Liquidity Analysis 1. Current Ratio

LIQUIDITY ANALYSIS
1. Current Ratio
The current ratio is a liquidity andefficiency ratio that measures a firm's ability to pay off its short-term liabilities with its current
assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.
This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets like
cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that companies
with larger amounts of current assets will more easily be able to pay off current liabilities when they become due without having
to sell off long-term, revenue generating assets.
Formula:
The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric format rather than in
decimal format. Here is the calculation:
GAAP requires that companies separate current and long-term assets and liabilities on thebalance sheet. This split allows
investors and creditors to calculate important ratios like the current ratio. On U.S. financial statements, current accounts are
always reported before long-term accounts.
Analysis
The current ratio helps investors and creditors understand the liquidity of a company and how easily that company will be able
to pay off its current liabilities. This ratio expresses a firm's current debt in terms of current assets. So a current ratio of 4 would
mean that the company has 4 times more current assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio because it shows the company can more easily make
current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company isn't making enough from
operations to support activities. In other words, the company is losing money. Sometimes this is the result of poor collections of
accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down with a current
debt, its cash flow will suffer.
Example:
Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is applying for loans to help fund his dream of
building an indoor skate rink. Charlie's bank asks for his balance sheet so they can analysis his current debt levels. According to
Charlie's balance sheet he reported $100,000 of current liabilities and only $25,000 of current assets. Charlie's current ratio
would be calculated like this:
As you can see, Charlie only has enough current assets to pay off 25 percent of his current liabilities. This shows that Charlie is
highly leveraged and highly risky. Banks would prefer a current ratio of at least 1 or 2, so that all the current liabilities would be
covered by the current assets. Since Charlie's ratio is so low, it is unlikely that he will get approved for his loan.
2. Quick Ratio
The quick ratio or acid test ratio is aliquidity ratio that measures the ability of a company to pay its current liabilities when they
come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-
term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered
quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be
converted into cash within the next 90 days. Marketable securities are traded on an open market with a known price and readily
available buyers. Any stock on the New York Stock Exchange would be considered a marketable security because they can easily
be sold to any investor when the market is open.
The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early
miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base
metal and of no value.
The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay off its current
liabilities. It also shows the level of quick assets to current liabilities.
Formula
The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current receivables together then
dividing them by current liabilities.
Sometimes company financial statements don't give a breakdown of quick assets on thebalance sheet. In this case, you can still
calculate the quick ratio even if some of the quick asset totals are unknown. Simply subtract inventory and any current prepaid
assets from the current asset total for the numerator. Here is an example.
Analysis
The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets. If a
firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to
sell off any long-term orcapital assets.
Since most businesses use their long-term assets to generate revenues, selling off these capital assets will not only hurt the
company it will also show investors that current operations aren't making enough profits to pay off current liabilities.
Higher quick ratios are more favorable for companies because it shows there are more quick assets than current liabilities. A
company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay off
its current liabilities without selling any long-term assets. An acid ratio of 2 shows that the company has twice as many quick
assets than current liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More assets will be easily converted into cash if need be.
This is a good sign for investors, but an even better sign to creditors because creditors want to know they will be paid back on
time.
Example
Let's assume Carole's Clothing Store is applying for a loan to remodel the storefront. The bank asks Carole for a detailed balance
sheet, so it can compute the quick ratio. Carole's balance sheet included the following accounts:
Cash: $10,000
Accounts Receivable: $5,000
Inventory: $5,000
Stock Investments: $1,000
Prepaid taxes: $500
Current Liabilities: $15,000
The bank can compute Carole's quick ratio like this.
As you can see Carole's quick ratio is 1.07. This means that Carole can pay off all of her current liabilities with quick assets and
still have some quick assets left over.
Now let's assume the same scenario except Carole did not provide the bank with a detailed balance sheet. Instead Carole's
balance sheet only included these accounts:
Inventory: $5,000
Prepaid taxes: $500
Total Current Assets: $21,500
Current Liabilities: $15,000
Since Carole's balance sheet doesn't include the breakdown of quick assets, the bank can compute her quick ratio like this:
ASSET MANAGEMENT ANALYSIS
3. Accounts Receivable Turnover Ratio
Accounts receivable turnover is anefficiency ratio or activity ratio that measures how many times a business can turn its
accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times
a business can collect its average accounts receivable during the year.
A turn refers to each time a company collects its average receivables. If a company had $20,000 of average receivables during
the year and collected $40,000 of receivables during the year, the company would have turned its accounts receivable twice
because it collected twice the amount of average receivables.
This ratio shows how efficient a company is at collecting its credit sales from customers. Some companies collect their
receivables from customers in 90 days while other take up to 6 months to collect from customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are more liquid the faster they
can covert their receivables into cash.
Formula
Accounts receivable turnover is calculated by dividing net credit sales by the average accounts receivable for that period.
The reason net credit sales are used instead of net sales is that cash sales don't create receivables. Only credit sales establish a
receivable, so the cash sales are left out of the calculation. Net sales simply refers to sales minus returns and refunded sales.
The net credit sales can usually be found on the company's income statement for the year although not all companies report
cash and credit sales separately. Average receivables is calculated by adding the beginning and ending receivables for the year
and dividing by two. In a sense, this is a rough calculation of the average receivables for the year.
Analysis
Since the receivables turnover ratio measures a business' ability to efficiently collect itsreceivables, it only makes sense that a
higher ratio would be more favorable. Higher ratios mean that companies are collecting their receivables more frequently
throughout the year. For instance, a ratio of 2 means that the company collected its average receivables twice during the year.
In other words, this company is collecting is money from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from customers sooner, it will be
able to use that cash to pay bills and other obligations sooner.
Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A company with a higher ratio
shows that credit sales are more likely to be collected than a company with a lower ratio. Since accounts receivable are often
posted as collateral for loans, quality of receivables is important.
Example
Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to all of his main customers. At the end of
the year, Bill's balance sheet shows $20,000 in accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last
year's balance sheet showed $10,000 of accounts receivable.
The first thing we need to do in order to calculate Bill's turnover is to calculate net credit sales and average accounts receivable.
Net credit sales equals gross credit sales minus returns (75,000 25,000 = 50,000). Average accounts receivable can be
calculated by averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Bill's accounts receivable turnover ratio for the year can be like this.
As you can see, Bill's turnover is 3.33. This means that Bill collects his receivables about 3.3 times a year or once every 110 days.
In other words, when Bill makes a credit sale, it will take him 110 days to collect the cash from that sale.
4.Receivable Turnover in Days / Days Sales Outstanding
The days sales outstanding calculation, also called the average collection period or days' sales in receivables, measures the
number of days it takes a company to collect cash from its credit sales. This calculation shows the liquidity and efficiency of a
company's collections department.
In other words, it shows how well a company can collect cash from its customers. The sooner cash can be collected, the sooner
this cash can be used for other operations. Both liquidity and cash flows increase with a lower days sales outstanding
measurement.
Formula
The ratio is calculated by dividing the ending accounts receivable by the total credit sales for the period and multiplying it by the
number of days in the period. Most often this ratio is calculated at year-end and multiplied by 365 days.
Accounts receivable can be found on the year-end balance sheet. Credit sales, however, are rarely reported separate from gross
sales on the income statement. The credit sales figure will most often have to be provided by the company.
This formula can also be calculated by using the accounts receivable turnover ratio
Analysis
The days sales outstanding formula shows investors and creditors how well companies' can collect cash from their customers.
Obviously, sales don't matter if cash is never collected. This ratio measures the number of days it takes a company to convert its
sales into cash.
A lower ratio is more favorable because it means companies collect cash earlier from customers and can use this cash for other
operations. It also shows that the accounts receivables are good and won't be written off as bad debts.
A higher ratio indicates a company with poor collection procedures and customers who are unable or unwilling to pay for their
purchases. Companies with high days sales ratios are unable to convert sales into cash as quickly as firms with lower ratios.
Example
Devin's Long Boards is a retailer that offers credit to customers. Devin often selling inventory to customers on account with the
agreement that these customers will pay for the merchandise within 30 days. Some customers promptly pay for their goods,
while others are delinquent. Devin's year-end financial statements list the following accounts:
Accounts Receivable: $15,000
Net Credit Sales: $175,000
Devin's days sales is calculated like this:
As you can see, it takes Devin approximately 31 days to collect cash from his customers on average. This is a good ratio since
Devin is aiming for a 30 day collection period.
5. Inventory Turnover Ratio
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods
sold with average inventory for a period. This measures how many times average inventory is "turned" or sold during a period.
In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A
company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components of performance. The first component is stock
purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of
inventory to improve its turnover. If the company can't sell these greater amounts of inventory, it will incur storage costs and
other holding costs. The second component is sales. Sales have to match inventory purchases otherwise the inventory will not
turn effectively. That's why the purchasing and sales departments must be in tune with each other.
Formula
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
Average inventory is used instead of ending inventory because many companies' merchandise fluctuates greatly throughout the
year. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year. By
December almost the entire inventory is sold and the ending balance does not accurately reflect the company's actual inventory
during the year. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.
The cost of goods sold is reported on the income statement.
Analysis
Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is important to have a high turn.
This shows the company does not overspend by buying too much inventory and wastes resources by storing non-salable
inventory. It also shows that the company can effectively sell the inventory it buys.
This measurement also shows investors how liquid a company's inventory is. Think about it. Inventory is one of the biggest
assets a retailer reports on its balance sheet. If this inventory can't be sold, it is worthless to the company. This measurement
shows how easily a company can turn its inventory into cash.
Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks want to know that this
inventory will be easy to sell.
Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic car industry.
Example
Donny's Furniture Company sells industrial furniture for office buildings. During the current year, Donny reported cost of goods
sold on its income statement of $1,000,000. Donny's beginning inventory was $3,000,000 and its ending inventory was
$4,000,000. Donny's turnover is calculated like this:
As you can see, Donny's turnover is .29. This means that Donny only sold roughly a third of its inventory during the year. It also
implies that it would take Donny approximately 3 years to sell his entire inventory or complete one turn. In other words, Danny
does not have very good inventory control.
6. Inventory Turnover in Days / Days Sales in Inventory
The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory, measures the number
of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a
company's current stock of inventory will last.
This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash flows. Both investors
and creditors want to know how valuable a company's inventory is. Older, more obsolete inventory is always worth less than
current, fresh inventory. The days sales in inventory shows how fast the company is moving its inventory. In other words, it
shows how fresh the inventory is.
This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company can convert its
inventory into cash sooner. In other words, the inventory is extremely liquid.
Along the same line, more liquid inventory means the company's cash flows will be better.
Formula
The days sales inventory is calculated by dividing the ending inventory by the cost of goods sold for the period and multiplying it
by 365.
Ending inventory is found on the balance sheet and the cost of goods sold is listed on the income statement. Note that you can
calculate the days in inventory for any period, just adjust the multiple.
Since this inventory calculation is based on how many times a company can turn its inventory, you can also use the inventory
turnover ratio in the calculation. Just divide 365 by the inventory turnover ratio
Days inventory usually focuses on ending inventory whereas inventory turnover focuses on average inventory.
Analysis
The days sales in inventory is a key component in a company's inventory management. Inventory is a expensive for a company
to keep, maintain, and store. Companies also have to be worried about protecting inventory from theft and obsolescence.
Management wants to make sure its inventory moves as fast as possible to minimize these costs and to increase cash flows.
Remember the longer the inventory sits on the shelves, the longer the company's cash can't be used for other operations.
Management strives to only buy enough inventories to sell within the next 90 days. If inventory sits longer than that, it can start
costing the company extra money.
It only makes sense that lower days inventory outstanding is more favorable than higher ratios.
Example
Keith's Furniture Company's management have been extremely happy with their sales staff because they have been moving
more inventory this year than in any previous year. At the end of the year, Keith's financial statements show an ending inventory
of $50,000 and a cost of good sold of $150,000. Keith's days sales in inventory is calculated like this:
As you can see, Keith's ratio is 122 days. This means Keith has enough inventories to last the next 122 days or Keith will turn his
inventory into cash in the next 122 days. Depending on Keith's industry, this length of time might be short or long.
7. Operating Cycle
GAAP requires that assets and liabilities must be broken out into current and non-current categories on a balance sheet. This
allows thefinancial statement user to see what assets will be used and what liabilities will come due in the current year or
current operating cycle.
An operating cycle is the amount of time a company spends between spending money operating activities and collecting money
from the same operating activity. Operating cycle often focus on the purchase and sale of assets. For instance a retailer's
operating cycle would be the time between buying merchandise inventory and selling the same inventory. A manufacturer's
operating cycle might start when the company spends money on raw manufacturing materials to make a product. The operating
cycle wouldn't end until the products are produced and sold to retailers or wholesalers.
Most companies try to keep their operating cycles at a year or less. This means that it would take a retailer an entire year to sell
its inventory. Depending on the industry, this kind of an inventory turn might be unacceptable. Operating cycles are important
because they determine cash flow. If a company is able to keep a short operating cycle, its cash flow will consistent and the
company won't have problems paying current liabilities. Conversely, long operating cycle means that current assets are not
being turned into cash very quickly. In other words, cash is not being collected from customer very quickly. Companies with
longer operating cycles often have to borrow from banks in order to pay short term liabilities. These companies are often less
profitable because of these extra loans.
8. Accounts Payable Turnover Ratio
The accounts payable turnover ratio is a liquidity ratio that shows a company's ability to pay off its accounts payable by
comparing net credit purchases to the average accounts payable during a period. In other words, the accounts payable turnover
ratio is how many times a company can pay off its average accounts payable balance during the course of a year.
This ratio helps creditors analyze the liquidity of a company by gauging how easily a company can pay off its current suppliers
and vendors. Companies that can pay off supplies frequently throughout the year indicate to creditor that they will be able to
make regular interest and principle payments as well.
Vendors also use this ratio when they consider establishing a new line of credit or floor plan for a new customer. For instance,
car dealerships and music stores often pay for their inventory with floor plan financing from their vendors. Vendors want to
make sure they will be paid on time, so they often analyze the company's payable turnover ratio.
Formula
The accounts payable turnover formula is calculated by dividing the total purchases by the average accounts payable for the
year.
The total purchases number is usually not readily available on any general purpose financial statement. Instead, total purchases
will have to be calculated by adding the ending inventory to the cost of goods sold and subtracting the beginning inventory.
Most companies will have a record of supplier purchases, so this calculation may not need to be made.
The average payables is used because accounts payable can vary throughout the year. The ending balance might be
representative of the total year, so an average is used. To find the average accounts payable, simply add the beginning and
ending accounts payable together and divide by two.
Analysis
Since the accounts payable turnover ratio indicates how quickly a company pays off its vendors, it is used by supplies and
creditors to help decide whether or not to grant credit to a business. As with most liquidity ratios, a higher ratio is almost always
more favorable than a lower ratio.
A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. It also implies that new
vendors will get paid back quickly. A high turnover ratio can be used to negotiate favorable credit terms in the future.
As with all ratios, the accounts payable turnover is specific to different industries. Every industry has a slightly different
standard. This ratio is best used to compare similar companies in the same industry.
Example
Bob's Building Suppliers buys constructions equipment and materials from wholesalers and resells this inventory to the general
public in its retail store. During the current year Bob purchased $1,000,000 worth of construction materials from his vendors.
According to Bob'sbalance sheet, his beginning accounts payable was $55,000 and his ending accounts payable was $958,000.
Here is how Bob's vendors would calculate his payable turnover ratio:
As you can see, Bob's average accounts payable for the year was $506,500 (beginning plus ending divided by 2). Based on this
formula Bob's turnover ratio is 1.97. This means that Bob pays his vendors back on average once every six months of twice a
year. This is not a high turnover ratio, but it should be compared to others in Bob's industry.
9. Payable Turnover in Days / Days Payable Outstanding (DPO)
The days payable outstanding (DPO) is a financial ratio that calculates the average time it takes a company to pay its bills and
invoices to other company and vendors by comparing accounts payable, cost of sales, and number of days bills remain unpaid.
Definition What is Days Payable Outstanding (DPO)?
In other words, DPO means the average number of days a company takes to pay invoices from suppliers and vendors. Typically,
this ratio is measured on a quarterly or annual basis to judge how well the companys cash flow balances are being managed. For
instance, a company that takes longer to pay its bills has access to its cash for a longer period and is able to do more things with
it during that period.
For example, lets assume Company A purchases raw material, utilities, and services from its vendors on credit to manufacture a
product. This credit or accounts payable isnt due for 30 days. This means that the company can use the resources from its
vendor and keep its cash for 30 days. This cash could be used for other operations or an emergency during the 30-day payment
period. DPO takes the average of all payables owed at a point in time and compares them with the average number of days they
will need to be paid.
The importance of DPO becomes obvious. A company with a high DPO can deploy its cash for productive measures such as
managing operations, producing more goods, or earning interestinstead of paying its invoices upfront.
Lets take a look at the equation and how to calculate DPO.
Formula
The days payable outstanding formula is calculated by dividing the accounts payable by the derivation of cost of sales and the
average number of days outstanding. Heres what the equation looks like:
Days Payable Outstanding = [ Accounts Payable / ( Cost of Sales / Number of days ) ]
The DPO calculation consists of two three different terms.
Accounts Payable this is the amount of money that a company owes a vendor or supplier for a purchase that was made on
credit. This total number can be found on the balance sheet.
Cost of Sales this is the total cost incurred by the company in manufacturing the product or bringing the product to a level at
which it can be sold to the customer. It includes all direct costs such as raw material, utilities, transportation cost, and rent
directly applicable to manufacturing. This can be found on the income statement of a company.
Number of days this is the actual number of days that the account payable and cost of sales in based (for example 365 days).
Lets take a look at a DPO example.
Example
Ted owns a clothing manufacturer that purchases materials from several vendors. At the end of the year, his accounts payable
on the balance sheet was $1,000,000. On average, he paid $15,000 ( $5,475,000 / 365 days ) of invoices each day. Ted would
calculate his DPO like this:
This means that Ted pays his invoices 67 days after receiving them on average.
Now lets make the example a little more complicated and include money that Ted will collect from customers. Here are some
terms from his latest purchases from vendors and sales to customers.
Accounts Payable: $100
Due date of A/P: 10 days
Accounts receivable from sales to customers: $100
Due date of A/R: 5 days
In the above, over simplified example, we are assuming that Ted has to pay $100 in 10 days to his vendors and he will receive
$100 from his customers in 5 days. So the net impact of these transactions will be that the company can hold on to $100 for 5
days. Hypothetically, if the interest rate is 1 percent, then in 5 days the company can earn $1 (1% of $100 in 5 days) without
even charging a margin to its customers (remember the company bought goods for $100 and sold the finished product for the
same price).
There are several factors at play which define the level of DPO, primary among them are:
1) Type of industry
2) Competitive positioning of a company A market leader with significant purchasing power can negotiate favorable terms with
its supplier so as to have a very high DPO.
3) Competitiveness if there are many suppliers with little differentiation than they will have to offer longer payment cycle to
gain business from a client.
Ultimately, the DPO may depend on the contract between the vendor and the company. The vendor might offer discounts for
early payment. In that case, the company will have to weigh the option of holding on the cash versus availing the discount.
Lets look at a Real World Example
Consider the case of Wal-Mart and Tesco. These retail giants have significant market clout, which allows them to negotiate
better deals with their suppliers and pay as late as possible. In the case of Wal-Mart the DPO has hovered around 38- 39 days for
last 3-4 years, implying that Wal-Mart might be typically paying its suppliers after more than a month of sourcing the products
from them. On the other hand, Tesco has a DPO of ~60 days, implying two month lag in payment to suppliers. Days Payable
Outstanding (unit - number of days)
Analysis and Interpretation
DPO is an important financial ratio that investors look at to gauge the operational efficiency of a company. A higher DPO means
that the company is taking longer to pay its vendors and suppliers than a company with a smaller DPO. Companies with high
DPOs have advantages because they are more liquid than companies with smaller DPOs and can use their cash for short-term
investments.
A high ratio also has disadvantages. Vendors and suppliers might get mad that they arent being paid early and refuse to do
business with the company or refuse to give discounts. Days payable outstanding walks the line between improving company
cash flow and keeping vendors happy.
Its important to always compare a companys DPO to other companies in the same industry to see if that company is paying its
invoices too quickly or too slowly. If a company is paying invoices in 20 days and the industry is paying them in 45 days, the
company is at a disadvantage because its not able to use its cash as long as the other companies in its industry. It may want to
lengthen its payment periods to improve its cash flow as long as this doesnt mean losing an early payment discount or hurting a
vendor relationship.
Talking about Wal-Mart, it has a DPO of 39 days, while the industry average is for example 30 days. This might imply that Wal-
Mart has been able to negotiate better terms with the suppliers compared to the broader industry. We need to be careful while
selecting the peers for comparison. DPO can be impacted by product mix (for example Amazon might have very high DPO
because of its historical business of books which tend to have longer payment cycle).
Investors also compare the current DPO with the companys own historical range. A consistent decline in DPO might signal
towards changing product mix, increased competition, or reduction in purchasing power of a company. For example, Wal-Mart
has historically had DPO as high as 44-46 days, but with the increase in competition (especially from the online retails) it has
been forced to ease the terms with its suppliers.
Usage Explanations and Cautions
A company has to maintain the delicate balance of improving DPO and not pushing its supplier too much to spoil the relationship
completely. A company can employ several techniques to improve DPO, few of them are
1) Identify products with shortest DPO and formulating ways to improve the DPO of that product either by re-negotiating with
the supplier or changing suppliers
2) Change product mix
3) Internal restructuring of the operations team to improve the efficiency of payable processing.
In conclusion, Days Payable Outstanding (DPO) is a key metric to analyze the operational efficiency of a company and can act as
an important source of generating extra returns for the investors, but it should always be viewed relative to the industry and
product mix. For example, just because one company has a higher ratio than another company doesnt mean that company is
running more efficiently. The lower company might be getting more favorable early pay discounts than the other company and
thus they always pay their bills early.
Its important to keep all of these things in mind when analyzing the days outstanding payable ratio.
10. CASH CYCLE / Cash Conversion Cycle
The cash conversion cycle is a cash flow calculation that attempts to measure the time it takes a company to convert its
investment in inventory and other resource inputs into cash. In other words, the cash conversion cycle calculation measures
how long cash is tied up in inventory before the inventory is sold and cash is collected from customers.
The cash cycle has three distinct parts. The first part of the cycle represents the current inventory level and how long it will take
the company to sell this inventory. This stage is calculated by using the days inventory outstanding calculation.
The second stage of the cash cycle represents the current sales and the amount of time it takes to collect the cash from these
sales. This is calculated by using the days sales outstanding calculation.
The third stage represents the current outstanding payables. In other words, this represents how much a company owes its
current vendors for inventory and goods purchases and when the company will have to pay off its vendors. This is calculated by
using the days payables outstanding calculation.
Formula
The cash conversion cycle is calculated by adding the days inventory outstanding to the days sales outstanding and subtracting
the days payable outstanding.
All three of these smaller calculations will have to be made before the CCC can be calculated.
Analysis
The cash conversion cycle measures how many days it takes a company to receive cash from a customer from its initial cash
outlay for inventory. For example, a typical retailer buys inventory on credit from its vendors. When the inventory is purchased,
a payable is established, but cash isn't actually paid for some time.
The payable is paid within 30 days and the inventory is marketed to customers and eventually sold to a customer on account.
The customer then pays for the inventory within 30 days of purchasing it.
The cash cycle measures the amount of days between paying the vendor for the inventory and when the retailer actually
receives the cash from the customer.
As with most cash flow calculations, smaller or shorter calculations are almost always good. A small conversion cycle means that
a company's money is tied up in inventory for less time. In other words, a company with a small conversion cycle can buy
inventory, sell it, and receive cash from customers in less time.
In this way, the cash conversion cycle can be viewed as a sales efficiency calculation. It shows how quickly and efficiently a
company can buy, sell, and collect on its inventory.
Example
Tim's Tackle is a retailer that sells outdoor and fishing equipment. Tim buys its inventory from one main vendor and pays its
accounts within 10 days in order to get a purchase discount. Tim has a fairly high inventory turnover ratio for his industry and
can collect accounts receivable from his customer within 30 days on average.
Tim's days calculations are as follows:
DIO represents days inventory outstanding: 15 days
DSO represents days sales outstanding: 2 days
DPO represents days payable outstanding: 12 days
Tim's conversion cycle is calculated like this:
As you can see, Tim's cash conversion cycle is 5 days. This means it takes Tim 5 days from paying for his inventory to receive the
cash from its sale. Tim would have to compare his cycle to other companies in his industry over time to see if his cycle is
reasonable or needs to be improved.
11. Fixed Asset Turnover Ratio
The fixed asset turnover ratio is an efficiency ratio that measures a companies return on their investment in property, plant, and
equipment by comparing net sales with fixed assets. In other words, it calculates how efficiently a company is a producing sales
with its machines and equipment.
Investors and creditors use this formula to understand how well the company is utilizing their equipment to generate sales. This
concept is important to investors because they want to be able to measure an approximate return on their investment. This is
particularly true in the manufacturing industry where companies have large and expensive equipment purchases. Creditors, on
the other hand, want to make sure that the company can produce enough revenues from a new piece of equipment to pay back
the loan they used to purchase it.
Management typically doesnt use this calculation that much because they have insider information about sales figures,
equipment purchases, and other details that arent readily available to external users. They measure the return on their
purchases using more detailed and specific information.
Lets take a look at how to calculate fixed asset turnover.
Formula
The fixed asset turnover ratio formula is calculated by dividing net sales by the total property, plant, and equipment net of
accumulated depreciation.
As you can see, its a pretty simple equation. Since using the gross equipment values would be misleading, we always use the net
asset value thats reported on the balance sheet by subtracting the accumulated depreciation from the gross.
Businesses often purchase and sell equipment throughout the year, so its common for investors and creditors to use an average
net asset figure for the denominator by adding the beginning balance to the ending balance and dividing by two.
Analysis
A high turn over indicates that assets are being utilized efficiently and large amount of sales are generated using a small amount
of assets. It could also mean that the company has sold off its equipment and started to outsource its operations. Outsourcing
would maintain the same amount of sales and decrease the investment in equipment at the same time.
A low turn over, on the other hand, indicates that the company isnt using its assets to their fullest extent. This could be due to a
variety of factors. For example, they might be producing products that no one wants to buy. Also, they might have
overestimated the demand for their product and overinvested in machines to produce the products. It might also be low
because of manufacturing problems like a bottleneck in the value chain that held up production during the year and resulted in
fewer than anticipated sales.
Keep in mind that a high or low ratio doesnt always have a direct correlation with performance. There are a few outside factors
that can also contribute to this measurement.
Accelerated depreciation is one of the main factors. Remember we always use the net PPL by subtracting the depreciation from
gross PPL. If a company uses an accelerated depreciation method like double declining depreciation, the book value of their
equipment will be artificially low making their performance look a lot better than it actually is.
Similarly, if a company doesnt keep reinvesting in new equipment, this metric will continue to rise year over year because the
accumulated depreciation balance keeps increasing and reducing the denominator. Thus, if the companys PPL are fully
depreciated, their ratio will be equal to their sales for the period. Investors and creditors have to be conscious of this fact when
evaluating how well the company is actually performing.
Lets take a look at an example.
Example
Jeffs Car Restoration is a custom car shop that builds custom hotrods and restores old cars to their former glory. Jeff is applying
for a loan to build a new facility and expand his operations. His sales for the year are $250,000 using equipment he paid
$100,000 for. The accumulated deprecation on the equipment is $50,000.
Heres how the bank would calculate Jeffs turn over.
As you can see, Jeff generates five times more sales than the net book value of his assets. The bank should compare this metric
with other companies similar to Jeffs in his industry. A 5x metric might be good for the architecture industry, but it might be
horrible for the automotive industry that is dependent on heavy equipment.
Its always important to compare ratios with other companies in the industry.
12. Asset Turnover Ratio
The asset turnover ratio is an efficiency ratio that measures a company's ability to generate sales from its assets by comparing
net sales with average total assets. In other words, this ratio shows how efficiently a company can use its assets to generate
sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how many sales are generated from each
dollar of company assets. For instance, a ratio of .5 means that each dollar of assets generates 50 cents of sales.
Formula
The asset turnover ratio is calculated by dividing net sales by average total assets.
Net sales, found on the income statement, are used to calculate this ratio returns and refunds must be backed out of total sales
to measure the truly measure the firm's assets' ability to generate sales.
Average total assets are usually calculated by adding the beginning and ending total asset balances together and dividing by two.
This is just a simple average based on a two-yearbalance sheet. A more in-depth, weighted average calculation can be used, but
it is not necessary.
Analysis
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always more favorable. Higher
turnover ratios mean the company is using its assets more efficiently. Lower ratios mean that the company isn't using its assets
efficiently and most likely have management or production problems.
For instance, a ratio of 1 means that the net sales of a company equals the average total assets for the year. In other words, the
company is generating 1 dollar of sales for every dollar invested in assets.
Like with most ratios, the asset turnover ratio is based on industry standards. Some industries use assets more efficiently than
others. To get a true sense of how well a company's assets are being used, it must be compared to other companies in its
industry.
The total asset turnover ratio is a general efficiency ratio that measures how efficiently a company uses all of its assets. This
gives investors and creditors an idea of how a company is managed and uses its assets to produce products and sales.
Sometimes investors also want to see how companies use more specific assets like fixed assets and current assets. The fixed
asset turnover ratio and the working capital ratio are turnover ratios similar to the asset turnover ratio that are often used to
calculate the efficiency of these asset classes.
Example
Sally's Tech Company is a tech start up company that manufactures a new tablet computer. Sally is currently looking for new
investors and has a meeting with an angel investor. The investor wants to know how well Sally uses her assets to produce sales,
so he asks for her financial statements.
Here is what the financial statements reported:
Beginning Assets: $50,000
Ending Assets: $100,000

Net Sales: $25,000
The total asset turnover ratio is calculated like this:
As you can see, Sally's ratio is only .33. This means that for every dollar in assets, Sally only generates 33 cents. In other words,
Sally's start up in not very efficient with its use of assets.
DEBT MANAGEMENT ANALYSIS
13. Debt to Equity Ratio
The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt to total equity. The debt to equity
ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio
indicates that more creditor financing (bank loans) is used than investor financing (shareholders).
Formula
The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt to equity ratio is considered a balance
sheet ratio because all of the elements are reported on the balance sheet.
Analysis
Each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A
debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are
funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while
creditors only own 33.3 cents on the dollar.
A debt to equity ratio of 1 would mean that investors and creditors have an equal stake in the business assets.
A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are
considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid
to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive
form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments.
Creditors view a higher debt to equity ratio as risky because it shows that the investors haven't funded the operations as much
as creditors have. In other words, investors don't have as much skin in the game as the creditors do. This could mean that
investors don't want to fund the business operations because the company isn't performing well. Lack of performance might
also be the reason why the company is seeking out extra debt financing.
Example
Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its property. The shareholders of the
company have invested $1.2 million. Here is how you calculate the debt to equity ratio.
14. Debt to Asset Ratio
The debt to asset ratio is a leverage ratio that measures the amount of total assets that are financed by creditors instead of
investors. In other words, it shows what percentage of assets is funded by borrowing compared with the percentage of
resources that are funded by the investors.
Basically it illustrates how a company has grown and acquired its assets over time. Companies can generate investor interest to
obtain capital, produce profits to acquire its own assets, or take on debt. Obviously, the first two are preferable in most cases.
This is an important measurement because it shows how leveraged the company by looking at how much of companys
resources are owned by the shareholders in the form of equity and creditors in the form of debt. Both investors and creditors
use this figure to make decisions about the company.
Investors want to make sure the company is solvent, has enough cash to meet its current obligations, and successful enough to
pay a return on their investment. Creditors, on the other hand, want to see how much debt the company already has because
they are concerned with collateral and the ability to be repaid. If the company has already leveraged all of its assets and can
barely meet its monthly payments as it is, the lender probably wont extend any additional credit.
Now that you know what this measurement is, lets take a look at how to calculate the debt to total assets ratio.
Formula
The debt to assets ratio formula is calculated by dividing total liabilities by total assets.
As you can see, this equation is quite simple. It calculates total debt as a percentage of total assets. There are different variations
of this formula that only include certain assets or specific liabilities like the current ratio. This financial comparison, however, is a
global measurement that is designed to measure the company as a whole.
Analysis
Analysts, investors, and creditors use this measurement to evaluate the overall risk of a company. Companies with a higher
figure are considered more risky to invest in and loan to because they are more leveraged. This means that a company with a
higher measurement will have to pay out a greater percentage of its profits in principle and interest payments than a company
of the same size with a lower ratio. Thus, lower is always better.
If debt to assets equals 1, it means the company has the same amount of liabilities as it has assets. This company is highly
leveraged. A company with a DTA of greater than 1 means the company has more liabilities than assets. This company is
extremely leveraged and highly risky to invest in or lend to. A company with a DTA of less than 1 shows that it has more assets
than liabilities and could pay off its obligations by selling its assets if it needed to. This is the least risky of the three companies.
Example
Teds Body Shop is an automotive repair shop in the Atlanta area. He is applying for a loan to build out a new facility that will
accommodate more lifts. Currently, Ted has $100,000 of assets and $50,000 of liabilities. His DTA would be calculated like this:
As you can see, Teds DTA is .5 because he has twice as many assets as liabilities. Teds bank would take this into consideration
during his loan application process.
Teds .5 DTA is helpful to see how leveraged he is, but it is somewhat worthless without something to compare it to. For
instance, if his industry had an average DTA of 1.25, you would think Ted is doing a great job. The opposite is true if the industry
standard was 10 percent. Its always important to compare a calculation like this to other companies in the industry.
15. Long-Term Debt To Capitalization Ratio
The long-term debt to capitalization ratio is a ratio showing the financial leverage of a firm, calculated by dividing long-term
debt by the amount of capital available:
A variation of the traditional debt-to-equity ratio, this value computes the proportion of a company's long-term debt compared
to its available capital. By using this ratio, investors can identify the amount of leverage utilized by a specific company and
compare it to others to help analyze the company's risk exposure as generally, companies that finance a greater portion of their
capital via debt are considered riskier than those with lower leverage ratios.
BREAKING DOWN 'Long-Term Debt To Capitalization Ratio'
The choice between using long-term debt and other forms of capital, namely preferred and common stock or categorically called
equity, is a balancing act to build a financing capital structure with lower cost and less risk. Long-term debt can be advantageous
if a company anticipates strong growth and ample profitability that can help ensure on-time debt repayments. Lenders collect
only their due interest and do not participate in profit sharing among equity holders, making debt financing sometimes a
preferred funding source. On the other hand, long-term debt may be risky when a company already struggles with its business,
and the financial strain imposed by the debt burden may well lead to insolvency.
Cost of Capital
Contrary to intuitive understanding, using long-term debt can actually help lower a company's total cost of capital. Borrowing
terms are stipulated independent of a company's future business and financial performance. In other words, if a company turns
out to be highly profitable, it does not need to pay the lender anything more than what the borrowing interest rate calls for and
can keep the rest of the profits to itself. When a company's existing owners finance their capital with equity, they must share its
available profits proportionately with all other equity holders. Although a company does not need to worry about returning
capital to equity holders, the cost of using the safer equity capital is never cheap.
Financing Risk
When the amount of long-term debt relative to the sum of all capital has become a dominant funding source, it may increase
financing risk. Long-term debt is often compared to something called debt service coverage to see by how many times total debt
payments have exceeded a company's operating income or earnings before interest, tax, depreciation and amortization
(EBITDA). The more that long-term debt has gone beyond EBITDA, the more uncertain if future debt payments may be fully
covered. A balanced capital structure takes advantage of low-cost debt financing but also prevent the risk of a potential debt
default.
16. Times Interest Earned Ratio
The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the
proportionate amount of income that can be used to cover interest expenses in the future.
In some respects the times interest ratio is considered a solvency ratio because it measures a firm's ability to make interest and
debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an
ongoing, fixed expense. As with most fixed expenses, if the company can't make the payments, it could go bankrupt and cease to
exist. Thus, this ratio could be considered a solvency ratio.
Formula
The times interest earned ratio is calculated by dividing income before interest and income taxes by the interest expense.
Both of these figures can be found on the income statement. Interest expense and income taxes are often reported separately
from the normal operating expenses for solvency analysis purposes. This also makes it easier to find the earnings before interest
and taxes or EBIT.
Analysis
The times interest ratio is stated in numbers as opposed to a percentage. The ratio indicates how many times a company could
pay the interest with its before tax income, so obviously the larger ratios are considered more favorable than smaller ratios.
In other words, a ratio of 4 means that a company makes enough income to pay for its totalinterest expense 4 times over. Said
another way, this company's income is 4 times higher than its interest expense for the year.
As you can see, creditors would favor a company with a much higher times interest ratio because it shows the company can
afford to pay its interest payments when they come due. Higher ratios are less risky while lower ratios indicate credit risk.
Example
Tim's Tile Service is a construction company that is currently applying for a new loan to buy equipment. The bank asks Tim for his
financial statements before they will consider his loan. Tim's income statement shows that he made $500,000 of income before
interest expense and income taxes. Tim's overall interest expense for the year was only $50,000. Tim's time interest earned ratio
would be calculated like this:
As you can see, Tim has a ratio of ten. This means that Tim's income is 10 times greater than his annual interest expense. In
other words, Tim can afford to pay additional interest expenses. In this respect, Tim's business is less risky and the bank
shouldn't have a problem accepting his loan.
PROFITABILITY RATIO
In relation to sales
17. Gross Profit Margin
Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. In other
words, it measures how efficiently a company uses its materials and labor to produce and sell products profitably. You can think
of it as the amount of money from product sales left over after all of the direct costs associated with manufacturing the product
have been paid. These direct costs are typically called cost of goods sold or COGS and usually consist of raw materials and direct
labor.
The gross profit ratio is important because it shows management and investors how profitable the core business activities are
without taking into consideration the indirect costs. In other words, it shows how efficiently a company can produce and sell its
products. This gives investors a key insight into how healthy the company actually is. For instance, a company with a seemingly
healthy net income on the bottom line could actually be dying. The gross profit percentage could be negative, and the net
income could be coming from other one-time operations. The company could be losing money on every product they produce,
but staying a float because of a one-time insurance payout.
That is why it is almost always listed on front page of the income statement in one form or another. Lets take a look at how to
calculate gross profit and what its used for.
Formula
The gross profit formula is calculated by subtracting total cost of goods sold from total sales.
Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is broken down into smaller
categories of costs like materials and labor. This equation looks at the pure dollar amount of GP for the company, but many
times its helpful to calculate the gross profit rate or margin as a percentage.
The gross profit percentage formula is calculated by subtracting cost of goods sold from total revenues and dividing the
difference by total revenues. Usually a gross profit calculator would rephrase this equation and simply divide the total GP dollar
amount we used above by the total revenues. Both equations get the result.
Example
Monica owns a clothing business that designs and manufactures high-end clothing for children. She has several different lines of
clothing and has proven to be one of the most successful brands in her space. Heres what appears on Monicas income
statement at the end of the year.
Total sales: $1,000,000
COGS: $350,000
Rent: $100,000
Utilities: $10,000
Office expenses: $2,500
Monica has an upcoming meeting with investors and wants to know how to find gross profit and what method to use. First, we
can calculate Monicas overall dollar amount of GP by subtracting the $350,000 of COGS from the $1,000,000 of total sales like
this:
As you can see, Monica has a GP of $650,000. This means the goods that she sold for $1M only cost her $350,000 to produce.
Now she has $650,000 that can be used to pay for other bills like rent and utilities.
Monica can also compute this ratio in a percentage using the gross profit margin formula. Simply divide the $650,000 GP that we
already computed by the $1,000,000 of total sales.
Monica is currently achieving a 65 percent GP on her clothes. This means that for every dollar of sales Monica generates, she
earns 65 cents in profits before other business expenses are paid.
Analysis
The gross profit method is an important concept because it shows management and investors how efficiently the business can
produce and sell products. In other words, it shows how profitable a product is.
The concept of GP is particularly important to cost accountants and management because it allows them to create budgets and
forecast future activities. For instance, Monicas GP was $650,000. This means if she wants to be profitable for the year, all of
her other costs must be less than $650,000. Conversely, Monica can also view the $650,000 as the amount of money that can be
put toward other business expenses or expansion into new markets.
Investors are typically interested in GP as a percentage because this allows them to compare margins between companies no
matter their size or sales volume. For instance, an investor can see Monicas 65 percent margin and compare it to Ralph Laurens
margin even though RL is a billion dollar company. It also allows investors a chance to see how profitable the companys core
business activities are.
General Motors is a good example of this back in the 1990s. GM had a low margin and wasnt making much money one each car
they were producing, but GM was profitable. Why? Because GMs financing services were raking in the money. In other words,
GM was making more money financing cars like a bank than they were producing cars like a manufacturer. Investors want to
know how healthy the core business activities are to gauge the quality of the company.
They also use a gross profit margin calculator to measure scalability. Monicas investors can run different models with her
margins to see how profitable the company would be at different sales levels. For instance, they could measure the profits if
100,000 units were sold or 500,000 units were sold by multiplying the potential number of units sold by the sales price and the
GP margin.
18. Operating Margin Ratio
The operating margin ratio, also known as the operating profit margin, is a profitability ratio that measures what percentage of
total revenues is made up by operating income. In other words, the operating margin ratio demonstrates how much revenues
are left over after all the variable or operating costs have been paid. Conversely, this ratio shows what proportion of revenues is
available to cover non-operating costs like interest expense.
This ratio is important to both creditors and investors because it helps show how strong and profitable a company's operations
are. For instance, a company that receives 30 percent of its revenue from its operations means that it is running its operations
smoothly and this income supports the company. It also means this company depends on the income from operations. If
operations start to decline, the company will have to find a new way to generate income.
Conversely, a company that only converts 3 percent of its revenue to operating income can be questionable to investors and
creditors. The auto industry made a switch like this in the 1990's. GM was making more money on financing cars than actually
building and selling the cars themselves. Obviously, this did not turn out very well for them. GM is a prime example of why this
ratio is important.
Formula
The operating margin formula is calculated by dividing the operating income by the net sales during a period.
Operating income, also called income from operations, is usually stated separately on theincome statement before income from
non-operating activities like interest and dividend income. Many times operating income is classified as earnings before interest
and taxes. Operating income can be calculated by subtracting operating expenses, depreciation, and amortization from gross
income or revenues.
The revenue number used in the calculation is just the total, top-line revenue or net sales for the year.
Analysis
The operating profit margin ratio is a key indicator for investors and creditors to see how businesses are supporting their
operations. If companies can make enough money from their operations to support the business, the company is usually
considered more stable. On the other hand, if a company requires both operating and non-operating income to cover the
operation expenses, it shows that the business' operating activities are not sustainable.
A higher operating margin is more favorable compared with a lower ratio because this shows that the company is making
enough money from its ongoing operations to pay for its variable costs as well as its fixed costs.
For instance, a company with an operating margin ratio of 20 percent means that for every dollar of income, only 20 cents
remains after the operating expenses have been paid. This also means that only 20 cents is left over to cover the non-operating
expenses.
Example
If Christie's Jewelry Store sells custom jewelry to celebrities all over the country. Christie reports the follow numbers on
her financial statements:
Net Sales: $1,000,000
Cost of Goods Sold: $500,000

Rent: $15,000
Wages: $100,000
Other Operating Expenses: $25,000
Here is how Christie would calculate her operating margin.
As you can see, Christie's operating income is $360,000 (Net sales all operating expenses). According to our formula, Christie's
operating margin .36. This means that 64 cents on every dollar of sales is used to pay for variable costs. Only 36 cents remains to
cover all non-operating expenses or fixed costs.
It is important to compare this ratio with other companies in the same industry. The gross margin ratio is a helpful comparison.
19. Net Profit Margin / Profit Margin Ratio
The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount
of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other
words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to
make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to
pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit
margin formula would indicate the expenses are too high and the management needs to budget and cut expenses.
The return on sales ratio is often used by internal management to set performance goals for the future.
Formula
The profit margin ratio formula can be calculated by dividing net income by net sales.
Net sales is calculated by subtracting any returns or refunds from gross sales. Net incomeequals total revenues minus total
expenses and is usually the last number reported on theincome statement.
Analysis
The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how
much profits are produced at a certain level of sales.
This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies
strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep
revenues constant and lower expenses.
Since most of the time generating additional revenues is much more difficult than cutting expenses, managers generally tend to
reduce spending budgets to improve their profit ratio.
Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also
effective for measuring past performance of a company.
Example
Trisha's Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the public. Last year Trisha had the
best year in sales she has ever had since she opened the business 10 years ago. Last year Trisha's net sales were $1,000,000 and
her net income was $100,000.
Here is Trisha's return on sales ratio.
As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that with this year's numbers of $800,000 of
net sales and $200,000 of net income.
This year Trisha may have made less sales, but she cut expenses and was able to convert more of these sales into profits with a
ratio of 25 percent.
In relation to investment
20. Return on Investment - ROI
Return on investment or ROI is aprofitability ratio that calculates the profits of an investment as a percentage of the original
cost. In other words, it measures how much money was made on the investment as a percentage of the purchase price. It shows
investors how efficiently each dollar invested in a project is at producing a profit. Investors not only use this ratio to measure
how well an investment performed, they also use it to compare the performance of different investments of all types and sizes.
For example, an investment in stock can be compared to one in equipment. It doesnt matter what the type of investment
because the return on investment calculation only looks that the profits and the costs associated with the investment.
That being said, the ROI calculation is one of the most common investment ratios because its simple and extremely versatile.
Managers can use it to compare performance rates on capital equipment purchases while investors can calculate what stock
purchases performed better.
Formula
The return on investment formula is calculated by subtracting the cost from the total income and dividing it by the total cost.
As you can see, the ROI formula is very simplistic and broadly defined. What I mean by that is the income and costs are not
clearly specified. Total costs and total revenues can mean different things to different individuals. For example, a manager might
use the net sales and cost of goods sold as the revenues and expenses in the equation, where as an investor might look more
globally at the equation and use gross sales and all expenses incurred to produce or sell the product including operating and
non-operating costs.
In this way, the ROI calculation can be very versatile, but it can also be very manipulative depending on what the user wants to
measure or show. Its important to realize that there is no one standardized equation for return on investment. Instead, well
look at the basic idea of recognizing profits as a percentage of income. To truly understand the return on an investment
presented to you, you have to understand what revenues and costs are being used in the calculation.
Example
Now that you know that there isnt a standard equation, lets look at a basic version without getting into cost and revenue
segments. Lets look at Keiths Brokerage House for example. Keith is a stockbroker who specializes in penny stocks. Keith made
a somewhat risky investment in a liquid metals stock last year when he purchased 5,000 shares at $1 per share. Today, a year
later, the fair market value of per share is $3.50. Keith sells the share and uses an ROI calculator to measure his performance.
As you can see, Keiths return on investment is 2.5 or 250 percent. This means that Keith made $2.50 for every dollar that he
invested in the liquid metals company. This investment was extremely efficient because it increased 2.5 times.
We can compare Keiths good choice of liquid metals with his other financial choice of investing in a medical equipment
company. He purchased 1,000 shares at $1 per share and sold them for $1.25 per share.
Keiths return on this stock purchase was only .25 or 25 percent. Its still a good return, but nothing compared to the other
investment.
Analysis
Generally, any positive ROI is considered a good return. This means that the total cost of the investment was recouped in
addition to some profits left over. A negative return on investment means that the revenues werent even enough to cover the
total costs. That being said, higher return rates are always better than lower return rates.
Going back to our example about Keith, the first investment yielded an ROI of 250 percent, where as his second investment only
yielded 25 percent. The first stock out performed the second one ten fold. Keith would have been better off investing all of his
money into the first stock.
The ROI calculation is extremely versatile and can be used for any investment. Managers can use it to measure the return on
invested capital. Investors can use it to measure the performance of their stock and individuals can use it to measure their
return on assets like their homes.
One thing to remember is that it does not take into consideration the time value of money. For a simple purchase and sale of
stock, this fact doesnt matter all that much, but it does for calculation of a fixed asset like a building or house that appreciates
over many years. This is why the original simplistic earnings portion of the formula is usually altered with a present value
calculation.
21. Basic Earning Power Ratio
Basic earning power (BEP) ratio is a measure that calculates the earning power of a business before the effect of the business'
income taxes and its financial leverage. It is calculated by dividing earnings before interest and taxes (EBIT) by total assets.
Basic earning power (BEP) ratio is similar to return on assets ratio as both have the same denominator i.e. total assets. However,
unlike return on assets which measures the net earning power, the basic earning power (BEP) ratio calculated the operating
earning power i.e. their numerators are different.
Formula
Earnings Before Interest and Taxes (EBIT)

Basic Earning Power =
Total Assets
Example
Dell Inc. earnings before interest and taxes for the financial year ended 2 February 2012 are $4,431 million while its total assets
as at 2 February 2012 are $44,533. The company's net income for the same period is $3,492 million. Find the basic earning
power ratio and return on assets and high light how is BEP ratio useful.
Basic Earning Power (BEP) Ratio = EBIT ($4,431 million) Total Assets ($44,533 million) = 9.95%
Return on Assets Ratio = Net Income ($3,492 million) Total Assets ($44,533 million) = 7.84%
Basic earning power ratio tells that Dell has a raw earning power of 9.95%. Since its return on assets is 7.84%, we can conclude
that 2.11% of the company's revenue is expensed out as interest expense and taxes.
22. Return on Equity Ratio
The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its
shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of
common stockholders' equity generates.
So a return on 1 means that every dollar of common stockholders' equity generates 1 dollar of net income. This is an important
measurement for potential investors because they want to see how efficiently a company will use their money to generate net
income.
ROE is also and indicator of how effective management is at using equity financing to fund operations and grow the company.
Formula
The return on equity ratio formula is calculated by dividing net income by shareholder's equity.
Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not included in the
calculation because these profits are not available to common stockholders. Preferred dividends are then taken out of net
income for the calculation.
Also, average common stockholder's equity is usually used, so an average of beginning and ending equity is calculated.
Analysis
Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the
company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor's point of viewnot the
company. In other words, this ratio calculates how much money is made based on the investors' investment in the company, not
the company's investment in assets or something else.
That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors'
funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies' ratios
in the industry. Since every industry has different levels of investors and income, ROE can't be used to compare companies
outside of their industries very effectively.
Many investors also choose to calculate the return on equity at the beginning of a period and the end of a period to see the
change in return. This helps track a company's progress and ability to maintain a positive earnings trend.
Example
Tammy's Tool Company is a retail store that sells tools to construction companies across the country. Tammy reported net
income of $100,000 and issued preferred dividends of $10,000 during the year. Tammy also had 10,000, $5 par common shares
outstanding during the year. Tammy would calculate her return on common equity like this:
As you can see, after preferred dividends are removed from net income Tammy's ROE is 1.8. This means that every dollar of
common shareholder's equity earned about $1.80 this year. In other words, shareholders saw a 180 percent return on their
investment. Tammy's ratio is most likely considered high for her industry. This could indicate that Tammy's is a growing
company.
An average of 5 to 10 years of ROE ratios will give investors a better picture of the growth of this company.
Company growth or a higher ROE doesn't necessarily get passed onto the investors however. If the company retains these
profits, the common shareholders will only realize this gain by having an appreciated stock.
MARKET VALUE RATIO
23. Price Earnings P/E Ratio
The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market prospect ratio that calculates the market
value of a stock relative to its earnings by comparing the market price per share by the earnings per share. In other words, the
price earnings ratio shows what the market is willing to pay for a stock based on its current earnings.
Investors often use this ratio to evaluate what a stock's fair market value should be by predicting future earnings per share.
Companies with higher future earnings are usually expected to issue higher dividends or have appreciating stock in the future.
Obviously, fair market value of a stock is based on more than just predicted future earnings. Investor speculation and demand
also help increase a share's price over time.
The PE ratio helps investors analyze how much they should pay for a stock based on its current earnings. This is why the price to
earnings ratio is often called a price multiple or earnings multiple. Investors use this ratio to decide what multiple of earnings a
share is worth. In other words, how many times earnings they are willing to pay.
Formula
The price earnings ratio formula is calculated by dividing the market value price per share by theearnings per share.
This ratio can be calculated at the end of each quarter when quarterly financial statements are issued. It is most often calculated
at the end of each year with the annual financial statements. In either case, the fair market value equals the trading value of the
stock at the end of the current period.
The earnings per share ratio is also calculated at the end of the period for each share outstanding. A trailing PE ratio occurs
when the earnings per share is based on previous period. A leading PE ratios occurs when the EPS calculation is based on future
predicted numbers. A justified PE ratio is calculated by using the dividend discount analysis.
Analysis
The price to earnings ratio indicates the expected price of a share based on its earnings. As a company's earnings per share being
to rise, so does their market value per share. A company with a high P/E ratio usually indicated positive future performance and
investors are willing to pay more for this company's shares.
A company with a lower ratio, on the other hand, is usually an indication of poor current and future performance. This could
prove to be a poor investment.
In general a higher ratio means that investors anticipate higher performance and growth in the future. It also means that
companies with losses have poor PE ratios.
An important thing to remember is that this ratio is only useful in comparing like companies in the same industry. Since this ratio
is based on the earnings per share calculation, management can easily manipulate it with specific accounting techniques.
Example
The Island Corporation stock is currently trading at $50 a share and its earnings per share for the year is 5 dollars. Island's P/E
ratio would be calculated like this:
As you can see, the Island's ratio is 10 times. This means that investors are willing to pay 10 dollars for every dollar of earnings.
In other words, this stock is trading at a multiple of ten.
Since the current EPS was used in this calculation, this ratio would be considered a trailing price earnings ratio. If a future
predicted EPS was used, it would be considered a leading price to earnings ratio.
24. Price to Book Ratio
The price to book ratio, also called the P/B or market to book ratio, is afinancial valuation tool used to evaluate whether the
stock a company is over or undervalued by comparing the price of all outstanding shares with the net assets of the company. In
other words, its a calculation that measures the difference between the book value and the total share price of the company.
This comparison demonstrates the difference between the market value and book value of a company. The market value equals
the current stock price of all outstanding shares. This is the price that the market thinks the company is worth. The book value,
on the other hand, comes from the balance sheet. It equals the net assets of the company.
Investors and analysts use this comparison to differentiate between the true value of a publicly traded company and investor
speculation. For example, a company with no assets and a visionary plan that is able to drum up a lot of hype can have investors
drooling over it. Thus, causing the stock price to increase quarter over quarter. The book value of the company hasnt changed
though. The business still has no assets.
Lets take a look at how to calculate the price to book ratio.
Formula
The price-to-book ratio formula is calculated by dividing the market price per share by book value per share.
The market price per share is simply the current stock price that the company is being traded at on the open market. The book
value per share is a little more complicated. We first subtract the total liabilities from the total assets and divide the difference
by the total number of shares outstanding on that date.
Many investors rephrase this equation to form the book to market ratio formula by dividing the total book value of the firm by
the total market value of the company.
Unlike the PB ratio, the MB formula compares values on a company-wide basis. It doesnt look at individual shares.
Analysis
Investors use both of these formats to help determine whether a company is overpriced or underpriced. For example, a P/B
ratio above 1 indicates that the investors are willing to pay more for the company than its net assets are worth. This could
indicate that the company has healthy future profit projections and the investors are willing to pay a premium for that
possibility.
If the market book ratio is less than 1, on the other hand, the companys stock price is selling for less than their assets are
actually worth. This company is undervalued for some reason. Investors could theoretically buy all of the outstanding shares of
the company, liquidate the assets, and earn a profit because the assets are worth more than the cumulative stock price.
Although in reality, this strategy probably wouldnt work.
This valuation method is only one that investors use to see if an investment is overpriced. Keep in mind that this method doesnt
take dividends into consideration. Investors are almost always willing to pay more for shares that will regularly and reliability
issue a dividend. There are many other factors like this that this basic calculation doesnt take into account. The real purpose of
it is to give investors a rough idea as to whether the sale price is close to what it should be.
Example
Tim wants to invest in Bobs Furniture Company, a publicly traded company. Bob has 100,000 shares outstanding that are
trading at $1 per share. The furniture business reported $50,000 of net assets on their balance sheet this year. Tim would
calculate Bobs price book ratio like this:
As you can see, the market price of the company is twice that of the book value. This means that Bobs stock costs twice as much
as the net assets reported on the balance sheet. All else equal, this company would be considered over valued because investors
are willing to pay more for the assets than they are worth, but they might have a good reason for this. Bob might have a big
expansion in the works that could double the size of the business.
This metric has its limitations, but generally works well for businesses like Bobs. It doesnt however work well for valuing
company with high levels of intangible assets and low fixed assets like tech companies.

Liquidity Analysis 1. Current Ratio

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Liquidity Analysis 1. Current Ratio

Uploaded by

Copyright:

Available Formats

LIQUIDITY ANALYSIS

Accounts Receivable: $5,000

Stock Investments: $1,000

Prepaid taxes: $500

Current Liabilities: $15,000

The bank can compute Carole's quick ratio like this.

Prepaid taxes: $500

Total Current Assets: $21,500

Current Liabilities: $15,000

Accounts Receivable: $15,000

Net Credit Sales: $175,000

Devin's days sales is calculated like this:

The cost of goods sold is reported on the income statement.

Definition What is Days Payable Outstanding (DPO)?

Lets take a look at the equation and how to calculate DPO.

Days Payable Outstanding = [ Accounts Payable / ( Cost of Sales / Number of days ) ]

The DPO calculation consists of two three different terms.

Lets take a look at a DPO example.

Accounts Payable: $100

Due date of A/P: 10 days

Accounts receivable from sales to customers: $100

Due date of A/R: 5 days

Lets look at a Real World Example

Usage Explanations and Cautions

2) Change product mix

Tim's days calculations are as follows:

DIO represents days inventory outstanding: 15 days

DSO represents days sales outstanding: 2 days

DPO represents days payable outstanding: 12 days

Tim's conversion cycle is calculated like this:

Lets take a look at how to calculate fixed asset turnover.

Lets take a look at an example.

Heres how the bank would calculate Jeffs turn over.

Here is what the financial statements reported:

Beginning Assets: $50,000

Ending Assets: $100,000

The total asset turnover ratio is calculated like this:

Lets take a look at an example.

BREAKING DOWN 'Long-Term Debt To Capitalization Ratio'

Total sales: $1,000,000

Office expenses: $2,500

Net Sales: $1,000,000

Cost of Goods Sold: $500,000

Other Operating Expenses: $25,000

Here is how Christie would calculate her operating margin.

Here is Trisha's return on sales ratio.

Earnings Before Interest and Taxes (EBIT)

Lets take a look at how to calculate the price to book ratio.

Lets take a look at an example.

You might also like