Understanding Corporate Finance Ratios: A Comprehensive Guide

Corporate Finance Ratios are quantitative measures that are used to assess businesses. These ratios are used by financial analysts, equity research analysts, investors, and asset managers to evaluate the overall financial health of businesses, with the end goal of making better investment decisions. Corporate Finance Ratios are also heavily used by financial managers and C-suite officers to get a better understanding of how their business is performing.

 

Types of Corporate Finance Ratios

Corporate Finance Ratios can be broken down into four categories that measure different types of financial metrics for a business: Liquidity ratios, Operational Risk ratios, Profitability ratios, and Efficiency Ratios. The differences between these categories are explained in the following graphic:

 

 

How to Use Ratios?

Corporate Finance Ratios enable analysts, management, and investors to assess the financial performance of a company by ranking them against time-series data, competitor ratios, or performance targets.

Ratios are not very meaningful by themselves. To draw better insights from them, we should calculate the same ratios for a number of different companies that operate within the same industry (i.e., competitors). This will enable us to better understand how well a company is performing within the context of the industry. Ratios can also be computed at various periods in time in order to see how they have evolved over time. This can be done for an individual company, or for a number of companies operating in the same industry in order to observe how specific metrics have changed.

Lastly, ratios can be used to benchmark the performance of a company’s management team against targets that were set out earlier. Some companies compensate their management teams when certain specific ratio targets are achieved. For example, a CEO may receive a special bonus if, under his tenure, the company is able to increase its return on equity by 10%.

 

 

Corporate Finance Ratios

 

Liquidity Ratios

CAPEX to Operating Cash RatioMeasuring how much of a company’s operating cash flow is funnelled into capital expenditure projectsCash Flow from Operations / CAPEX Cash RatioA liquidity ratio that measures a company’s ability to pay off short-term liabilities with highly liquid assetsCash and Cash Equivalents / Current Liabilities Current RatioMeasures a business' ability to meet its obligations that are due in less than 1 yearCurrent Assets / Current Liabilities Defensive Interval RatioCompares a business' current assets to its daily cash expendituresCurrent Assets / Daily Expenditures Operating Cash Flow RatioEvaluates a business' ability to pay off short term liabilities using the cash flow from operationsCash Flow from Operations / Current Liabilities Quick RatioDo the company’s current assets easily cover its current liabilities?(Cash & Equivalents + Marketable Securities + Accounts Receivable) / Current liabilities Times Interest Earned (Cash Basis) RatioEvaluating a company's ability to meet its debt obligations with cashAdjusted Operating Cash Flow / Interest Expense

 

Operational Risk Ratios

Asset Coverage RatioMeasures a business' abiliy to cover debt obligations with assets[(Total Assets - Intangible Assets) - (Current Liabilities - Short Term Debt)] / Interest Expense Cash Coverage RatioMeasures a business' abiliy to cover debt obligations with cashTotal Cash / Interest Expense Cash Flow to Debt RatioCalculates the percentage of debt that could be paid off using cash generated from operationsCash Flow from Operations / Total Business Debt Debt Service Coverage RatioEvaluates a company’s ability to use its operating income to repay its debt obligations (including interest)Operating Income / Total Debt Service Debt to Assets RatioEnvisioning a company's debt load in relation to its assetsTotal Debt / Total Assets Interest Coverage RatioMeasures a business' abiliy to cover debt obligations with operating incomeOperating Income / Interest Expense Times Interest Earned RatioCalculates how many times over a company could pay its interest expenses with its earnings before interest and taxesEBIT / Interest Expense

 

Profitability Ratios

Gross Margin RatioCalculates the percentage of revenues that are left over after COGS(Revenue - COGS) / Revenue Net Profit MarginCalculates the percentage of revenues that are left over after all expenses and taxesNet Profit / Revenue Operating MarginCalculates the percentage of revenues that are left over after all expensesOperating Income / Revenue Pretax Margin RatioDisplays Earnings Before Taxes (EBT) relative to revenuesEBT / Revenue Return on Assets (ROA)Quantifies how much profit the business has generated given its available assetsNet Income / Average Assets Return on Equity (ROE)Quantifies how much profit the business has generated given its available equity financingNet Income / Shareholder's Equity Return on Investment (ROI)Represents a general return figure that investors can utilize to quantify investment performanceChange in Value of Investment / Investment Cost

 

Efficiency Ratios

Accounts Payable Turnover RatioExpresses credit purchases as a multiple of accounts payableNet Credit Purchases / Average Accounts Payable Accounts Receivable Turnover RatioExpresses credit sales as a multiple of accounts receivableNet Credit Sales / Average Accounts Receivable Asset Turnover RatioExpresses net sales as a multiple of the company's total assetsNet Sales / Average Total Assets Contribution Margin RatioShows the percentage of earnings retained after variable costs(Total Revenue - Variable Costs) / Total Revenue Employee TurnoverShows the percentage of employees that have left the company (voluntarily or involuntarily)Number of Employees Separated / Average Number of Employees Fixed Asset TurnoverExpresses net sales as a multiple of the company's fixed assetsNet Sales / Average Fixed Assets Inventory TurnoverExpresses COGS as a multiple of the company's average inventoryCOGS / Average Inventory

 

Additional Resources

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