interval ratio of 50 would indicate that the company can continue to pay its operating expenses for 50 days before running out of quick assets, assuming no additional cash inflows.

Receivables Turnover and DSO

The number of DSO represents the elapsed time between a sale and cash collection, reflecting how fast the company collects cash from customers to whom it offers credit. A relatively high receivables turnover ratio (and commensurately low DSO) might indicate highly efficient credit and collection. Receivables turnover=Revenue/Average receivables DSO=Number of days in period/Receivables turnover

Payables Turnover and the Number of Days of Payables

The number of days of payables reflects the average number of days the company takes to pay its suppliers, and the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors.

Common-size analysis

The restatement of financial statement items using a common denominator or reference item that allows one to identify trends and major differences; an example is an income statement in which all items are expressed as a percent of revenue.

Debt-to-assets ratio

This ratio measures the percentage of total assets financed with debt. For example, a debt-to-assets ratio of 0.40 or 40 percent indicates that 40 percent of the company's assets are financed with debt.

Cash conversion cycle

A financial metric that measures the length of time required for a company to convert cash invested in its operations to cash received as a result of its operations; equal to days of inventory on hand + days of sales outstanding - number of days of payables.

DuPont analysis

As a company takes on liabilities, its leverage increases. As long as a company is able to borrow at a rate lower than the marginal rate it can earn investing the borrowed money in its business, the company is making an effective use of leverage and ROE would increase as leverage increases. If a company's borrowing cost exceeds the marginal rate it can earn on investing in the business, ROE would decline as leverage increased because the effect of borrowing would be to depress ROA. ROE = ROA × Leverage ROA = Net profit margin × Total asset turnover

Graphs in analysis

Choosing the appropriate graph to communicate the most significant conclusions of a financial analysis is a skill. In general, pie graphs are most useful to communicate the composition of a total value (e.g., assets over a limited amount of time, say one or two periods). Line graphs are useful when the focus is on the change in amount for a limited number of items over a relatively longer time period. When the composition and amounts, as well as their change over time, are all important, a stacked column graph can be useful.

Inventory turnover and DOH (inventory on hand)

If, for example, a company's cost of goods sold for a recent year was €120,000 and its average inventory was €10,000, the inventory turnover ratio would be 12. The company theoretically turns over (i.e., sells) its entire inventory 12 times per year (i.e., once a month). (Again, we say "theoretically" because in practice the company likely carries some inventory from one month into another.) Turnover can then be converted to days of inventory on hand (DOH) by dividing inventory turnover into the number of days in the accounting period. In this example, the result is a DOH of 30.42 (365/12), meaning that, on average, the company's inventory was on hand for about 30 days, or, equivalently, the company kept on hand about 30 days' worth of inventory, on average, during the period.

Solvency ratios

Ratios that measure a company's ability to meet its long-term obligations. Major solvency ratios include debt ratios (including the debt-to-assets ratio, debt-to-capital ratio, debt-to-equity ratio, and financial leverage ratio) and coverage ratios (including interest coverage and fixed charge coverage).

Activity ratios

Ratios that measure how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory. Major activity ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, number of days of payables, working capital turnover, fixed asset turnover, and total asset turnover.