Wednesday, February 15, 2012

11 Financial Ratios, Part 2: Debt Management and Profitability Ratios


In Part 1, we took a look at financial ratios that we can use to assess the capacity of a firm to meet its short-term obligations and its ability to use its resources to generate revenues. In this post, we will discuss ratios that we can use to evaluate the firm's ability to meet long-term financial obligations and earn returns from investments.

Debt management ratios

7. Debt ratio = total liabilities / total assets OR total long-term debt / total assets

The debt ratio, also often referred to as financial leverage, is simply a measure of how the firm's assets are financed. If you recall from our post about the balance sheet, a business has two main sources of long-term financing: debt and shareholders' equity (i.e., capital provided by the firm's owners). A high debt ratio indicates that a big portion of the firm's assets is financed by debt--which is really neither "good" nor "bad". To a great extent, a firm's debt level depends on its industry as some business models do well on little debt while others thrive on a higher financial leverage. Also, according to financial theory, having too little and too much debt both involve significant risks and costs. But if we want to just focus on the firm's capacity to service long-term debt, then we would want to make sure that its debt ratio is not significantly higher than that of its competitors or the industry average.

8. Times interest earned = earnings before interest and taxes / interest expense

Times interest earned or TIE, sometimes also referred to as interest coverage ratio, reflects the firm's ability to meet interest payments on debt. In the income statement, earnings before interest and taxes (EBIT) is the item from which interest expense is deducted, so a TIE of at least 1 meas that the firm has interest "fully covered."

Caveat: We should however remember that interest is not the only obligation that arises from borrowing money. Often, the firm also needs to make periodic principal payments, particularly for amortized loans or bond issues with sinking fund provisions, so we should also consider these in our analysis.

Profitability ratios

9. Net profit margin = net profit / sales

Essentially, the net profit margin is a measure of how well a firm is able to control costs to maximize profitability, so typically, a firm with a consistently high net profit margin is a sign of good financial management.

Caveat: However, we must take care not to focus too much on costs at the expense of other aspects of the business. For example, some managers may be tempted to use cheaper, sub-standard materials in production or forego "costly" human resource development programs in an effort to boost profitability, but in the long run these actions may actually do more harm than good to the firm.

10. Return on total assets = net profit / total assets

Return on total assets or ROA measures the profitability of the firm's investments in assets regardless of how these assets were finance. Businesses of course work to improve their ROAs through the efficient use of resources (i.e., by improving the total asset turnover ratio) and/or by controlling costs (i.e., by improving the net profit margin). A relatively high ROA reflects efficient operations and a sound business model.

Caveat: Because "total assets" is in the denominator, the ROA suffers from the same limitations as other similar ratios in that firms with highly depreciated assets would have superficially high ROAs.

11. Return on common equity = net profit / shareholder's equity

Unlike ROA which does not take the source of the business' capital into consideration, return on common equity or ROE focuses on the profitability of the owners' investment in the business. Naturally, firms target a high ROE or a higher "bang for the buck" for common shareholders. Incidentally, ROE and "return on investment" or ROI are basically the same thing: the percentage of an investment that investors earn as profit. However, if many business persons and enthusiasts refer to ROI as the time it takes for an investment to be recovered; this quantity is actually not ROI but a commonly-used capital budgeting criteria called payback period.

Caveat: One way to mathematically or artificially get a higher ROE is by getting more debt. While "leveraging," to a certain extent, can amplify returns to the firm's owners, some costs like "financial distress" are not reflected by the numbers. Also, many cite ROE's limitations as an end-all measure of profitability, foremost of which is that it does not account for important factors like risk and time value of money.

There you have it, 11 financial ratios that you can use to evaluate the financial health of a business. Remember, these ratios only mean something when used in comparison with an appropriate benchmark. If you have time, you can download annual reports from the PSE website and try to perform your own analysis using these ratios.

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