Understanding Financial Ratios

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Understanding Financial Ratios

Financial Ratios can be said is one the most loved questions in professional qualification examinations like the CPA / CMA. Students often can get overwhelmed trying to remember every single ratio in their head. Let’s see how to easily remember these ratios?

Take for example the following ratios: 

Times Interest Earned Ratio

The ratio name gives away the formula. It has both interest and earnings in its name so both are items in the P & L statement. Basically, the formula wants you to calculate the number of times I can cover my interest cost with the earnings in the period. Example: If the company’s EBIT(Earnings before Interest and Tax) is $1000 and the interest cost is $100. Times Interest Earned is 10. It’s a ratio generally used by creditors to check the earnings potential, solvency, and ability of the company to repay its debts from its earnings. 

Debt to Equity Ratio

Both are balance sheet items – all you have to do is divide the company’s debt to its equity. Higher Debt to Equity ratio means the company is leveraged to a higher degree. 

Current Ratio

The name current should ring a bell that it is a point in time ratio so you should scan your eyes to the balance sheet for current assets and divide it by current liabilities.

Cash Flow Ratio

The name cash flow indicates that you have to look for it in the cash flow statement. As an analyst you would be interested in knowing the cash flow from the normal course of business – so you take the cash flow from operating activities(available in cash flow statement) and divide it with the current liabilities(balance sheet) to arrive at this ratio. A higher ratio indicates a firm’s ability to meet the current liabilities with cash generated from the core business. 

Price Earnings Ratio

As the name says, it’s the current market price per share divided by earnings (expressed as earnings per share for current or expected future earnings). The PE ratio says how much price is the market willing to pay for $1 of earnings. A forward PE ratio of 20 means the market is willing to pay $20(to buy a single share of the company) for each $1 in expected future earnings. 

To summarize, it’s important to read the ratio properly and most of the time, it will  give away the contents of the formula as can be seen from the examples above.

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