Financial index and indicators

The financial statements analysis involves comparisons between the performance of a company and their similar in a same Market, as well as analyzing its past, checking historical data and events. Financial indictors are used for getting information which is not that obvious and can’t be found simply by looking at the books. These indicators can be calculated from the balance sheets and reports, and the cash flow of course. When analyzing financial indicators, the company’s sector must be always considered, because some companies show bad figures, but are not necessarily unhealthy. The main financial indicators are:

**Liquidity ratio**

These indicators try to find whether the company has enough cash for paying liabilities or not. Its variables can be found within the balance sheets, all of them. Liquidity indicators include:

**Current liquidity ratio**

The current ratio is the best indicator of short-term solvency, it reveals protection from creditors in short-term assets, where there is an expectation that they can be converted into cash quickly. The formula to calculate the current ratio is as follows:

Current Liquidity Ratio = Current Assets / Current Liabilities

As noticed in the formula, the calculations are made by taking all short term rights and assets, like the cash, inventories, notes receivable, financing and short-term loans. If the result of the current ratio is > 1, it means that the company can honor its short-term obligations. If the result is = 1, means that the rights and obligations of short term are equivalente. If the result is < 1, the company could present problems because their assets are insufficient to honor its short-term obligations.

However, a high current ratio may not be so good, because it may mean that the company has a lot of money tied up in non-productive assets such as inventories that are not being sold and becoming obsolete. The correct is always analyzing the levels in the industry, finding an average for the current ratio. If it are above average, may be good news, but if it is far below the average, it may be that the company is experiencing financial difficulties.

**“Dry” liquidity ratio**

To find a solution for the problem with inventories, which can inflate the ratio and provide a “false positive” for the analysis, it’s been created a “dry” ratio, simply found by excluding inventories before divinding the current assets by the current liabilities. A liquid asset is one that is traded on an active market and can be readily converted into cash. Inventories usually have low liquidity and are often the least liquid asset current assets. If a bankruptcy occurs with the company, the stock is usually lost. Thus, the “dry” liquidity ratio aims settle the obligations of the company short term without relying on the sale of inventories for that. The formula of “dry” liquidity ratio is as follows:

Dry Ratio = (Current Assets – Inventories) / Current Liabilities

Results for the dry ratio will be always lower than the current ratio, being the same interpretation.

**Immediate liquidity ratio**

The Immediate liquidity ratio is a variation of the previous ratios, however, consider only how much cash the company has in the very short term, such as cash, bank balances and highly liquid investments, such as CDs without grace and investment funds with redemption of units of D + 0. The formula of immediate liquidity is as follows:

Immediate ratio = Cash + Equivalents / Current Liabilities

As we can see, the immediate ratio totally excludes inventories and receivables, showing the company’s solvency for a very short-term. Interpreation remains the same – anything above 1 is quite good, below that it can be not good at all.

**General liquidity ratio**

The general liquidity ratio is an indicator of solvency, and it can be both short-term and long-term. He indicates that every $ 1 the company has debt, how much its has rights and assets in current assets and noncurrent assets. The formula for the general liquidity ratio is as follows:

General liquidity ratio = (Current + Noncurrent assets) / (Current + Noncurrent liabilities)

Like any other liquidity index, the general liquidity ratio must track the sector’s averages. Besides, some companies may have horrible general liquidity ratios, but without being in a bad situation. For instance, a company that moves inventories really frequently usually has a terrible general liquidity ratios, but it can be ok with suppliers and even a good cash flow position.

**Assets Management Indexes**

Assets Management indexes, as its name suggests, look for measuring how effective the company is while managing its assets, which is commonly related to several factors, like the sector, seasonal effects, operational cycles, capital expenditures, etc. For instance, if a company invests too much in assets, so the operational capital tends to be unnecessarily high, which compromises the cash flow and equivalents. On the other hand, a company whose capital investment are not enough might be facing decreasing sales, profitabiliy issues and consequences to its own equity value. The main indexes and tools for managing assets are:

**Inventory Turnover Index**

This index measures the inventories performance and quality, and can be used with any kind of inventories, in spite of its sizing or complexity. The formula to find the stocks turnover index is the following:

Inventory Turnover Index = Sales / Inventories

Results show the number of times that each item on inventories was replaced during a certain period of time. If the number is 5, for example, it means inventories have been sold and then replaced 5 times per year. The index must always be compared to sector’s or industry’s averages. High levels of inventories added to net operating working capital imply on a reduced free cash flow. Low levels of inventory may mean that the company is holding goods, which may not be worth the stated value. Another important point is that this index should be analyzed by the average inventory because there are companies that have seasonality, like higher sales at certain times of year, such as chocolate, which is pretty sold at Easter. Simply add up the monthly values of stocks and divide by 12.

**Average receivables turnover index**

The average receivables turnover index measures the lapse of time for a company to receive for items sold, and stands for the average timing between a closed sale and the payment. In other words, it gives the number of days, in average, that a company needs to wait for receiving for products it has already sold. It can be calculated by using the formula below:

Average receivables turnover index = Receivables / (Annual revenues/365)

If the ratio results in 40, for instance, that means the company waits 40 days between closing a sale and receiving for that. The timing can be influenced by a number of factors, like the industry’s segment, the charge effectiveness, the clients’ financial situation, the economy as a whole, etc. The shorter this period, the better. The result has to be compared with other companies. If the result is smaller, and the average collection period of sales is lower than its competitors, the company may have a competitive advantage over other companies in the same industry.

**Fixed assets turnover index**

It measures the company’s effectiveness while using its fixed assets. It gives a picture on how the company is using its fixed assets, like machinery and equipments. The formula is the following:

Fixed Assets Turnover Index = Revenues / Fixed Assets

The turnover ratio of fixed assets indicates how much the company sold for $ 1.00 each for total investment. The higher value the better, since it indicates that the company is efficient in using its fixed assets to generate revenues.

**Total ****Assets turnover ratio**

The turnover ratio of total assets measures the efficiency with which the company uses all of its assets to generate revenue. It indicates the company’s revenues in comparison with the growth of the asset. The formula for calculating the index of total turnover is as follows:

Assets Turnover Ratio = Revenues / Total Assets

The higher the ratio is, the better, as it indicates the company is efficiently using its assets and properties, and providing a good return on investments. In other words, a higher ratio, or at least higher than the sector’s average, explicits a company that generates a good volume of businesses and provides return for its investors. It’s a key indicator, as it tracks whether the use of the totality of resources of a company was efficient or not. If the company makes a low rate, it will have to increase the sales and sell some assets.

**Receivables turnover ratio**

The turnover ratio of receivables indicates how many times the accounts receivable transited the cash during the year, or how many times the company turns its accounts receivable to sales. The formula to calculate the rate of turnover of receivables is as follows:

Receivables turnover ratio = Net Sales / Notes Receivable

The higher is the turnover, the better. However, for excessively high ratios, it can expose problems with financing customers.

**Medium-term inventories index**

This ratio measures how long products stayed on the company’s investories before being sold, in average. It reflects the efficience of the company in generating cash from inventories. The formula is the following:

Medium-term inventories index = Average inventories x 360 / Cost of sales

Results indicate how many days, in average, the company lasts for completely renewing its inventories. The average will change depending on the company and the sector. For instance, a supermarket has a really quick stock flow, while a company which sells luxury cars keeps the inventories for a considerable lapse of time. To find out if the company maintains healthy levels of inventory turnover, the index should be compared with other companies in the same industry

**Average payment period index**

The index of average payment comprises the ratio of accounts payable and average daily sales. It indicates how many days, on average, short-term funds were allocated in the accounts payable, or how many days the company uses resources from suppliers to finance. The formula for calculating the index of average payment is as follows:

Average payment period index = Suppliers x 360 / Purchases

For any company, the larger the period for paying suppliers can be the better. So that means a higher ratio is always better, as it indicates the company can manage longer periods to pay for the products and services it consumes.

**Debts management Index**

The more a company invests, the larger will be its potential for growing. For such, it needs cash. The cash can be injected by shareholders and owners or come from third parties. If coming from others, the cash comprises a debt. In general, a higher use of external capital indicates a not healthy situation, especially for companies like airlines, for instance. By hiring loans, shareholders can keep their stakes at the company, without increasing investment. Debt management ratios measure the quality and the quantity of debts at a company, in order to find out whether the indebtedness is healthy or not, and detect financial problems as well as finding if the company generates enough cash to pay those debts back and keep the business runnings. The most common debt ratios are:

**Indebtedness ratio**

Also known as total indebtedness index, is the proportion between the total assets and total liabilities. Represented as a percentage, it measures the impact of current liabilities and long term debts. The ratio can be found by using the formula:

Indebtedness ratio = Total Liabilities (Current liabilities + Long Term) / Total Assets

The result indicates the proportion of third-parties capital the company relies on. The higher is the percentage, the more agressive is the presence of third parties on company’s financial operations. Thus, creditors prefer lower indebtedness ratios, which gives them more protection in case of a bankruptcy.

**Debt/Equity ratio**

This ratio shows how much owner’s equity the company has to each R$ 1.00 of debts. This ratio has the same intentions of the indebtedness ratio, but it returns a value rather than a percentage. The formula for calculating that is the following:

Debt/Equity Ratio = Total Liabilities / Owner’s Equity

The larger the number is, the worse. A higher ratio indicates that excessive third party capital is being used by the company, inflating the debts. Again, it is always useful to compare the ratios to the sector’s average.

**Interests coverage ratio**

It measures how much the EBIT can be shrink before the company is unable to pay for interests. This ratio exposes the size of the company’s debts and whether it generates enough cash flow to meet them. The formula is the following:

Interests Coverage Ratio = EBIT / Payable Interests

The result indicates how many times the EBIT can cover the costs of the loans and debts, and whether the company is able to pay its debts over time. Therefore, the larger the index, the better. If a company can cover 3.6 times its payable interests, and the sector’s average is 6 times, then the company is probably having problems to secure a safe margin for covering costs, and the company will probably have difficulty borrowing funds from third parties.

**Profitability indicators**

These indicators intend to analyze how effective are the company’s operations, showing combined streams of liquidity, assets management and debts management over the operational results. The profitability of a company explicits its self-funding ability, payments of dividends and cash flow generation. These ratios indicate the percentage of return over the invested capital, or the equity payments. It’s one of the most important indicators for shareholders, once it doesn’t just show the return of investments, but also can compare it to other options at the market or other companies in a same sector. Some other profitability ratios show the return over sales. However, profitable companies on sales are not necessarily companies with good cash flow generation. Many times, administrative expenses or debt interest may be eroding the cash gains in a company. The main profitability ratios are:

**Net profit margin**

Net profit margins, also known as sales profit margins or simply net margins shows the percentage of net profits the company was able to made from its total sales. It stands as a percentage and can be found by using the formula below:

Net margin = Net profits / Sales Revenues

The net margin indicates the percentage of gains over the company’s sales, after deducting all expenses, incluing interests and income tax. For instance, a net margin for a company can reach 9%. However, to find out whether it is good or not, we must compare it with the sector’s average. If the ratio is higher, the company is competitive, if not, the company proves to be inefficient or excessively tied to interests.

**Operational profits margin**

Indicates the performance of the company’s operational activities before the impact of interests and income tax. In other words, it measures the effectiveness of the company while operating, identifying the stake of net revenues that actually came from sales. The formula is the following:

Operational Profits Margin = EBIT / Sales

This ratio shows company’s gains from its operations, disconsidering any financial expenses or taxes, and making possible to find whether problems with the net margins are coming from the operations or not. To find whether a company has a good margin or not, it’s just using the sector’s average to compare.

**Gross profit margin**

The gross profit margin indicates the profitability of sales after their costs and expenses, cancellations, rebates, cost of goods sold, tax, etc. The formula used is below:

Gross profit margin = Gross profits / Net Operating Revenues

The gross margin reflects how much the company earns as a result of its operational activities. The larger it is, the more profitable the activities will be. For instance, if a company provides a gross margin of 62%, that means to each $ 1.00 sold, the company actually earns $ 0.62. To find whether the margins are good or not, one must compare them with similar companies.

**Operational Revenues/Total Assets** ratio

This analysis of the operational revenues shows the ability of the company’s assets to generate income, before taxes and leveraging. The formula is the following:

Operational Revenues/Total Assets ratio = EBIT / Total Assets

**Return on Assets (ROA)**

Return on assets, also known as return on investments (ROI), measures the return over the total assets after taxes and interests. This ratio is considered one of the most important, as it shows the profitability of a company compared to the total investments, represented by average of total assets. The ROA formula is the following:

ROA = Net Profits / Total Assets

The higher the ROA can be, the better – more capitalized companies actually show lower ROA ratios. If a company has a low return on assets, that means its ability to produce operational revenues is not enough, or interests are being paid in excess. To better analyze the ROA, companring it with past periods in always indicated, to study its behavior over time. Besides, it’s always useful to compare the Roa with the same ratio for similar companies and markets, to find out if this company has a competitive advantage over their competitors.

**Return on Equity (ROE)**

The return on equity, or ROE, indicates the rewards that shareholders are getting from their investments at the company, via their stakes. The formula is the following:

ROE = Net Profits / Owner’s Equity

The ROE is also considered a key ratio, as it gives the ability of the company to reward shareholders while using its own resources, providing organic growth, causing it to grow using only what it already has. Like the ROA, the best you can do is to track the ratio over time, and compare it to other companies.

**Leveraging ratio**

The Leveraging ratio is important to measure the risks faced by a company, or the presence of third parties’ capital in its structure, which shows whether the company is leveraged or not. The formula for finding the ratio is below:

Leveraging ratio = ROE / ROA

If the result is 1, that implies on a ‘zero’ leveraging ratio, or a smaller presence of third parties and smaller risks. If it is higher than 1, the leveraging is good and provides a better return, because the return on total assets will be greater than the compensation paid to third-party capital. If lower than 1, could be indicating a bad situation for the company, exposing financial risks and aversion to the company by investors.

**Market Value Ratios**

The Market value ratios establish links between the share prices of a company and its profits, cash flow and equity. They are a way of measuring the performance of a company’s stock compared with other companies in the same sector. Besides, they can reflect the fair pricing levels for shares. These ratios help investors to analyze risks and return of companies, provinding invaluable information and data for making decisions. The main market value indicators are:

**Price/Earnings Ratio**

This ratio shows how much the investors are willing to pay for a certain amount of reported profits. Besides, it is used to find whether shares are cheap or not. This is one of the most used ratios by investors. The formula is the following:

Price/Earnings Ratio = Share Prices / Profits per Share

The higher the ratio is, the stronger will be the possibilities of growth for a company. Thus, if two companies in a same sector show highly different ratios, one should invest in that with the higher ratio. Besides, it’s always useful to compare the ratio to the company’s and the sector’s historical data.

**Pricing/Cash Flow ratio**

The share pricing depend on the ability of a company to generates profits and cash. Thus, the pricing/cash flow ratio indicates the value that the investor is willing to pay for the return from the company’s operations. The formula is the following:

Pricing/Cash Flow Ratio = Share prices / Cash Flow per Share

The pricing/cash flow ratio can inform investors about how much they will receive for an amount of cash flow. This index is important to identify if buy shares of a particular company will be profitable in the future, causing the share price to grow and add shareholder value.

**Equity Value per Share**

The equity value per share is a simple ratio that indicates the company’s value from the point of view of its shareholders. It represents how much the shareholders agree to be paying for the company’s equity. The formula is the following:

Equity Value per Share = Owner’s Equity / Total Number of Shares

The results must be compared to the company’s floating shares price. If the market is pricing the shares below the equity value, maybe it’s a good moment for buying shares. Otherwise, if the share price traded in the market was above the book value, it can reflect a good forecast for the company’s profits and margins in the future, or even a mispricing on floating shares by the market and investors.

**Market value versus / Book value**

This ratio compares the company’s market value with the book value based on the company’s equity, and expressed the appreciation of the company in relation to its accounting data. When this ratio is greater than unity, it means that the market recognizes that particular company is worth more than its book value, and the market is valuing something that is not being recorded in the accounting or being incomplete. When this ratio is less than unity, it means that the market is not recognizing values that accounting is recording in its books. The formula for calculating the index of market value / book value is as follows:

Market/Book Value Ratio = Market Pricing per Share / Equity Value per Share

Pointing out, the market value corresponds to the value investors are willing to pay for company’s shares, while the book value just reflects the value of a company in consonance with its books and balance sheets, based on equity calculated as the difference between the active and the passive.