Key Financial Ratios to Analyze the Mining Industry

The mining industry is one of the oldest established industrial operations. Mining has been critical to the development of major countries such as the United States, Canada and Australia. The entire western hemisphere, both North and South America, is rich in a wide variety of mining deposits. Russia is by far the leading country for mining enterprises in Europe. Africa is rich in mineral deposits, notably gold and diamonds, and several of the major mining companies have had mining operations established there for decades. Australia is a notable source of gold and aluminum. China is the world's richest source of rare earth minerals, containing an estimated 90% of these minerals that are important elements in the manufacture of automobiles and many other products.

The U.S. was at one time the world's leader in production of many major mining products, but increasing environmental regulations have curtailed much of the U.S. mining industry. The mining industry is subdivided into categories based on the principal mining interest. The three main subdivisions of the industry are precious metals and gem stones mining; industrial and base metal mining; and nonmetal mining, which includes mining for such important commodities as coal.

The industry is further divided into major mining companies, such as Rio Tinto Group (NYSE: RIO) and BHP Billiton Limited (NYSE: BHP), and those referred to as "junior miners." Junior miners are typically much smaller companies primarily engaged in the business of exploration, discovering new mining deposits. Many junior mining companies that make major finds are eventually acquired by one of the major mining companies that has much more extensive financial resources capable of funding large-scale mining operations.

Mining requires extensive capital expenditures, both for exploration and for the initial establishment of mining operations. However, once a mine is operational, its operating costs tend to be significantly lower and relatively stable. Since mining revenues are subject to fluctuations in commodity prices, it is important for mine operators to wisely manage changes in production levels.

The quick ratio is a basic metric of liquidity and financial solvency. The ratio measures a company's ability to handle its current short-term financial obligations with liquid assets, either cash or assets that can quickly be converted into cash. The quick ratio is calculated by dividing the total of current assets minus inventory by the company's total short-term obligations. This ratio is often referred to as the "acid test ratio" because it is considered such a strong fundamental indicator of a company's basic financial health or soundness. It is important for evaluating mining companies because of the substantial capital expenditures and financing necessary for mining operations. Analysts and creditors prefer to see quick ratio values higher than 1, the minimum acceptable value.

Operating profit margin is a primary profitability ratio examined by analysts to gauge how effectively a company manages costs. This is important in the mining industry since mining companies frequently have to adjust production levels, significantly changing their total operational costs. Operating profit margin is calculated by dividing total revenues by total company expenses, excluding taxes and interest. A company's operating profit margin is considered a strong indicator of its potential growth and revenue. The average operating profit margin varies substantially between and within industries, and is best used in comparisons between very similar companies.

The return-on-equity ratio, or ROE, is a key financial indicator considered by investors because it indicates the level of profit a company is able to generate from equity and return to stockholders. Average ROEs in the mining industry are between 5 and 9%, with the best-performing companies producing ROEs closer to 15% or better. The ratio is calculated by dividing net income by stockholders' equity. Analysts sometimes factor out of the calculation preferred stock equity and preferred stock dividends, resulting in the return-on-common-equity ratio, known as ROCE. A popular alternative metric to the ROE ratio is the return-on-assets ratio, or ROA.