Literature Review on Financial Ratio Analysis: The 50 Metrics that Matter

Introduction

Financial ratio analysis is a cornerstone of financial analysis, providing valuable insights into a company's financial health, performance, and risk profile. Financial ratios are calculated using data from a company's financial statements, including the balance sheet, income statement, and cash flow statement. By comparing these ratios to industry benchmarks or historical averages, analysts can assess a company's strengths, weaknesses, and potential investment opportunities.

Top 50 Financial Ratios

Numerous financial ratios exist, each serving a specific purpose. Here are the 50 most commonly used financial ratios:

1. Current Ratio: Measures a company's short-term liquidity.
2. Quick Ratio: A more conservative measure of short-term liquidity, excluding inventory.
3. Cash Ratio: The most stringent measure of short-term liquidity, including only cash and cash equivalents.
4. Debt-to-Equity Ratio: Compares a company's debt to its equity, indicating financial leverage.
5. Debt-to-Asset Ratio: Measures a company's overall leverage.
6. Times Interest Earned Ratio: Assesses a company's ability to meet interest payments.
7. Gross Profit Margin: Indicates a company's profit margin on sales before operating expenses.
8. Net Profit Margin: Measures a company's profit margin on sales after all expenses.
9. Operating Profit Margin: Evaluates a company's profitability from core operations.
10. Inventory Turnover: Assesses a company's inventory management efficiency.
11. Days Sales Outstanding: Measures the average time it takes a company to collect receivables.
12. Accounts Payable Turnover: Indicates how quickly a company pays its suppliers.
13. Asset Turnover: Measures a company's efficiency in using its assets to generate sales.
14. Return on Assets: Assesses a company's overall profitability in relation to its assets.
15. Return on Equity: Measures a company's return on its shareholders' investment.
16. Earnings Per Share: Indicates a company's earnings per outstanding share of common stock.
17. Price-to-Earnings Ratio: Compares a company's stock price to its earnings per share.
18. Price-to-Book Ratio: Compares a company's stock price to its book value.
19. Dividend Payout Ratio: Measures the proportion of a company's earnings that is paid out as dividends.
20. Dividend Yield: Indicates the return on investment a shareholder receives from dividends.
21. Capital Expenditure Ratio: Assesses a company's investment in capital assets.
22. Research and Development Expense Ratio: Measures a company's investment in research and development.
23. Sales Growth Rate: Indicates the percentage increase in a company's sales over a period.
24. Earnings Growth Rate: Measures the percentage increase in a company's earnings per share.
25. Return on Invested Capital: Assesses a company's return on its total capital invested.
26. Working Capital: Measures a company's net working capital, which represents its current assets minus current liabilities.
27. Net Working Capital Turnover: Indicates how efficiently a company uses its working capital.
28. Inventory Days: Measures the number of days it takes a company to sell its inventory.
29. Accounts Receivable Days: Assesses the average number of days it takes a company to collect receivables.
30. Accounts Payable Days: Measures the average number of days it takes a company to pay its suppliers.
31. Cash Conversion Cycle: Indicates the number of days it takes a company to convert its inventory into cash.
32. Price-to-Sales Ratio: Compares a company's stock price to its annual sales revenue.
33. Enterprise Value-to-Sales Ratio: Assesses a company's overall value in relation to its sales.
34. Market Capitalization: Measures a company's total market value, which is the number of outstanding shares multiplied by the stock price.
35. Beta: Measures a company's volatility relative to the overall market.
36. Sharpe Ratio: Assesses a company's risk-adjusted return.
37. Sortino Ratio: Similar to the Sharpe Ratio, but it excludes downside volatility.
38. Altman Z-Score: Predicts the likelihood of a company filing for bankruptcy.
39. Piotroski F-Score: Evaluates a company's financial strength.
40. Beneish M-Score: Assesses the likelihood of a company engaging in financial fraud.
41. Tobin's Q: Measures a company's market value relative to its asset value.
42. ROIC Spread: Compares a company's return on invested capital to its weighted average cost of capital.
43. DuPont Analysis Return on Equity Decomposition: Breaks down a company's return on equity into its components.
44. Magic Formula: A quantitative stock-picking strategy based on return on invested capital and debt-to-equity ratio.
45. Z-Score: A bankruptcy prediction model that combines financial ratios with other variables.
46. CAMELS Rating: A composite financial ratio used by bank regulators to assess the financial health of banks.
47. CARA Ratio: A financial ratio developed by the Certified Financial Analyst Institute to evaluate the financial strength of life insurance companies.
48. Solvency Ratio: A measure of a company's ability to meet its long-term financial obligations.
49. Coverage Ratio: Assesses a company's ability to generate enough cash to cover specific expenses or obligations.
50. Liquidity Ratio: Measures a company's ability to meet immediate and short-term financial obligations.

Benefits of Financial Ratio Analysis

Financial ratio analysis offers numerous benefits for investors, analysts, and other stakeholders:

• Provides a snapshot of a company's financial health: Financial ratios condense complex financial data into easy-to-interpret metrics, giving a quick overview of a company's financial performance and risk profile.
• Identifies potential investment opportunities: By comparing financial ratios to industry benchmarks or historical averages, analysts can identify companies that are undervalued or overvalued, providing potential investment opportunities.
• Assesses a company's financial risks: Financial ratios can highlight areas of concern, such as high levels of debt, low profitability, or poor liquidity, helping investors and analysts assess a company's financial risks.
• Supports strategic decision-making: Financial ratio analysis can help managers make informed decisions about capital budgeting, dividend policy, and other strategic initiatives.
• Facilitates performance monitoring: By tracking financial ratios over time, analysts can monitor a company's progress towards strategic goals and identify trends that may require attention.

Tips and Tricks for Effective Financial Ratio Analysis

• Use multiple ratios: Relying on a single financial ratio can provide a limited view of a company's financial health. Consider using multiple ratios to get a more comprehensive picture.
• Compare to industry benchmarks: Financial ratios should be compared to industry benchmarks or historical averages to provide context and identify areas of strength or weakness.
• Consider company-specific factors: Financial ratios should be interpreted in the context of the company's industry, business model, and stage of development.
• Look for trends: Tracking financial ratios over time can provide valuable insights into a company's performance and risk profile.
• Use ratio analysis tools: Numerous software tools and online resources are available to assist with financial ratio analysis.

Common Mistakes to Avoid in Financial Ratio Analysis

• Relying on outdated data: Financial ratios should be based on the most recent financial statements available.
• Using ratios that are not relevant to the industry or company: Some financial ratios may not be applicable to all industries or companies.
• Misinterpreting ratios: Financial ratios should be interpreted correctly, taking into account company-specific factors and the limitations of ratio analysis.
• Failing to consider qualitative factors: Financial ratios alone do not provide a complete picture of a company's financial health. Qualitative factors, such as management team, business strategy, and market conditions, should also be considered
• Overemphasizing financial ratios: Financial ratio analysis should be used as a tool to support decision-making, but it should not be the sole basis for investment or other financial decisions.

Conclusion

Financial ratio analysis remains a powerful tool for assessing a company's financial health, performance, and risk profile. By leveraging the insights provided by financial ratios, investors, analysts, and other stakeholders can make informed decisions, identify investment opportunities, and manage financial risks. However, it is important to approach financial ratio analysis with a critical eye, considering multiple ratios, comparing to industry benchmarks, and taking into account company-specific factors. By following these best practices, financial ratio analysis can be a valuable tool for navigating the complexities of financial markets.

Tables

TABLE 1: Liquidity Ratios