An integral aspect of fundamental analysis involves performing what many would call “ratio analysis”. This involves calculating a number of different industry standard ratios and comparing them to various benchmarks. The benchmarks can be the ratios of other competitors, industry average ratios, or industry “rules-of-thumb”. There’s no set procedure for performing ratio analysis because it all depends on the type of company you’re analyzing – certain industries have industry specific ratios. Regardless, this article will give you an overview of some of the standard ratios and what they may tell us about a company.

In this article I’ll group ratios into four categories used to evaluate the different facets of a company’s performance and overall condition: liquidity, operating performance, leverage, and equity valuation.

Liquidity Ratios
The Current Ratio is the perhaps best-known measure of a company’s liquidity.

This ratio gives you a sense of the company’s abilities to pay its short-term liabilities. A value of less than 1 indicates that the company may have trouble meeting its short-term obligations and could be facing a liquidity crisis. As a general rule-of-thumb look for companies with a current ratio of 2 or more.

The Quick Ratio is a more stringent measure of a company’s short-term liquidity position.

Like the current ratio, it’s generally better to have a high quick ratio. Both ratios measure the same thing, but the quick ratio ignores inventory and other assets included in Current Assets that may not be all that liquid, and thus may not be easily sold to meet short-term obligations. Look for companies with ratios of 1 or more.

One thing to note is that while it’s favourable to have high current and quick ratios, ratios that are too high could indicate that a company isn’t being efficient and that it’s just sitting on a hoard of cash or inventory.

Inventory Turnover measures how efficient the firm is in processing inventory and inventory management. It measures how lean the firm runs with respect to inventory and how quickly it can sell its inventory.

Generally, turnover ratios that are closest to the industry norm are ideal. Inventory turnover ratios that are too low may indicate that the firm has too much capital tied up in inventory and the inventory may be obsolete. A ratio that is too low, on the other hand, may suggest the firm has inadequate stock on hand to meet sales. Note: average inventory in this case would just be the average of the inventory balances shown on the current period’s and last period’s balance sheets.

Performance Ratios
There are number of ratios used to evaluate a firm’s operating performance. Some are pretty basic, like Earnings per Share (EPS). All are fairly sell-explanatory and easy to interpret, but all need to be taken in the context of the firm’s industry. With these ratios, higher is almost always better. Without going into much detail, I’ll simply list some of the key metrics to use.

Operating Profit can either be Earnings Before Interest and Taxes (EBIT) or Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA).

My personal preference is to use the Gross Profit Margin or the EBITDA version of the Operating Profit Margin since sales, gross profit and EBITDA the harder to manipulate, when compared to net income (we’ll save discussing accounting manipulation for another article).

Leverage Ratios
Leverage ratios all deal with the degree to which a firm uses debt financing. These ratios are particularly important to debt financers who evaluate a firm’s credit worthiness.

The Debt-to-Total Capital Ratio measures the degree to which the firm has been financed by debt.

Total long-term capital includes long-term debt, preferred equity and common equity. High debt-to-total capital ratios aren’t necessarily a bad thing. If a company is financing a large project for future growth or has just recently acquired another company, it would make sense for that company’s debt balances to be high. What a high ratio does suggest is that the company may have more difficulty raising more debt in the future. A low ratio on the other hand suggests the company has lots of capacity to take on more debt for future projects, acquisitions, etc.; but it could also imply that the company isn’t using all available resources to pursue business opportunities (debt isn’t all bad). In the M&A space, low debt balances makes a company more attractive from an acquirer’s point of view.

The Interest Coverage Ratio can help to determine the firm’s ability to repay its debt obligations.

Since EBIT is the earnings total just before interest and taxes are deducted, this amount is a good proxy for the firm’s capacity to pay its interest expenses. In general, higher ratios are more favourable. While low ratios may not necessarily mean the firm is in trouble of defaulting on interest payments, it does suggest the firm may not have the capacity to take on more debt.

Another way of measuring whether a company will be able to meet upcoming debt obligations is to use the Cash Flow to Interest-Bearing Debt Ratio.

When a firm’s debt matures and requires repayment, that firm has two choices: it can either refinance that debt with new debt or equity, or it can pay it off using the firm’s cash balances. Cash Flow from Operations (CFO) is a good proxy for what cash will be available for these purposes.

Equity Valuation Ratios
Valuation ratios help measure how expensive a company’s equity is relative to that of its competitors. These are the ratios that many value investors sight when looking for stocks that appear cheap. In isolation these ratios don’t mean much; it’s always best to compare ratios among companies within a particular industry, or to compare ratios to historical averages. In each case, low ratios identify stocks that could be considered cheap and high ratios could mean the stock is expensive.

The Price-to-Earnings Ratio (P/E) is the most popular of all valuation ratios and a number of empirical studies have shown this ratio to be significantly related to stock returns over the long-run.

The problem with this ratio is that earnings can be very volatile and sometimes negative leading to a meaningless ratio. So, for firms in distressed situations, using the P/E ratio may not be appropriate. Additionally, since EPS is just net income per share, this amount can be subject to accounting manipulation and earnings distortion as mentioned earlier.

The Price-to-Book Ratio (P/B) compares a company’s market price to its accounting or book value. Book value is just the equity portion of a company’s balance sheet (Assets – Liabilities – preferred stock). This ratio is generally considered a floor value for a company’s stock price because at stock prices below book value, an acquirer could purchase and liquidate the company (sell assets and repay liabilities) and make a profit (of course this ignores off balance sheet financing, but that’s a topic for another discussion). In this case, book value can represent a company’s break-up value.

This ratio overcomes the P/E problem when earnings become negative. Book value is also generally more stable than earnings. One drawback to this ratio is that book value may not be an accurate measure of a company’s break-up value if that company hold illiquid assets (e.g. mining companies). As such, this ratio is typically used when analyzing banks, insurance or other finance firms. Another drawback is that this ratio can be difficult to use when comparing companies that have different accounting conventions.

The Price-to-Sales Ratio (P/S) is useful especially when comparing companies within a certain industry. Aside from sales recognition accounting standards, sales figures aren’t highly dependent on the accounting conventions adopted by the firm and aren’t easily manipulated. In general, the sales recognition accounting standard is the same for all companies within a certain industry, thus making the ratio highly comparable. And, like the P/B ratio, the P/S ratio overcomes a number of key issues that plague the P/E ratio – i.e., sales are generally less volatile than earnings, and are always positive.

Sales, however, do not necessarily determine whether or not a company is profitable. Sales may be surging, but if earnings aren’t growing or are falling, then the company deserves a discount valuation.

The Price-to-Cash Flow Ratio (P/CF) is another metric that solves the manipulation issues evident in the P/E ratio. Cash flow is also one of the best measures of a company’s financial performance. At the end of the day, a company’s ability to generate cash is what determines whether that company will be able to pursue future growth opportunities, pay dividends, or repay debt.

The problem with this ratio is that there are a number of different ways to define cash flow. You can use cash flow as reported on a company’s statement of cash flows, earnings plus non cash charges, Free Cash Flow (FCF), or EBITDA. From a usability perspective, EBITDA is likely the easiest.

A related ratio is the Price-to-Cash (P/C) ratio, which just compares a company’s market cap to its cash balance. Like the P/B ratio, this ratio is widely used to determine a stock’s floor price.

Summary
Countless ratios exist, and this list is by no means exhaustive. I’ve tried to identify the most widely used and what are in my opinion, the most relevant ratios in the industry. Ratio analysis works best as a supplement to other stock analyses. Remember, you have to make comparisons among companies in a particular industry, or to historical averages. Performing ratio analysis correctly will take time, a lot of time, but when it comes to investing your money, you should always be willing to spend time to make an informed decision.