ROA And ROE Give Clear Picture Of Corporate Health

With all the ratios that investors toss around, it's easy to get confused. Consider return on equity (ROE) and return on assets (ROA). Because they oth !easure a "ind of return, at first glance, these t#o !etrics see! $retty si!ilar. Both gauge a co!$any's a ility to generate earnings fro! its invest!ents. But they don't e%actly re$resent the sa!e thing. A closer loo" at these t#o ratios reveals so!e "ey differences. &ogether, ho#ever, they $rovide a clearer re$resentation of a co!$any's $erfor!ance. 'ere #e loo" at each ratio and #hat se$arates the!.

ROE Of all the funda!ental ratios that investors loo" at, one of the !ost i!$ortant is return on equity. (t's a asic test of ho# effectively a co!$any's !anage!ent uses investors' !oney ) ROE sho#s #hether !anage!ent is gro#ing the co!$any's value at an acce$ta le rate. ROE is calculated as*

Annual Net Income Average Shareholders\' Equity

+ou can find net inco!e on the inco!e state!ent, and shareholders' equity a$$ears at the otto! of the co!$any's alance sheet. ,et's calculate ROE for the fictional co!$any Ed's Car$ets. Ed's -../ inco!e state!ent $uts its net inco!e at 01.2-- illion. On the alance sheet, you'll find total stoc"holder equity for -./ #as 0-3.-42 illion5 in -..2 it #as 04.267 illion. &o calculate ROE, average shareholders' equity for -../ and -..2 (0-3.-42 n 8 04.267 n 9 - : 064..76 n), and divide net inco!e for -../ (01.2-- illion) y that average. +ou #ill arrive at a return on equity of ..-1, or -1;. &his tells us that in -../ Ed's Car$ets generated a -1; $rofit on every dollar invested y shareholders. <any $rofessional investors loo" for a ROE of at least 63;. =o, y this standard alone, Ed's Car$ets' a ility to squee>e $rofits fro! shareholders' !oney a$$ears rather i!$ressive. (?or further reading, see Keep Your Eyes On The ROE.)

ROA @o#, let's turn to return on assets, #hich, offering a different ta"e on !anage!ent's effectiveness, reveals ho# !uch $rofit a co!$any earns for every dollar of its assets. Assets include things li"e cash in the an", accounts receiva le, $ro$erty, equi$!ent, inventory and furniture. ROA is calculated li"e this* Annual Net Income Total Assets ,et's loo" at Ed's again. +ou already "no# that it earned 01.2-- illion in -../, and you can find total assets on the alance sheet. (n -../, Ed's Car$ets' total assets a!ounted to 0772.3.A illion. (ts net inco!e divided y total assets gives a return on assets of ....23, or ..23;. &his tells us that in -../ Ed's Car$ets earned less than 6; $rofit on the resources it o#ned. &his is an e%tre!ely lo# nu! er. (n other #ords, this co!$any's ROA tells a very different story a out its $erfor!ance than its ROE. ?e# $rofessional !oney !anagers #ill consider stoc"s #ith an ROA of less than 3;. (?or further reading, see ROA On The Way.)

The Difference Is All A out !ia ilities &he ig factor that se$arates ROE and ROA is financial leverage, or de t. &he alance sheet's funda!ental equation sho#s ho# this is true* assets : lia ilities 8 shareholders' equity. &his equation tells us that if a co!$any carries no de t, its shareholders' equity and its total assets #ill e the sa!e. (t follo#s then that their ROE and ROA #ould also e the sa!e. But if that co!$any ta"es on financial leverage, ROE #ould rise a ove ROA. &he alance sheet equation ) if e%$ressed differently ) can hel$ us see the reason for this* shareholders' equity : assets ) lia ilities. By ta"ing on de t, a co!$any increases its assets than"s to the cash that co!es in. But since equity equals assets !inus total de t, a co!$any decreases its equity y increasing de t. (n other #ords, #hen de t increases, equity shrin"s, and since equity is the ROE's deno!inator, ROE, in turn, gets a oost. At the sa!e ti!e, #hen a co!$any ta"es on de t, the total assets ) the deno!inator of ROA ) increase. =o, de t a!$lifies ROE in relation to ROA.

Ed's alance sheet should reveal #hy the co!$any's return on equity and return on assets #ere so different. &he car$et)!a"er carried an enor!ous a!ount of de t ) #hich "e$t its assets high #hile reducing shareholders' equity. (n -../, it had total lia ilities that e%ceeded 07-- illion ) !ore than 64 ti!es its total shareholders' equity of 0-3.-42 illion. Because ROE #eighs net inco!e only against o#ners' equity, it doesn't say !uch a out ho# #ell a co!$any uses its financing fro! orro#ing and onds. =uch a co!$any !ay deliver an i!$ressive ROE #ithout actually eing !ore effective at using the shareholders' equity to gro# the co!$any. ROA ) ecause its deno!inator includes oth de t and equity ) can hel$ you see ho# #ell a co!$any $uts oth these for!s of financing to use. "onclusion =o, e sure to loo" at ROA as well as ROE. &hey are different, ut together they $rovide a clear $icture of !anage!ent's effectiveness. (f ROA is sound and de t levels are reasona le, a strong ROE is a solid signal that !anagers are doing a good Bo of generating returns fro! shareholders' invest!ents. ROE is certainly a ChintC that !anage!ent is giving shareholders !ore for their !oney. On the other hand, if ROA is lo# or the co!$any is carrying a lot of de t, a high ROE can give investors a false i!$ression a out the co!$any's fortunes.

Profitability Indicator Ratios: Return On Equity

&his ratio indicates ho# $rofita le a co!$any is y co!$aring its net inco!e to its average shareholders' equity. &he return on equity ratio (ROE) !easures ho# !uch the shareholders earned for their invest!ent in the co!$any. &he higher the ratio $ercentage, the !ore efficient !anage!ent is in utili>ing its equity ase and the etter return is to investors. #ormula$

"om%onents$

As of Dece! er 16, -..3, #ith a!ounts e%$ressed in !illions, Ei!!er 'oldings had net inco!e of 0A1-.3 (inco!e state!ent), and average shareholders' equity of 07,16-.A ( alance sheet). By dividing, the equation gives us an ROE of 6A; for ?+ -..3. &ariations$ (f the co!$any has issued $referred stoc", investors #ishing to see the return on Bust co!!on equity !ay !odify the for!ula y su tracting the $referred dividends, #hich are not $aid to co!!on shareholders, fro! net inco!e and reducing shareholders' equity y the outstanding a!ount of $referred equity. "ommentary$ Widely used y investors, the ROE ratio is an i!$ortant !easure of a co!$any's earnings $erfor!ance. &he ROE tells co!!on shareholders ho# effectively their !oney is eing e!$loyed. Feer co!$any, industry and overall !ar"et co!$arisons are a$$ro$riate5 ho#ever, it should e recogni>ed that there are variations in ROEs a!ong so!e ty$es of usinesses. (n general, financial analysts consider return on equity ratios in the 63)-.; range as re$resenting attractive levels of invest!ent quality.

While highly regarded as a $rofita ility indicator, the ROE !etric does have a recogni>ed #ea"ness. (nvestors need to e a#are that a dis$ro$ortionate a!ount of de t in a co!$any's ca$ital structure #ould translate into a s!aller equity ase. &hus, a s!all a!ount of net inco!e (the nu!erator) could still $roduce a high ROE off a !odest equity ase (the deno!inator). ?or e%a!$le, let's reconfigure Ei!!er 'oldings' de t and equity nu! ers to illustrate this circu!stance. (f #e reduce the co!$any's equity a!ount y 0!illion and increase its long)ter! de t y a corres$onding a!ount, the reconfigured de t)equity relationshi$ #ill e (figures in !illions) 0-,.26.4 and 0-,42-.2, res$ectively. Ei!!er's financial $osition is o viously !uch !ore highly leveraged, i.e., carrying a lot !ore de t. 'o#ever, its ROE #ould no# register a #ho$$ing -A.1; (0A1-.3 G 0-,42-.2), #hich is quite an i!$rove!ent over the 6A; ROE of the al!ost de t)free ?+ -..3 $osition of Ei!!er indicated a ove. Of course, that i!$rove!ent in Ei!!er's $rofita ility, as !easured y its ROE, co!es #ith a $rice...a lot !ore de t. &he lesson here for investors is that they cannot loo" at a co!$any's return on equity in isolation. A high, or lo#, ROE needs to e inter$reted in the conte%t of a co!$any's de t)equity relationshi$. &he ans#er to this analytical dile!!a can e found y using the return on ca$ital e!$loyed (ROCE) ratio.

Profitability Ratio Analysis

Determining Profitability is Important to

ompany In!estors

Every fir! is !ost concerned #ith its $rofita ility. One of the !ost frequently used tools of financial ratio analysis is $rofita ility ratios #hich are used to deter!ine the co!$any's otto! line and its return to its investors. Frofita ility !easures are i!$ortant to co!$any !anagers and o#ners ali"e. (f a s!all usiness has outside investors #ho have $ut their o#n !oney into the co!$any, the $ri!ary o#ner certainly has to sho# $rofita ility to those equity investors. Profitability ratios sho# a co!$any's overall efficiency and $erfor!ance. We can divide $rofita ility ratios into t#o ty$es* !argins and returns. Ratios that sho# !argins re$resent the fir!'s a ility to translate sales dollars into $rofits at various stages of !easure!ent. Ratios that sho# returns re$resent the fir!'s a ility to !easure the overall efficiency of the fir! in generating returns for its shareholders.

'argin Ratios Gross Profit Margin &he gross profit margin loo"s at cost of goods sold as a $ercentage of sales. &his ratio loo"s at ho# #ell a co!$any controls the cost of its inventory and the !anufacturing of its $roducts and su sequently $ass on the costs to its custo!ers. &he larger the gross $rofit !argin, the etter for the co!$any. &he calculation is* (ross )rofit*Net Sales + ,,,,-. Both ter!s of the equation co!e fro! the co!$any's income statement. Operating Profit Margin O$erating $rofit is also "no#n as EBIT and is found on the co!$any's inco!e state!ent. EB(& is earnings efore interest and ta%es. &he o$erating $rofit !argin loo"s at EB(& as a $ercentage of sales. &he o$erating $rofit !argin ratio is a !easure of overall o$erating efficiency, incor$orating all of the e%$enses of ordinary, daily usiness activity. &he calculation is* E.IT*Net Sales + ,,,,,-. Both ter!s of the equation co!e fro! the co!$any's income statement. Net Profit Margin When doing a si!$le $rofita ility ratio analysis, net $rofit !argin is the !ost often !argin ratio used. &he net $rofit !argin sho#s ho# !uch of each sales dollar sho#s u$ as net inco!e after all e%$enses are $aid. ?or e%a!$le, if the net $rofit !argin is 3;, that !eans that 3 cents of every dollar is $rofit. &he net $rofit !argin !easures $rofita ility after consideration of all e%$enses including ta%es, interest, and de$reciation. &he calculation is* Net Income*Net Sales + ,,,,,-. Both ter!s of the equation co!e fro! the inco!e state!ent. Cash Flow Margin &he Cash ?lo# <argin ratio is an i!$ortant ratio as it e%$resses the relationshi$ et#een cash generated fro! o$erations and sales. &he co!$any needs cash to $ay dividends, su$$liers, service de t, and invest in ne# ca$ital assets, so cash is Bust as i!$ortant as profitto a usiness fir!.

&he Cash ?lo# <argin ratio !easures the a ility of a fir! to translate sales into cash. &he calculation is* "ash flo/ from o%erating cash flo/s*Net sales + ,,,,,-. &he nu!erator of the equation co!es fro! the fir!'s Statement of Cash Flows. &he deno!inator co!es fro! the (nco!e =tate!ent. &he larger the $ercentage, the etter. Returns Ratios Return on Assets 0also called Return on Investment1 &he Return on Assets ratio is an i!$ortant $rofita ility ratio ecause it !easures the efficiency #ith #hich the co!$any is !anaging its invest!ent in assets and using the! to generate $rofit. (t !easures the a!ount of $rofit earned relative to the fir!'s level of invest!ent in total assets. &he return on assets ratio is related to the asset management category of financial ratios. &he calculation for the return on assets ratio is* Net Income*Total Assets : HHHHH;. @et (nco!e is ta"en fro! the inco!e state!ent and total assets is ta"en fro! the alance sheet. &he higher the $ercentage, the etter, ecause that !eans the co!$any is doing a good Bo using its assets to generate sales. Return on Equity &he Return on Equity ratio is $erha$s the !ost i!$ortant of all the financial ratios to investors in the co!$any. (t !easures the return on the !oney the investors have $ut into the co!$any. &his is the ratio $otential investors loo" at #hen deciding #hether or not to invest in the co!$any. &he calculation is* Net Income*Stoc2holder's Equity : HHHHH;. @et inco!e co!es fro! the inco!e state!ent and stoc"holder's equity co!es fro! the alance sheet. (n general, the higher the $ercentage, the etter, #ith so!e e%ce$tions, as it sho#s that the co!$any is doing a good Bo using the investors' !oney. "ash Return on Assets &he cash return on assets ratio is generally used only in !ore advanced $rofita ility ratio analysis. (t is used as a co!$arison to return on assets since it is a cash co!$arison to this ratio as return on assets is stated on an accrual asis. Cash is required for future investments. &he calculation is* "ash flo/ from o%erating activities*Total Assets + ,,,,,- . &he nu!erator is ta"en fro! the =tate!ent of Cash ?lo#s and the deno!inator fro! the alance sheet. &he higher the $ercentage, the etter.

"om%arative Data ?inancial ratio analysis is only a good !ethod of financial analysis if there is comparative dataavaila le. &he ratios should e co!$ared to oth historical data for the co!$any and industry data.

Tying it all Together - The uPont Mo!el &here are so !any financial ratios ) liquidity ratios, debt or financial leverage ratios, efficiency or asset management ratios, and profitability ratios ) that it is often hard to see the ig $icture. +ou can get ogged do#n in the detail. One !ethod that usiness o#ners can use to su!!ari>e all of the ratios is to use the Du$ont <odel. &he Du$ont <odel is a le to sho# a usiness o#ner #here the co!$onent $arts of the eturn of !ssets "or eturn on Investment ratio co!es fro! as #ell as the eturn on Equity ratio. ?or e%a!$le, did ROA co!e fro! net $rofit or asset turnoverI Did return on equity co!e fro! net $rofit, asset turnover, or the usiness' de t $ositionI &he DuFont !odel is very hel$ful to usiness o#ners in deter!ining in financial adBust!ents need to e !ade.

Debt to Equity Ratio

Once you have determined the debt to equity ratio for a particular company, you can get an idea of their capital stack. A ratio of 1, for example, indicates that the company funds its projects with an even mix of debt and equity. A low ratio (below about 0.30) is generally considered good, because the company has a low amount of debt, and is therefore exposed to less risk in terms of interest rate increases or credit rating. Generally, a high debt to equity ratio (2, for example) is worrisome, as it indicates a precarious amount of leverage. However, in some industries this is appropriate. Construction firms, for example, fund their projects almost entirely with debt in the form of construction loans. This leads to a high debt to equity ratio, but the firm is in no real risk of insolvency, as the owners of each construction project are essentially paying to service the debt themselves. When a company issues stock, shares are usually held on the balance sheet at par value (often only $0.01 per share). When the firm buys back stock, the treasury stock is recorded at the purchase price; this results in a massive subtraction from shareholder's equity, increasing the debt to equity ratio. A troublingly high debt to equity ratio may simply be the result of stock buybacks. The debt to equity ratio should never be used alone. For example, if a company's debt to equity ratio is quite high, you might reasonably worry about their ability to service their debt. To address this concern, you can also analyze the firm's interest coverage ratio, which is the company's operating income divided by debt service payments. A high operating income will allow even a debt-burdened firm to meets its obligations.

ebt to equity ratio is a long term solvency ratio that indicates the soundness of long#term financial policies of the company$ It shows the relation between the portion of assets provided by the the stoc%holders and the portion of assets provided by creditors$ It is calculated by dividing total liabilities by stoc%holder&s equity$ 'ebt to equity ratio is also %nown as (e)ternal#internal equity ratio*$

Example:
!BC company has applied for a loan$ The lender of the loan requests you to compute the debt to equity ratio as a part of the long#term solvency test of the company$ The (+iabilities and Stoc%holders& Equity* section of the balance sheet of !BC company is given below, Liabilities and Stockholders Equity Current liabilities:

Accounts payable Accrued payables Short-term notes payable

2,900 450 150

Total current liabilities Long-term liabilities: !" #onds payable

,500

,$50

Total liabilities

$,250

Stockholders equity: %re&erred stoc', (100, !" )ommon stoc', (12 par Additional paid-in capital 1,000 ,000 500 Total paid in capital *etained earnin+s 4,500 4,000 Total stoc'holders, e-uity .,500 Total liabilities and stoc'holders e-uity 15,$50 Required: Compute debt to equity ratio of !BC company$

Solution:

- ./012 3 4/122 - 2$41 The debt to equity ratio of !BC company is 2$41 or 2$41 , 5$ It means the creditors of !BC company provide 41 cents of assets for each 65 of assets provided by stoc%holders$

Significance and interpretation:

! ratio of 5 or 5 , 5 means that creditors and stoc%holders equally contribute to the assets of the business$ ! less than 5 ratio indicates that the portion of assets provided by stoc%holders is greater than the portion of assets provided by creditors and a greater than 5 ratio indicates that the portion of assets provided by creditors is greater than the portion of assets provided by stoc%holders$ Creditors usually li%e a low debt to equity ratio because a low ratio "less than 57 is the indication of greater protection to their money$ But stoc%holders li%e to get benefit from the funds provided by the creditors therefore they would li%e a high debt to equity ratio$ 'ebt equity ratio vary from industry to industry$ 'ifferent norms have been developed for different industries$ ! ratio that is ideal for one industry may be worrisome for another industry$ ! ratio of 5 , 5 is normally considered satisfactory for most of the companies$ ! company8s debt to equity ratio shows you what proportion of debt or equity a company is using to finance its assets$ The debt to equity ratio is calculated by dividing its total debt by its total shareholder equity, 'ebt3equity ratio - Total debt3shareholder equity ! high debt to equity ratio shows that the company has a relatively heavy debt load$

/i&&erent 'inds o& companies ha0e di&&erent debt to e-uity ratios1 2or e3ample, a ratio o& 2 is considered healthy &or capital-intensi0e industries li'e car ma'ers, 4hile so&t4are ma'ers could ha0e a ratio as lo4 as 0151 This is usually a bad sign for shares investors because the cost of servicing high debt levels can pressure a company8s earnings and ma%e them more volatile$ It can also do the same to its share price$

Debt is not necessarily a bad sign

9eavy debt is not always a danger sign though/ especially for capital#intensive industries li%e car manufacturing/ which typically have a debt to equity ratio higher than 0 and are still considered healthy$ In contrast/ software companies/ which do not need lots of e)pensive machinery to produce their goods/ tend to have a debt to equity ratio as low as 2$1$ !lso/ if money that has been borrowed is invested prudently it can boost a company8s future earnings$

The cost of borrowing is a significant factor

5& money that a company has borro4ed is +eneratin+ hi+her returns than it cost to borro4 it, a hi+h debt to e-uity ratio is not necessarily a bad thin+1 6eep an eye on interest rates and the company,s credit ratin+ to see ho4 its borro4in+ costs mi+ht chan+e1 :hat you the/ potential shareholder/ need to research is how much that debt is costing the company in interest$ If the earnings growth that the borrowed money generates is higher than the cost of borrowing it/ a high debt to equity ratio can be a positive for the company8s financial health and its share price$ For e)ample/ if a company has total debt of ;0 million and total assets of ;0 million/ this gives it a debt to equity ratio of 5$ If it then ta%es out a ;< million loan to buy a new production facility/ its debt to equity ratio will rise to an unhealthy#loo%ing =$ If however/ the new factory generates a >? return on assets and the interest on the loan is <?/ the relatively high debt to equity ratio is positive for the company and could boost its share price$

If interest rates on the debt later rise to .?/ the company is now paying more for its debt than the >? return on assets the factory is generating$ This could in the long term lead to ban%ruptcy/ and wipe out the value of the company8s shares$ Shares investors should therefore %eep an eye on national interest rates and on a company8s credit rating$ If interest rates are rising or a company8s credit rating falls/ it will have to pay more for its debt$ This will help you gauge how much of a potential problem a high debt to equity ratio might become$

Summary
So far you have learned that$$$

111 a company7s debt to e-uity ratio calculation sho4s you 4hat proportion o& debt or e-uity a company is usin+ to &inance its assets1 111 di&&erent 'inds o& companies ha0e di&&erent debt to e-uity ratios1 2or e3ample, a ratio o& 2 is considered healthy &or capital-intensi0e industries li'e car ma'ers, 4hile so&t4are ma'ers could ha0e a ratio as lo4 as 0151 111 i& the earnin+s +ro4th that the borro4ed money +enerates is hi+her than the cost o& borro4in+ it, a hi+h debt to e-uity ratio can be a positi0e &or the company7s &inancial health and its share price1 111 i& interest rates are risin+ or a company7s credit ratin+ &alls, it 4ill ha0e to pay more &or its debt1

! 9igh :or%ing Capital Turnover atio Indicates :hat@

Working capital is a crucial ingredient to running a small business. It is the money a business has available to spend on its operations after paying off its bills and short-term debts. The working capital turnover ratio measures how efficiently a business uses its working capital to produce sales. A higher ratio indicates greater efficiency. In general, a high ratio can help your companys operations run more smoothly and limit the need for additional funding.

Working Capital Calculation

:or%ing capital equals total current assets minus total current liabilities/ both of which are reported on the balance sheet$ Current assets include cash and other resources you e)pect to use or convert to cash within a year/ such as accounts receivable and inventory$ Current liabilities are debts you e)pect to pay off within a year/ such as accounts payable and short#term loans$ For e)ample/ if your small business has 6.22/222 in total current assets and 6122/222 in total current liabilities/ your wor%ing capital is 6022/222$

Working Capital Turnover Calculation

The wor%ing capital turnover ratio equals net sales for the year ## or sales minus refunds and discounts ## divided by average wor%ing capital$ !verage wor%ing capital equals wor%ing capital at the beginning of the year plus wor%ing capital at year#end/ divided by 0$ !ssume you have 60$5 million in net sales and 6022/222 and 6<22/222 in wor%ing capital at the beginning and end of the year/ respectively$ Aour average wor%ing capital is 6=22/222$ Aour wor%ing capital turnover ratio is ./ or 60$5 million divided by 6=22/222$

Determining a High Turnover Ratio

! wor%ing capital turnover ratio is generally considered high when it is greater than the turnover ratios of similar companies in the same industry$ Competitors& turnover ratios are a good benchmar% because these companies sell similar products and li%ely have similar business structures$ For e)ample/ if three of your close competitors have wor%ing capital turnover ratios of 1$1/ <$0 and 1/ your ratio of . is high because it e)ceeds theirs$

Benefits of a High Ratio

! high wor%ing capital turnover ratio can potentially give you a competitive edge in your industry$ It indicates you use up your wor%ing capital more times per year/ which suggests that money is flowing in and out of your small business smoothly$ This gives you more spending fle)ibility and can help avoid financial trouble$ If you e)perience more demand for your products/ you are less li%ely to suffer inventory shortages that sometimes come with rising sales$

Considerations
! wor%ing capital turnover that is too high can be misleading$ Bn the surface/ it appears that you are operating at a very high efficiency/ but in reality/ your wor%ing capital level might be dangerously low$ Cery low wor%ing capital can possibly cause you to run out of money to fund your business$ Dsing the previous e)ample/ assume you have the same net sales but instead have 612/222 in average wor%ing capital$ Aour turnover ratio would be <0 ## far too high for your industry$

Definition of 'Working Capital Turnover'

A !easure!ent co!$aring the de$letion of #or"ing ca$ital to the generation of sales over a given $eriod. &his $rovides so!e useful infor!ation as to ho# effectively a co!$any is using its #or"ing ca$ital to generate sales.

Investopedia explains 'Working Capital Turnover'

A co!$any uses #or"ing ca$ital (current assets ) current lia ilities) to fund o$erations and $urchase inventory. &hese o$erations and inventory are then converted into sales revenue for the co!$any. &he #or"ing ca$ital turnover ratio is used to analy>e the relationshi$ et#een the !oney used to fund o$erations and the sales generated fro! these o$erations. (n a general sense, the higher the #or"ing ca$ital turnover, the etter ecause it !eans that the co!$any is generating a lot of sales co!$ared to the !oney it uses to fund the sales. ?or e%a!$le, if a co!$any has current assets of 06. !illion and current lia ilities of 0/ !illion, its #or"ing ca$ital is 06 !illion. When co!$ared to sales of 063 !illion, the #or"ing ca$ital turnover ratio for the $eriod is 63 (063<9 06<). When used in funda!ental analysis, this ratio can e co!$ared to that of si!ilar co!$anies or to the co!$any's o#n historical #or"ing ca$ital turnovers.

Importance of Sales to Working Capital

An increasing ales to Working !apital ratio is usually a positive sign, indicating the company is more able to use its working capital to generate sales. Although measuring the performance of a company for "ust one period reveals how well it is using its cash for that single period, this ratio is much more effectively used over a number of periods. This ratio can help uncover #uestionable management decisions such as rela$ing credit re#uirements to potential customers to increase sales, increasing inventory levels to reduce order fulfillment cycle times, and slowing payment to vendors and suppliers in an effort to hold on to its cash.

- ee more at% http%&&www.spireframe.com&define&financial-ratio&sales-toworking-capital'sthash.()e*n+,y.dpuf

"or#ing Capital Turno$er Ratio

/escription8 The working capital turnover ratio measures ho4 4ell a company is utili9in+ its 4or'in+ capital to support a +i0en le0el o& sales1 :or'in+ capital is current assets minus current liabilities1 A hi+h turno0er ratio indicates that mana+ement is bein+ e3tremely e&&icient in usin+ a &irm7s shortterm assets and liabilities to support sales1 )on0ersely, a lo4 ratio indicates that a business is in0estin+ in too many accounts recei0able and in0entory assets to support its sales, 4hich could e0entually lead to an e3cessi0e amount o& bad debts and obsolete in0entory1 Formula, To calculate the ratio/ divide net sales by wor%ing capital "which is current assets minus current liabilities7$ The calculation is usually made on an annual basis/ and uses the average wor%ing capital during that period$ The calculation is, Eet sales "Beginning wor%ing capital F Ending wor%ing capital7 3 0 E)ample, !BC Company has 650/222/222 of net sales over the past twelve months/ and average wor%ing capital during that period of 60/222/222$ The calculation of its wor%ing capital turnover ratio is, 650/222/222 Eet sales 60/222/222 !verage wor%ing capital - >$2 :or%ing capital turnover ratio Cautions, !n e)tremely high wor%ing capital turnover ratio can indicate that a company does not have enough capital to support it sales growthG collapse of the company may be imminent$ This is a particularly strong indicator when the accounts payable component of wor%ing capital is very high/ since it indicates that management cannot pay its bills as they come due for payment$ !n e)cessively high turnover ratio can be spotted by comparing the ratio for a particular business to those reported elsewhere in its industry/ to see if the business is reporting outlier results$

%i&ilar Ter&s The wor%ing capital turnover ratio is also %nown as net sales to working capital$

Profitability Indicator Ratios: Profit Margin Analysis

(n the inco!e state!ent, there are four levels of $rofit or $rofit !argins ) gross $rofit,o$erating $rofit, $reta% $rofit and net $rofit. &he ter! C!arginC can a$$ly to the a solute nu! er for a given $rofit level and9or the nu! er as a $ercentage of net sales9revenues. Frofit !argin analysis uses the $ercentage calculation to $rovide a co!$rehensive !easure of a co!$any's $rofita ility on a historical asis (1)3 years) and in co!$arison to $eer co!$anies and industry ench!ar"s. Basically, it is the a!ount of $rofit (at the gross, o$erating, $reta% or net inco!e level) generated y the co!$any as a $ercent of the sales generated. &he o Bective of !argin analysis is to detect consistency or $ositive9negative trends in a co!$any's earnings. Fositive $rofit !argin analysis translates into $ositive invest!ent quality. &o a large degree, it is the quality, and gro#th, of a co!$any's earnings that drive its stoc" $rice. #ormulas$

"om%onents$

All the dollar a!ounts in these ratios are found in the inco!e state!ent. As of Dece! er 16, -..3, #ith a!ounts e%$ressed in !illions, Ei!!er 'oldings had net sales, or revenue, of 01,-24.6., #hich is the deno!inator in all of the $rofit !argin ratios. &he nu!erators for Ei!!er 'oldings' ratios are ca$tioned as Cgross $rofitC, Co$erating $rofitC, Cearnings efore inco!e ta%es, !inority interest and cu!ulative effect of change in accounting $rinci$leC, and Cnet earningsC, res$ectively. By si!$ly dividing, the equations give us the $ercentage $rofit !argins indicated. &ariations$ @one "ommentary$ ?irst, a fe# re!ar"s a out the !echanics of these ratios are in order. When it co!es to finding the relevant nu! ers for !argin analysis, #e re!ind readers that the ter!s* Cinco!eC, C$rofitsC and CearningsC are used interchangea ly in financial re$orting. Also, the account ca$tions for the various $rofit levels can vary, ut generally are self)evident no !atter #hat ter!inology is used. ?or e%a!$le, Ei!!er 'oldings' $reta% (our shorthand for $rofit efore the $rovision for the $ay!ent of ta%es) is a literal, ut rather lengthy, descri$tion of the account. =econd, inco!e state!ents in the !ulti)ste$ for!at clearly identify the four $rofit levels. 'o#ever, #ith the single)ste$ for!at the investor !ust calculate the gross $rofit and o$erating $rofit !argin nu! ers. &o o tain the gross $rofit a!ount, si!$ly su tract the cost of sales (cost of goods sold) fro! net sales9revenues. &he o$erating $rofit a!ount is o tained y su tracting the su! of the co!$any's o$erating e%$enses fro! the gross

$rofit a!ount. Jenerally, o$erating e%$enses #ould include such account ca$tions as selling, !ar"eting and ad!inistrative, research and develo$!ent, de$reciation and a!orti>ation, rental $ro$erties, etc. &hird, investors need to understand that the a solute nu! ers in the inco!e state!ent don't tell us very !uch, #hich is #hy #e !ust loo" to !argin analysis to discern a co!$any's true $rofita ility. &hese ratios hel$ us to "ee$ score, as !easured over ti!e, of !anage!ent's a ility to !anage costs and e%$enses and generate $rofits. &he success, or lac" thereof, of this i!$ortant !anage!ent function is #hat deter!ines a co!$any's $rofita ility. A large gro#th in sales #ill do little for a co!$any's earnings if costs and e%$enses gro# dis$ro$ortionately. ,astly, the $rofit !argin $ercentage for all the levels of inco!e can easily e translated into a handy !etric used frequently y analysts and often !entioned in invest!ent literature. &he ratio's $ercentage re$resents the nu! er of $ennies there are in each dollar of sales. ?or e%a!$le, using Ei!!er 'oldings' nu! ers, in every sales dollar for the co!$any in -..3, there's roughly A2K, 1-K, 1-K, and --K cents of gross, o$erating, $reta%, and net inco!e, res$ectively. ,et's loo" at each of the $rofit !argin ratios individually* (ross )rofit 'argin ) A co!$any's cost of sales, or cost of goods sold, re$resents the e%$ense related to la or, ra# !aterials and !anufacturing overhead involved in its $roduction $rocess. &his e%$ense is deducted fro! the co!$any's net sales9revenue, #hich results in a co!$any's first level of $rofit, or gross $rofit. &he gross $rofit !argin is used to analy>e ho# efficiently a co!$any is using its ra# !aterials, la or and !anufacturing)related fi%ed assets to generate $rofits. A higher !argin $ercentage is a favora le $rofit indicator. (ndustry characteristics of ra# !aterial costs, $articularly as these relate to the sta ility or lac" thereof, have a !aBor effect on a co!$any's gross !argin. Jenerally, !anage!ent cannot e%ercise co!$lete control over such costs. Co!$anies #ithout a $roduction $rocess (e%., retailers and service usinesses)

don't have a cost of sales e%actly. (n these instances, the e%$ense is recorded as a Ccost of !erchandiseC and a Ccost of servicesC, res$ectively. With this ty$e of co!$any, the gross $rofit !argin does not carry the sa!e #eight as a $roducer)ty$e co!$any. O%erating )rofit 'argin ) By su tracting selling, general and ad!inistrative (=JLA), or o$erating, e%$enses fro! a co!$any's gross $rofit nu! er, #e get o$erating inco!e. <anage!ent has !uch !ore control over o$erating e%$enses than its cost of sales outlays. &hus, investors need to scrutini>e the o$erating $rofit !argin carefully. Fositive and negative trends in this ratio are, for the !ost $art, directly attri uta le to !anage!ent decisions. A co!$any's o$erating inco!e figure is often the $referred !etric (dee!ed to e !ore relia le) of invest!ent analysts, versus its net inco!e figure, for !a"ing inter)co!$any co!$arisons and financial $roBections. )reta3 )rofit 'argin ) Again !any invest!ent analysts $refer to use a $reta% inco!e nu! er for reasons si!ilar to those !entioned for o$erating inco!e. (n this case a co!$any has access to a variety of ta%)!anage!ent techniques, #hich allo# it to !ani$ulate the ti!ing and !agnitude of its ta%a le inco!e. Net )rofit 'argin ) Often referred to si!$ly as a co!$any's $rofit !argin, the so)called otto! line is the !ost often !entioned #hen discussing a co!$any's $rofita ility. While undenia ly an i!$ortant nu! er, investors can easily see fro! a co!$lete $rofit !argin analysis that there are several inco!e and e%$ense o$erating ele!ents in an inco!e state!ent that deter!ine a net $rofit !argin. (t ehooves investors to ta"e a co!$rehensive loo" at a co!$any's $rofit !argins on a syste!atic asis.