Understanding Financial Ratios: The Essentials for Lawyers
Financial ratios are a critical tool for analyzing a company’s financial performance over time. They are also useful for comparing financial performance among peer companies in a particular industry. While financial ratios and statistics are commonly calculated by investment bankers, in-house lawyers should also understand the key metrics and how they are calculated.
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Overview of Financial Ratio Analysis
The following broad categories of financial ratios are used to evaluate the performance of companies:
- Growth statistics
- Profitability ratios
- Return ratios
- Credit ratios
- Activity ratios
The calculation of historical growth provides key insights into a company’s financial health and is helpful for forecasting the company’s future growth. Various operating metrics can be used to project how fast a company is growing or shrinking. While revenue is the most commonly used metric to calculate a company’s growth, other metrics, such as a number of subscribers and the number of store openings, could be relevant for particular companies.
The compound annual growth rate, or CAGR, is a formula frequently used to measure growth over multiple periods of time.
Profitability ratios, also known as profitability margins, measure the company’s profitability as a percentage of revenue. The most common metrics in this category include gross profit margin, EBIT margin, EBITDA margin, and net income margin.
Gross profit margin measures the amount of gross profit generated by a company as a percentage of revenue. It is calculated as follows:
Companies with higher direct costs related to the sale of products or services, known by the accounting term cost of goods sold (COGS), will have lower gross margins. This is because gross profit is equal to revenue minus COGS.
EBIT margin, also known as operating income margin, provides insight into a company’s operating income relative to its revenue. Companies that have lower overhead structure, lower R&D expenses, or lower marketing costs will generally have higher EBIT margins. This is because operating income equals gross profit minus selling, general & administrative expenses (SG&A). EBITDA margin is similar to EBIT margin, except it includes depreciation and amortization costs.
Net income margin reflects the amount of net income generated per dollar of revenue. In contrast to EBIT margin, net income margin is also affected by nonoperating income or expenses. For example, a company with higher interest expenses as a result of having more debt in its capital structure would have a lower net income margin. As another example, a company with lower taxes or the ability to reduce its net taxes by using net operating loss carryforwards (NOLs) would have a higher net income margin.
Return ratios provide insight into a company’s ability to efficiently generate net income or operating cash flow using its assets or capital. A higher the return ratio indicates that the company earns more money for each dollar of asset or capital. The most common return ratios include return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC).
Return on assets (ROA) measures the amount of net income a company produces for each dollar of assets. When analyzing ROA ratios across peer companies, it is important to proceed with caution because some companies do not carry their assets at fair market value.
Return on equity (ROE) measures the amount of net income generated for shareholders. It is calculated using the book value of equity, not the market value of equity. A company’s capital structure can have a significant impact on its ROE ratio.
Return on invested capital (ROIC) is calculated using a more complex formula. The ROIC ratio provides insight into a company’s after-tax operating income as a percentage of its invested capital. It is perhaps the most useful of the three return ratios because the ROIC ratio is not impacted by a company’s capital structure.
Credit ratios are helpful for understanding a company’s debt profile. They can also be useful for estimating credit ratings, modeling leveraged buyout transactions, and analyzing potentially distressed companies. Common credit ratios include the leverage ratio, interest coverage ratio, debt to equity ratio, and debt to capitalization ratio.
Activity ratios provide an indication of the company’s efficiency in managing its working capital. Some commonly used activity ratios used across different industries include inventory turnover, accounts receivables days, and accounts payable days.
Inventory turnover is a metric that provides information into how often a company replaces its inventory. A very high inventory turnover ratio indicates that a company keeps less inventory. Accounts receivable days measures how long it takes for a company to collect unpaid bills due from its customers. Accounts payable days measures how long it takes for a company to pay its vendors.