Using ratios for analysis is a time-honored tradition in finance. These ratios can help you compare not only your own company, but your performance compared to others in your industry. Ratio analysis combines all sections of the financial statements and can give you a great overview of any company.
Calculating these ratios is fairly simple, once you know which ones to use and where to find the data. There are some industries such as banking and insurance that will have their ratios particular to their industry.
In today’s post, we will discuss:
- What is Ratio Analysis?
- What Does Ratio Analysis Tell Us?
- Ratio Analysis Formulas
- Examples of Ratio Analysis In Action
- Samples of Ratios Across Sectors
Ok, let’s dive in.
What is Ratio Analysis?
According to Investopedia:
“Ratio analysis is a quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis.”
The importance of ratio analysis is that it compares line-item detail from the financials of a company to unlock insights into profitability, liquidity, solvency, and operational efficiency.
Ratio analysis can tell us how a company is doing over time, also while revealing how one company compares to another company in the same industry.
Comparing ratios outside of industries is not advised, as that is not an apple to apple comparison. Comparing the profitability of Walmart to Apple is not a reasonable comparison as they are in different industries, and the costs of doing business are different.
While using ratios, it is important to relate them to other metrics to help give you an overall picture of the financial health of a company.
What Does Ratio Analysis Tell Us?
Analysts and investors utilize ratio analysis to scrutinize the financial health of companies by scouring past and present financial documents.
By using comparative data, we can demonstrate how a company is performing over time, plus we can use the ratios to determine the possible future performance.
Using the ratio analysis data can help compare the company’s financial performance to others in the same industry and see how they stack up performance-wise.
Investors of all levels can use ratios analysis easily. All of the data required to calculate the ratios is found on all three financial documents.
The best part of ratio analysis is they act as a comparison point for companies. For example, comparing PE ratios of companies is a common point of reference for investors. Another plus is the ability to compare the company’s performance over annual reports or quarterly reports.
We also have to understand the different variables that drive these ratios, and management’s ability to alter the strategies that can make these ratios more attractive to Wall Street.
Generally, these ratios are not used in isolation, rather concerning other metrics to tell a story. Having a good understanding of the ratios and the variables that move them is key to understanding the financial health of the company. Plus, the understanding will help you identify possible red flags and help you avoid mistakes.
Ok, let’s take a look at some ratios.
Ratio Analysis Formulas
The financial ratios typically are grouped into six different categories based on the data they provide.
Let’s walk through the metrics using a company to give us an idea of where and how to calculate the metrics. Most of these are simple ratios to calculate; the trick is to know where to look.
The company I would like to use is AT&T (T), the telecommunications giant with a market cap of $209.26B and the current price of $29.37. AT&T is also a member of the Dividend Aristocrats and has been paying a growing dividend for the last 33 years.
- Liquidity Ratios – These ratios measure a company’s ability to pay off its short-term liabilities, using the company’s current or quick assets as the debt comes due. Ratios associated with liquidity are the Current Ratio and Quick Ratio.
I am pulling the data from the above balance sheets for the liquidity ratios.
- Total Current Assets – $54,761
- Cash & Cash Equivalents – $12,130
- Accounts Receivables – $22,636
- Total Current Liabilities – $68,911
Now we can calculate our ratios for liquidity.
Current Ratio = Total Current Assets / Total Current Liabilities
Current Ratio = $54,761 / $68,911
Current Ratio = 0.79
Quick Rato = Cash & Cash Equivalents + Marketable Securities + Account Receivables / Total Current Liabilities
Quick Ratio = $12,130 + 0 + $22,636 / $68,911
Quick Ratio = 0.50
- Solvency Ratios – Also referred to as financial leverage ratios. The solvency ratios compare a company’s debt load to its assets, equity, and earnings. They are meant to evaluate the likelihood of a company to survive over the long-haul. They measure the ability to pay its interest on the debt, as well as pay off the long-term debt. There are three ratios associated with solvency, debt-to-equity, debt-to-assets, and interest coverage ratios.
Now, pulling the highlighted data from the balance sheet and the income statement, we can calculate our solvency ratios.
- Short-term debt – $11,838
- Long-term debt – $151,309
- Shareholders Equity – $210,394
- Total Assets – $551,669
- EBIT or Operating Income before Taxes, Income Expense – $27,955
- Interest Expense – $8,422
Ok, now we can calculate our ratios for solvency.
Debt-to-Equity = Short-term debt + Long-term debt / Shareholders Equity
Debt-to-Equity = $11,838 + $151,309 / $210,394
Debt-to-Equity = 0.78
Debt-to-Assets = Short-term Debt + Long-term Debt / Total Assets
Debt-to-Assets = $11,838 + $151,309 / $551,669
Debt-to-Assets = 0.30
Interest Coverage Ratio = EBIT / Interest Expense
Interest Coverage Ratio = $27,955 / $8,422
Interest Coverage Ratio = 3.31
- Profitability Ratios – These ratios tell us how well a company can generate profits from its operations. Included in these ratios are net profit margin, return on assets, return on equity, gross profit margin, and operating profit ratio.
I am pulling the highlighted data from the above income statement and balance sheets.
- Total Assets 2018 – $531,84
- Total Assets 2019 – $551,669
- Total Shareholders Equity 2018 – $193,884
- Total Shareholders Equity 2019 – $201,934
- Total Revenue – $181,193
- Costs of Goods Sold
- Total Operating Expenses – $153,238
- Depreciation and Amortization – $28,217
- Assets abandonment – $1458
- Selling, general and administrative – $39,422
- EBIT or Operating Income – $27,955
- Net Income or Earnings – $13,903
Ok, let’s start putting together our ratios for profitability.
Gross Profit Ratio = Gross Profit / Net Revenue
Before we go too far, let’s calculate our costs of goods sold. To do this, we will pull some numbers from the income statement that I highlighted above.
Costs of Goods Sold = $153,238 – $28,217 – $1,458 – $39,422
Costs of Goods Sold = $84,141
To find the Gross Profit, we need to subtract the costs of goods sold from the total revenue.
Gross Profit = $181,193 – $84,141
Gross Profit = $97,052
Gross Profit Ratio = $97,052 / $181,193
Gross Profit Ratio = 53.56%
Net Profit Ratio = Net Profit / Net Revenue
Net Profit Ratio = $13,903 / $181,193
Net Profit Ratio = 7.67%
Operating Profit Ratio = Operating Revenue / Net Revenue
Operating Profit Ratio = $27,955 / $181,193
Operating Profit Ratio = 15.42%
Return on Equity = Net Profit / ( ( Total Shareholders Equity 2018 + Total Shareholders Equity 2019 ) / 2 )
Return on Equity = $13,903 / (( $193,884 + $201,934 )/ 2)
Return on Equity = $13,903 / $197,909
Return on Equity = 7.02%
Return on Assets = Net Profit / (( Total Assets 2018 + Total Assets 2019 ) / 2 )
Return on Assets = $13903 / (($531,864 + $551,669)/2)
Return on Assets = $13,903 / $541,766.50
Return on Assets = 2.57%
- Efficiency Ratios – Also referred to as activity ratios, efficiency ratios measure how efficiently a company uses its assets and liabilities to create sales and maximize its Profit. Some key efficiency ratios to consider are asset turnover, receivables turnover, and days sales outstanding. There are others to consider, such as inventory turnover, which does not apply to AT&T.
We are pulling our data as before from the highlighted sections of the income statement and balance sheet.
- Revenue – $181,193
- Total Assets 2018 – $531,864
- Total Assets 2019 – $551,669
- Receivables 2019 – $22,636
- Receivables 2018 – $26,472
Now we can calculate our efficiency ratios for AT&T.
Asset Turnover = Net Revenue / (( Total Assets 2018 + Total Assets 2019 ) / 2)
Asset Turnover = $181,193 / (($531,864+$551,669) /2)
Asset Turnover = $181,193 / $541,766.50
Asset Turnover = 0.33
Receivables Turnover = Net Revnue / (( Accounts Receivables 2018 + Accounts Receivables 2019 )/2)
Receivables Turnover = $181,193 / (($26,472+$22,636)/2)
Receivables Turnover = $181,193 / $24,689
Receivables Turnover = 7.33
Days Sales Outstanding = Accounts Receivable / Revenue * Days in Period
Days Sales Outstanding = $22,636 / $181,193 * 365
Days Sales Outstanding = 45.59
- Earnings Ratios – Finally, some ratios that everyone is familiar with. These ratios are some of the most used in finance, and you are likely familiar with many of them. Investors use these to predict future earnings and future performance. The ratios include PE ratio, dividend yield, earnings per share (EPS), and dividend payout ratio.
Ok, using the above income statement, cash flow statement, and the first page of the 10-k, we gathered the data needed for our ratios.
- Market price per share – $29.61
- Earnings per Share – $1.90
- Net Income – $13,900
- Shares Outstanding – 7172
- Dividends Paid – $14,888
Now, we can put together our earnings ratios.
P/E Ratio = Market price per share / Earnings per share
P/E ratio = 29.61 / 1.90
P/E Ratio = 15.58
Earnings Per Share = Net Income / Shares Outstanding
Earnings Per Share = $13,900 / 7172
Earnings Per Share = 1.93
Dividends Per Share = Dividends Paid / Shares Outstanding
Dividends Per Share = $14,888 / 7172
Dividends Per Share = $2.08
Dividend Yield = Dividends Per Share / Market Price per Share
Dividend Yield = $2.08 / $29.61
Dividend Yield = 7.02%
Dividend Payout Ratio = Dividends Per Share / Earnings Per Share
Dividend Payout Ratio = $2.08 / $1.93
Dividend Payout Ratio = 1.07
Ok, that wraps up our foray into the list of ratios and how to calculate them. Now let’s put them to use to help us analyze a company.
All the above examples for AT&T are fairly simple to calculate, and by themselves, they don’t really tell us much. The ratios shine when comparing them to other companies.
Moving on to the next section, we will put them to use.
Examples of Ratio Analysis in Action
As we have seen from the above examples, calculating the different ratios are not complicated. The biggest challenge is knowing which ratios to use and where to find the data. Once that is done, they are a cinch.
There are several ways to use the data from ratios; one is to compare it to others in the same industry. The other is to use it as a reference against itself. For example, looking at the net profit ratio of a company over a longer period can give you an idea of the long-term profitability of a company, which can give you an example of how the company will do long-term.
I would like to use the data we just compiled and compare that to Verizon (VZ), which is AT&T’s biggest competitor in the cell phone world, at least in the US.
We will compare the annual ratios for the last calendar year; I will not force you to endure all those calculations again. Rather I will pull the data from our AT&T examples and calculate the ratios for Verizon myself to make this a touch easier to view.
Current Ratio 0.79 0.84
Quick Ratio 0.50 0.80
Debt-to-Equity 0.78 2.17
Debt-to-Assets 0.30 0.46
Interest Coverage 3.31 9.86
Gross Profit 53.56 58.50
Net Profit 7.67 14.61
Operating Profit 15.42 23.11
Return on Equity 7.02 33.64
Return on Assets 2.57 6.92
Asset Turnover 0.33 0.47
Receivables Turnover 7.33
Days Sales Outstanding 45.59 70.39
P/E Ratio 15.58 12.61
Earnings Per Share 1.93 4.65
Dividends Per Share 2.08 2.44
Dividend Yield 7.02 4.36
Dividend Payout 1.07 0.52
Ok, so what jumps out at you at first blush? The first couple of things I noticed is that Verizon has quite a bit higher debt to equity ratio, which might indicate that they are carrying more debt than AT&T.
Also, it looks like Verizon is more profitable than AT&T, their profit margins are much greater than AT&T. Another difference is the lower PE ratio for Verizon, which might indicate that Wall Street is valuing the earnings of AT&T more and pricing up the company.
The last little tidbit I can clean from the comparison is the dividends. Verizon has a much higher dividend per share, and the payout ratio is much lower, which would indicate there is more room to grow. AT&T’s dividend payout ratio is troubling because anything above one is unsustainable through operations and would need to be continued via more debt, which is never a good thing.
See, now wasn’t that interesting? The above example is a game you should play whenever analyzing a company, you don’t necessarily have to use all the above ratios, but it is helpful to compare all areas of the financial statements.
The other opportunity to use ratios is to compare them across the years to give you an idea of any trends that might be occurring with the company. Seeing them in isolation for only one year can cause a recency bias without putting the numbers in context.
Let’ look at AT&T over the years using some of the above ratios.
Putting together a chart like above is a good exercise to see trends in any of the ratios we are studying. Also, calculating a median over a long period is useful to give you an anchor to compare the current year’s performance.
I used quickfs.net to pull together all the above data; it is easier than digging back through all the old 10-ks.
Using the above chart and comparing the last year’s performance (2019) to the median numbers over the last ten years, it appears that AT&T underperformed its historical numbers.
Using charts like this is a great way to get a sense of how the company is trending. If you are currently holding the company, then paying closer attention in the coming years would be worthwhile. And if you are considering investing in AT&T, then watching the upcoming quarters/annual reports will be necessary to get an idea of its continuing performance.
Ratios Across Sectors
Not only do we want to compare our ratios to other companies, ourselves over a longer horizon, but also to the industry that we operate in.
To compare AT&T, we would want to look at how the industry has performed across some key metrics.
2018 Telecommunications Ratios – Whole Industry
- Debt to equity – 1.01
- Interest Coverage Ratio – 0.61
- Current Ratio – 0.84
- Quick Ratio – 0.67
- Profit Margin – 0.3
- Return on Equity – -0.8
- Return on Assets – -1.4
- Gross Margin – 38.9
- Operating Margin – 6.6
- Asset Turnover – 721 days
- Dividend Payout Ratio – 0.47
Looking at data like the above is useful because we can see how our company compares to the industry it operates in, and whether they are creating value for us.
The best place I found to compare ratios across industries is readyratios.com.
When calculating your ratios, I would highly recommend looking at the industry ratios to give you an idea of how your company stacks up. Both AT&T and Verizon are outperforming the telecommunications industry, which is helpful information.
Utilizing ratio analysis is a quick, easy way to determine the profitability, solvency, earnings power, and efficiency of any company you are investigating.
The calculations of all the ratios are simple; the biggest issue is locating the data you need to calculate the numbers.
Using the ratios across industries, comparing it to longer time horizons, and others in the same industry are the way to go. Sometimes when reading through the financial statements, your eyes can swim a little bit because the numbers sometimes don’t have context. Ratio analysis can help put the numbers in context and bring them much more to life, and help you determine a profitable company.
That is going to wrap up today’s discussion of ratio analysis.
As always, thank you for taking the time to read the post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care and be safe out there,