CFA topics - financial reporting and analysis (v)

This post is going to discuss financial ratios. A few categories of financial ratios allow financial analysts to understand the operating aspects of a company: profitability ratios, return ratios, leverage ratios, and working capital days.

Profitability ratios: allow analysts to understand how profitable a company is. In other words, for every $100 a company makes in revenue, how much it spends on COGS (cost of goods sold), how much it makes in operating profit, and how much it makes in net income. Popular ratios in this category include:

Gross margin = gross profit / revenue
EBIT margin (also called operating margin) = EBIT / revenue
Net margin = Net income / revenue

Return ratios: instead of measuring how much profit is made per dollar in revenue, return ratios measure how much profit is made per dollar of asset / dollar of shareholder equity. Popular ratios in this category include:

Return on asset = net income / average assets
Return on equity = net income / average equity

While profitability ratios give analysts an idea of the bargaining power of a company (ie the bargaining power over its supply chain, its customer, and its employees), return ratios give analysts an idea of the attractiveness of a company from a shareholder’s perspective.

Leverage ratios: measure how “indebted” a company is. Popular ratios in this category include:

EBITDA coverage ratio = Total debt / EBITDA (indebtedness of a company relative to cashflow)
Gearing ratio = Total debt / Total asset
Current ratio = Total current assets / total current liabilities (short term indebtedness)

Working capital days: allow analysts to understand whether a company is properly managing its working capital. For example, is inventory level too high? If so, company might have the risk of inventory write-down. Is receivable too high? Again, company might have the risk of bad debt. Popular ratios in this category include:

Inventory days = average inventory / COGS * 365 days
Receivable days = average receivable / revenue * 365 days
Payable days = average payable / COGS * 365 days