Financial Ratios

Lecture 6
This lecture is part of Chapter 3:
Evaluating a Company’s Performance
Today’s Lecture

Liquidity Ratios
Efficiency Ratios
Leverage Ratios
Profitability Ratios
 Liquidity Ratios
Liquidity is a measure of how quickly an asset can
be converted to cash.

E.g. Accounts receivable = quite liquid

Building = not very liquid

There are two important liquidity ratios:

Current Ratio
Quick Ratio
 Liquidity Ratios
Current Ratio:

Under normal circumstances, a company will pay

its current liabilities (bills due) with its current
assets.
The ratio between the two is therefore a good
indicator for how well a company can pay its
bills.
Current Assets
Current Ratio =
Current Liabilities
 Liquidity Ratios
Current Ratio:

A high current ratio means that the company

should more easily be able to pay its bills. So
that’s good to know if the company owes you
money.
But … if you’re an investor, too high a current
ratio could mean that the company is not using its
assets optimally.

Think a bit of it like water in a lake.

Good to have some, bad to have
none and so-so to have too much.
 Liquidity Ratios

Current Ratio:

Most successful businesses have a current ratio of

about 1.5 – 2.0.

Let’s have a look at the Balance Sheet of Lecture

2 again and add the current ratio.
 Adding Ratios
A B C D E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300
10 Total Current Assets 19500
11 Plant and Equipment 800
12 Accumulated Depreciation 500
13 Net fixed assets 300
14 Total Assets 19800
15 Liabilities and Owner's Equity
16 Accounts Payable 7600 Pretty good!
17 Other Current Liabilities 900
18 Total Current Liabilities 8500
19 Long Term Debt 1200
20 Total Liabilities 9700
21 Common Stock 6000
22 Retained Earnings 4100
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800
 Liquidity Ratios
Quick Ratio:

While inventories are necessary for many

businesses, they may at times be difficult to sell
rapidly.
It is therefore useful to also consider a current
ratio that takes out inventory from the Current
Assets.

Current Assets - Inventories

Quick Ratio =
Current Liabilities
 Liquidity Ratios
Quick Ratio:

The quick ratio is sometimes called acid-test

ratio.

In general, a quick ratio of 1 is considered safe,

but in some industries it may be much lower, e.g.
in the car industry, 0.2 is common.

Let us enter this into the Balance Sheet as well…

 Adding Ratios
A B C D E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800
12 Accumulated Depreciation 500
13 Net fixed assets 300
14 Total Assets 19800
15 Liabilities and Owner's Equity
16 Accounts Payable 7600
17 Other Current Liabilities 900
18 Total Current Liabilities 8500 Pretty good too!
19 Long Term Debt 1200
20 Total Liabilities 9700
21 Common Stock 6000
22 Retained Earnings 4100
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800
 Efficiency Ratios

As indicated by the name, efficiency ratios indicate how

efficient a company is in its operation.
Two of the most useful “turnover” ratios are:

• Inventory Turnover Ratio

• Total Asset Turnover Ratio
 Efficiency Ratios

Inventory Turnover Ratio

The inventory turnover ratio indicates how many times

the inventory is ‘turned over’ in one year. In other
words, it shows how quickly inventory can be sold.

Inventory Turnover Cost of Goods Sold

Ratio =
Inventory

Actually, it would be better to replace Inventory with

Average Inventory (defined as beginning inventory +
ending inventory)/2.
 Efficiency Ratios

Inventory Turnover Ratio

Let us apply this to our Balance Sheet again.

Only … the Cost of Goods sold are not on the Balance
Sheet. We need to get this item from the Income
Statement in Lecture one.

In general, a higher Inventory Turnover Rate is good but

the number may differ greatly per industry. Dell, e.g, is
somewhere above 40 but to many around 4 would
already be good.
 Adding Ratios
A B C D E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300
14 Total Assets 19800
15 Liabilities and Owner's Equity
16 Accounts Payable 7600
17 Other Current Liabilities 900
18 Total Current Liabilities 8500
19 Long Term Debt 1200
20 Total Liabilities 9700 Quite meager!
21 Common Stock 6000
22 Retained Earnings 4100
23
24
Total Shareholder's Equity
Total Liabilities and owner's Equity
10100
19800
But! What
happened here???
 Interlude – Excel
Worksheets
Excel can have several named worksheets. A worksheet
is basically a spreadsheet on a single page with a name.

This means that we can avoid making a complicated

single page spreadsheet with an area for the Balance
Sheet, and area for the Income Statement and so on.
Instead, we can make a separate worksheet for each. In
the previous slide, I have added the Income Statement
from Lecture 1 as a second worksheet.

Cells from other worksheets can be referred to by using

the ! mark.
 Efficiency Ratios

Total Asset Turnover Ratio

The Total Asset Turnover Ratio shows how well a

company is able to generate sales (and hence hopefully
profits) from the assets it owns.

It is defined as:

Asset Turnover Sales

Ratio =
Total Assets

Again we need to get the Sales from the Income Statement

 Adding Ratios
A B C D E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300 Total As. 0.57  =Income!D6/
14 Total Assets 19800 Balance!G14
15 Liabilities and Owner's Equity
16 Accounts Payable 7600
17 Other Current Liabilities 900
18 Total Current Liabilities 8500
19 Long Term Debt 1200
20 Total Liabilities 9700
21 Common Stock 6000
22
23
Retained Earnings
Total Shareholder's Equity
4100
10100
Ouch!?
24 Total Liabilities and owner's Equity 19800
 Leverage Ratios

Leverage in business refers to how much debt a

company uses to finance its operations.
The idea is that if a company can borrow money at say
7% and then use this money to make a 27% profit, it’s
clever to take out the loan.

Two of the most important leverage ratios are:

• Total Debt Ratio

• Debt to Equity Ratio
 Leverage Ratios

Total Debt Ratio

The Total Debt Ratio shows how much of a company’s

assets are financed through loans.

It is defined as:

Total Debt Total Debt

Ratio =
Total Assets
 Leverage Ratios

Total Debt Ratio

In general, a low Total Debt Ratio is good with the

critical number being 1.

Smaller than one means that the company has more

assets than debts.

Vice versa, larger than one mean that the company has
more debts than assets. If this is the case you’d better
hope they will not go out of business …
 A B C D
Adding Ratios
E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300 Total As. 0.57  =Income!D6/
14 Total Assets 19800 Balance!G14
15 Liabilities and Owner's Equity
16 Accounts Payable 7600 Total De. 0.49  =G20/G14
17 Other Current Liabilities 900
18 Total Current Liabilities 8500
19 Long Term Debt 1200
20 Total Liabilities 9700
21 Common Stock 6000
22 Retained Earnings 4100
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800

So so..
 Leverage Ratios

Debt to Equity Ratio

A favorite with many investors. It is similar to the Total

Debt Ratio, but rather than dividing by the Total Assets,
the Total Debt is divided by the Total Equity.

It is defined as:

Debt Equity Total Debt

Ratio =
Total Equity
 Leverage Ratios

Debt Equity Ratio

As with the Total Debt Ratio, a low Debt Equity Ratio is

good with the critical number being 1.

Smaller than one means that the company has more

equity than debts.
Vice versa, larger than one mean that the company has
more debts than equity.

Investors prefer this number since Equity is after all that

which belongs to the stock holders.
 A B C D
Adding Ratios
E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300 Total As. 0.57  =Income!D6/
14 Total Assets 19800 Balance!G14
15 Liabilities and Owner's Equity
16 Accounts Payable 7600 Total De. 0.49  =G20/G14
17 Other Current Liabilities 900 Debt-Eq. 0.96  =G20/G23
18 Total Current Liabilities 8500
19 Long Term Debt 1200
20 Total Liabilities 9700
21 Common Stock 6000
22 Retained Earnings 4100
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800

So so too..
 Profitability Ratios

PROFIT. Of course that’s what business is all about!

Three of the most commonly used profitability ratios are:

• Gross Profit Margin (Ratio or Percentage)

• Operating Profit Margin (Ratio or Percentage)
• Net Profit Margin (Ratio or Percentage)

Note: Though these are ratios they are often just called
margin which generally refers to the difference between a
certain cost and sales price (taken from the top).
 Profitability Ratios

Gross Profit Margin

The Gross Profit Margin is the ‘gross’ difference between

the actual cost of a product and its sales price.

It is defined as:

Gross Profit Gross Profit

Margin =
Sales

Where Gross Profit = Sales – Cost of Sales

 A B C D
Adding Ratios
E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300 Total As. 0.57  =Income!D6/
14 Total Assets 19800 Balance!G14
15 Liabilities and Owner's Equity
16 Accounts Payable 7600 Total De. 0.49  =G20/G14
17 Other Current Liabilities 900 Debt-Eq. 0.96  =G20/G23
18 Total Current Liabilities 8500
19 Long Term Debt 1200 Gross P. 0.36  =Income!D8/
20 Total Liabilities 9700 Income!D6
21 Common Stock 6000
22 Retained Earnings 4100
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800
 Profitability Ratios
Operating Profit Margin

The Gross Profit Margin is important but does not

indicate how much (or whether) the company can make a
profit from its running operations. This is indicated by
the Operating Profit Margin:

Operating Profit Net Operating Income

Margin =
Sales
Net Operating Income = EBIT (at least usually), the
profit after taking all the expenses related to the daily
running of the company into account. (Note:
Depreciation and Amortization should be included)
 Profitability Ratios
Operating Profit Margin

Since we did not separate Depreciation and Amortization

out in our Income Statement, let’s leave this ratio for an
exercise.
 Profitability Ratios
Net Profit Margin

The Net Profit Margin tells you how many cents out of
every dollar are actual profit and thus attributable to the
shareholders.

Net Profit Net Income

Margin =
Sales
 Adding Ratios
A B C D E F G

3 Golden Win Double Dragon International

4 Balance Sheet, As of Dec 31 2000
5
6 Assets Ratios:
7 Cash and Equivalents 10000
8 Accounts Receivable 1200 Current 2.29  =G10/G18
9 Inventory 8300 Quick 1.32  =(G10-G9)/G18
10 Total Current Assets 19500
11 Plant and Equipment 800 Inventory 0.87  =Income!D7/
12 Accumulated Depreciation 500 Balance!G9
13 Net fixed assets 300 Total As. 0.57  =Income!D6/
14 Total Assets 19800 Balance!G14
15 Liabilities and Owner's Equity
16 Accounts Payable 7600 Total De. 0.49  =G20/G14
17 Other Current Liabilities 900 Debt-Eq. 0.96  =G20/G23
18 Total Current Liabilities 8500
19 Long Term Debt 1200 Gross P. 0.36  =Income!D8/
20 Total Liabilities 9700 Income!D6
21 Common Stock 6000 Net Prof. 0.19  =Income!D12/
22 Retained Earnings 4100 Income!D6
23 Total Shareholder's Equity 10100
24 Total Liabilities and owner's Equity 19800
 Summary of Ratios
Current Assets

Liquidity Ratios
Current Ratio =
Current Liabilities
Current Assets - Inventories
Quick Ratio =
Current Liabilities
Efficiency Ratios

Inventory Turnover Cost of Goods Sold

Ratio =
Inventory
Asset Turnover Sales
Ratio =
Total Assets
 Summary of Ratios

Leverage Ratios
Total Debt Total Debt
Ratio =
Total Assets
Debt Equity Total Debt
Ratio =
Total Equity

Gross Profit Gross Profit

Profitability Ratios

Margin =
Sales
Operating Profit Net Operating Income
Margin =
Sales
Net Profit Net Income
Margin =
Sales
 Key Points of the Day

We have seen how various Ratios can give insight into the
performance, liquidity and profitability of a company

The Ratios can be calculated easily with Excel.