Financial ratios are relationships between one or more financial statement items. They are used by stock analysts and investors to compare companies within an industry sector, and by company management to identify internal strengths and weaknesses. The financial ratios for efficiency and effectiveness assess a company's operations and profitability.
Financial statements consist of the income statement, the balance sheet and the cash flow statement. Financial ratios, including efficiency and effectiveness ratios, are based on income statement and balance sheet items. Public companies often provide key financial ratios in their quarterly and annual financial reports. Some industry financial ratios are provided by the MSN Money and Yahoo! Finance websites.
The three main efficiency ratios are days sales outstanding, inventory turnover ratio and accounts payable-to-sales ratio. Days sales outstanding equal the accounts receivable divided by the credit sales, and the result multiplied by the number of days in the period. For example, if a company provides credit terms of net-30 days, meaning the cash payment is due within 30 days of purchase, and the days sales outstanding is 40 days, then it is taking on average 10 days longer for customers to settle their accounts.
The inventory turnover ratio is sales divided by inventory. The higher the ratio, the faster a company is able to move its inventory. The accounts payable-to-sales ratio equals the accounts payable divided by sales, expressed as a percentage. This ratio indicates the efficiency of the company in using supplier funds to generate sales. Accounts receivable, accounts payable and inventory are balance sheet items. Sales is an income statement item.
Effectiveness ratios include return on sales, return on assets and return on equity. They indicate how effective management has been in using shareholders' equity and company assets to generate an acceptable rate of return. The return on sales, also known as the profit margin, is net profit divided by net sales, expressed as a percentage. A company that dominates the competition is likely to have high profit margins; however, a new business with limited clients is going to have low margins.
The return on assets is the net profit divided by total assets, expressed as a percentage. It measures how effectively the company uses its assets to drive profits. The net profit is the bottom line of the company. It is the profit after cost of goods, overhead expenses, interest costs and taxes have been deducted from sales. The return on equity is the net profit divided by the shareholders' equity, expressed as a percentage. Shareholders' equity is equal to assets minus liabilities. It measures management’s ability to generate an adequate return on the invested capital.
Liquidity ratios (e.g., current ratio) and valuation ratios (e.g., price-to-earnings ratio) are other key ratios used to evaluate and compare businesses. The current ratio equals the current assets divided by the current liabilities. It indicates a company's ability to pay its short-term bills. The price-to-earnings ratio equals the share price divided by the earnings per share. It helps an investor determine if a company is undervalued or overvalued with respect to industry peers.