Sometime I wonder why Financial rations are so important. The simple answer is human mind needs number for rational decision. Financial ratios are mathematical calculations that provide insights into a company’s performance and financial health. By comparing different figures from a company’s financial statements, ratios highlight strengths or weaknesses in areas like profitability, debt levels, valuation, and how efficiently the company uses assets and capital. Some of the most common financial ratios used by investors include:
Profitability ratios like return on assets and return on equity, which measure how well a company generates profits from its resources. Higher returns generally indicate better management and prospects.
Debt ratios like debt-to-equity, which show how dependent a company is on debt financing versus shareholders’ equity. High debt levels mean higher risk.
Valuation ratios like price-to-earnings, which calculate the price of a stock compared to the company’s earnings per share. Low P/E can signal an undervalued stock.
Efficiency ratios like inventory turnover, which gauge how well inventory is managed. Higher turnover indicates greater efficiency.
Lets dig deep to understand the Financial Ratios. Assume that a named ACME has below balance sheet
Current Ratio:
The current ratio measures a company’s ability to pay off its short-term financial obligations or liabilities. It is calculated by dividing current assets by current liabilities.
Current assets include cash, accounts receivable, inventory, and other assets that can be converted to cash within one year. Current liabilities are financial obligations that will come due within one year, such as accounts payable or short-term debt.
A current ratio of greater than 1 indicates that the company’s current assets exceed its current liabilities. This means it has enough liquid assets to cover its short-term debt and other payables. The higher the current ratio, the more capable a company is of paying its short-term obligations.
A current ratio of less than 1 means current liabilities exceed current assets, indicating potential liquidity issues. Companies with good liquidity tend to have a current ratio between 1.5 and 3.
Using this sample balance sheet data, here is how the key ratios would be calculated:
Current Ratio = Current Assets / Current Liabilities = $120,000 / $50,000 = 2.4
2. Debt-to-Equity Ratio:
The debt-to-equity ratio compares a company’s total debt to its shareholder equity. This measures the extent of a company’s leverage and financial risk.
It is calculated by dividing total liabilities by shareholder’s equity. Total liabilities include both current and long-term debt. Shareholder’s equity equals assets minus total liabilities.
A debt-to-equity ratio above 1 indicates higher debt levels and risk since debt exceeds equity. A ratio of 1 means debt and equity are balanced. A low debt-to-equity ratio below 1 is favorable since the company is financing itself through equity rather than debt.
The optimal debt-to-equity depends on the industry, but most stable companies have a ratio between 1 and 2. A high ratio signals increased risk of insolvency if the company takes on more debt.
Debt-to-Equity Ratio = Total Liabilities / Shareholders’ Equity = $150,000 / $170,000 = 0.88
3. Return on Equity (ROE):
Return on equity measures a company’s net income generated compared to its shareholder equity. It indicates how efficiently a company uses invested capital to create profits for shareholders.
ROE is calculated by dividing net income by average shareholder’s equity. Net income is total revenues minus expenses over a period. Shareholder’s equity equals assets minus liabilities.
A high ROE indicates the company generates substantial profits from its equity. This means management is efficient at using capital from shareholders to generate income. Comparing ROE between companies even across industries measures profitability consistently.
A low or declining ROE means inefficient use of shareholder capital. Companies with stable growth tend to have a ROE between 15–20%. As a benchmark, ROE for the S&P 500 index is around 14%.
For example, if Net Income was $34,000:
Return on Equity (ROE) = Net Income / Average Shareholders’ Equity
= $34,000 / $170,000 = 20%
How to analyze the Financial Ration in Python
1. Setting Up the Python Environment
!pip install pandas yfinance
2. Downloading Microsoft’s Balance Sheet from Yahoo Finance
import yfinance as yf
# Define the ticker symbol for Microsoft
ticker = "MSFT"
# Fetch data
msft = yf.Ticker(ticker)
# Get balance sheet
balance_sheet = msft.balance_sheet
print(balance_sheet)
3. Downloading Microsoft’s Profit and Loss Statement from Yahoo Finance
# Fetch the income statement data
income_statement = msft.financials
# Get Net Income and Shareholder's Equity
net_income = income_statement.loc['Net Income']
shareholders_equity = balance_sheet.loc['Total Stockholder Equity']
4. Calculating Key Financial Rations
# Calculate Current Ratio
current_ratio = balance_sheet.loc['Total Current Assets'] / balance_sheet.loc['Total Current Liabilities']
# Calculate Debt-to-Equity Ratio
debt_to_equity = balance_sheet.loc['Total Liab'] / balance_sheet.loc['Total Stockholder Equity']
# Calculate ROE
# Extract Net Income from the income statement
net_income = income_statement.loc['Net Income']
# Extract Stockholders Equity from the balance sheet
shareholders_equity = balance_sheet.loc['Stockholders Equity']
# Calculate Return on Equity (ROE)
roe = net_income / shareholders_equity
# Display the calculated ratios
print(f"Current Ratio: {current_ratio}")
print(f"Debt-to-Equity Ratio: {debt_to_equity}")
print(f"Return on Equity (ROE): {roe}")
5. Plotting Key Financial Rations
# Plotting the Debt-to-Equity Ratio
plt.figure(figsize=(12, 6))
debt_to_equity.plot(kind='bar', color='teal', alpha=0.7)
plt.title('Debt-to-Equity Ratio')
plt.ylabel('Ratio')
plt.xlabel('Year')
plt.grid(axis='y')
plt.tight_layout()
plt.show()
Commentary: A decreasing Debt-to-Equity ratio is generally a good sign, indicating that the company is becoming less reliant on external liabilities (debt) relative to equity. This can be interpreted as the company being in a less risky financial position. The consistent decline over the years indicates that the company might be paying off its debts or increasing its equity, leading to a more stable capital structure.
# Plotting the Current Ratio
plt.figure(figsize=(12, 6))
current_ratio.plot(kind='bar', color='purple', alpha=0.7)
plt.title('Current Ratio')
plt.ylabel('Ratio')
plt.xlabel('Year')
plt.grid(axis='y')
plt.tight_layout()
plt.show()
Commentary: The decline in the ratio over the years signals a decrease in the company’s short-term liquidity position. While the ratios for all the years are above 1 (indicating a good liquidity position), the downward trend is a potential cause for concern. This could be due to an increase in short-term liabilities or a decrease in liquid assets. It’s essential to dig deeper and find the root cause of this declining trend.
# Plotting the ROE
plt.figure(figsize=(12, 6))
roe.sort_index().plot(kind='bar', color='orange', alpha=0.7) # Sorting by year in ascending order
plt.title('Return on Equity (ROE)')
plt.ylabel('ROE')
plt.xlabel('Year')
plt.grid(axis='y')
plt.tight_layout()
plt.show()
Commentary: The increase from 2020 to 2021 indicates that the company was more efficient in generating profit from its equity during that period. However, the subsequent decline in ROE might indicate reduced profitability or inefficient use of equity. This could be due to various factors, including increased competition, operational inefficiencies, or higher costs. A declining ROE might be a red flag for potential investors as it suggests that the company’s profitability relative to shareholder’s equity is decreasing.
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