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General Tips
 Ratio calculations cannot be looked at in isolation. In order to interpret a ratio, you need to compare it to the ratio of the same company over time, to budgeted results, or to other companies within the industry.
 If you are using ratio analysis for investment decisions, be aware of the impact caused by using book values, rather than market values.
 Ratios reflect the past, and may or may not be indicative of the future.
 There are a number of variations of calculating ratios, which can produce vastly
 different results. Use caution when interpreting ratios, and check the assumptions and conventions used.
 Ratios may change from period to period, based on changes in accounting estimates and principles.

Liquidity Ratios
are used to evaluate the company’s ability to meet its shortterm obligations.
  Current Ratio
  Quick Ratio

Liquidity Ratios
Current Ratio
 Formula:
 current assets
 current Liabilities
 Measures:
 the company's shortterm debt paying ability
Rule of thumb/interpretation
 2:1 or higher is considered good. A high working capital ratio isn't always a good thing. It could indicate that there is too much inventory, or that the company is not investing its
 excess cash.

Liquidity Ratios
Quick Ratio
 Formula
 quick assets
 current liabilities
 Measures
 the extent to which the company can cover its current liabilities with its quick, or liquid assets
 Rule of thumb/interpretation
 1:1 or higher is considered good. Quick assets include those that are readily convertible to cash (for example, cash equivalents, net accounts receivable, shortterm notes receivable, and shortterm investments in marketable securities).
 Variation:
 Sometimes quick assets will be calculated more simply as current assets less inventories.
A related and ultraconservative measure, the cash ratio, divides only cash and cash equivalents by current liabilities.

Activity Ratios
Activity ratios (sometimes referred to as productivity ratios) are used to assess the company’s ability to efficiently manage its assets to generate sales and collect funds.
 Days sales outstanding
 Inventory turnover
 Days sales in inventory
 Total asset turnover

Activity Ratios
Days sales outstanding
(Also known as days sales uncollected, average collection period, average age of receivables)
 Formula
 net credit sales x 365
 average accounts receivable
 Measures
 how quickly a company collects its accounts receivable
 Rule of thumb/interpretation
 This ratio should reflect the company’s credit terms extended to customers (for example, if credit terms are net 30, the ratio should be about 30 days on average to collect).

Activity Ratios
Inventory turnover
 Formula
 cost of goods sold
 average inventory
 Measures
 how quickly the company’s inventory is being sold
 Rule of thumb/interpretation
 This ratio varies considerably across industries; generally, higher is better, but too high may indicate risk of lost sales because of understocked items. Note that this ratio is influenced by the inventory costing method used.
 Variation:
 Because COGS is not always available, inventory turnover sometimes uses net sales in its place.

Activity Ratios
Days sales in inventory
 Formula
 cos t of goods sold x 365
 ending inventory
 Measures
 how many days it is expected to take to sell the entire inventory on hand
 Rule of thumb/interpretation
 This ratio varies considerably across industries; generally, lower is better. Note
 that this ratio is influenced by the inventory costing method used.

Activity Ratios
Total asset turnover
 Formula
 net sales
 average total assets
 Measures
 how efficiently total assets are used to generate revenues
 Rule of thumb/interpretation
 Generally, higher is better, but interpretation is dependent on whether the company is capital or labourintensive. Also note that companies with older, more amortized assets may have an artificially high ratio.
 Variation
 The capital asset turnover ratio focuses on how efficiently capital assets are used to generate revenues. That is, net sales average net capital assets

Profitability and return
Profitability and return ratios (sometimes called efficiency ratios) are used to evaluate management’s overall effectiveness in generating an adequate return.

Profitability and Return Ratios
Gross profit margin
 Formula
 (net sales – cost of goods sold)
 net sales
 Measures
 how much a company earns on each dollar of net sales after allowing for the costs
 incurred in producing its products and/or services
 Rule of thumb/interpretation
 Higher is better; this ratio varies considerably across industries.

Profitability and Return Ratios
Operating profit margin
 Formula
 (net sales – cost of goods sold – operating expenses)

 net sales
 Measures
 how effective a company is at controlling the costs and expenses associated with
 its normal business operations; the general health of a company’s core or normal
 business operations
 Rule of thumb/interpretation
 Higher is better; this ratio varies considerably across industries.

Profitability and Return Ratios
Net profit margin
 Formula
 net income before extraordinary items
 net sales
 Measures
 how effective a company is at converting each dollar of net sales into a dollar of
 net income; overall cost control effectiveness
 Rule of thumb/interpretation
 Higher is better; this ratio varies considerably across industries; best evaluated in conjunction with return on assets and return on equity.

Profitability and Return Ratios
Return on assets Ratio
 Formula
 net income
 average total assets
 Measures
 how efficient a company is in using its assets to generate net income
 Rule of thumb/interpretation
 Higher is better, but interpretation is dependent on whether the company is
 capital or labourintensive. Note that companies with older, more amortized
 assets may have an artificially high ratio. This ratio is the product of total asset
 turnover and net profit margin ratio — analyze these individually for additional
 information.

Profitability and Return Ratios
Return on equity
 Formula
 net income
 average shareholders' equity
 Measures
 management’s ability to realize a return on the capital invested by shareholders
 Rule of thumb/interpretation
 Higher is better, with 12 – 14% considered good. This ratio is the product of
 return on assets and equity multiplier average total assets / total shareholders’
 equity; a measure of financial leverage) — analyze these individually for additional information.
 Variation:
 The ordinary shareholders’ return, return on common equity, is sometimes
 isolated by including only ordinary equity.
 That is,
 net income – preferred dividends
 total ordinary shareholders' equity

Profitability and Return Ratios
Expenses as a percentage of sales
 Formula
 expenses
 net sales
 Measures
 This ratio identifies any anomalies in expense items. For example, if the cost of
 sales increased in a manufacturing operation, you would expect other related
 costs, such as advertising or utilities, to have also increased. Use your knowledge
 of the entity to analyze this ratio.

Leverage and Coverage
Leverage and coverage ratios are used to analyze the extent to which the company is financed through debt, as well as its ability to make interest payments and meet debt obligations as they mature.

Debttoequity
 Formula
 total liabilities
 total shareholders' equity
 Measures
 how much debt a company has for each dollar of equity
 Rule of thumb/interpretation
 Generally, the higher the debttoequity ratio, the greater the financial risk. This
 ratio varies considerably across industries; 0.5 is typically acceptable for
 industrial and retail companies, whereas about 1.5 is considered acceptable for
 utilities. Be aware of offbalancesheet liabilities that should be included in the
 numerator for your analysis.

Debt to assets
 Formula
 total liabilities
 total assets
 Measures
 how reliant a company is on debt to finance its assets
 Rule of thumb/interpretation
 Generally, lower is considered better because excessive debt can create a burden on a company’s cash flow requirements to make interest and principal payments. High debt levels also make the company more susceptible to problems caused by increases in interest rates.

Times interest earned
 Formula
 EBIT
 interest expense
 Measures
 how many times the company’s interest charges have been covered by its pretax
 income in a given year
 Rule of thumb/interpretation
 Higher is better because this indicates a higher margin of safety; generally, a ratio
 of 2 to 3, depending on the industry and other factors, is considered acceptable by
 creditors. A lower ratio is more tolerable for companies with stable or rising
 earnings.

Fixed charges coverage
Formula
 Measures
 how many times the company’s fixed charges have been covered by its pretax
 income in a given year
 Rule of thumb/interpretation
 This is a more conservative measure than times interest earned; higher is better
 because this indicates a higher margin of safety; a lower ratio is more tolerable for
 companies with stable or rising earnings.

Market Information
Priceearnings (PE ratio, PE multiple)
Formula
 market price per share
 earnings per share
 Measures
 the price that investors are willing to pay for each dollar of a company’s earnings
 Rule of thumb/Interpretation
 Higher P/E ratios are typically afforded to companies that investors believe have
 higher growth prospects; to make meaningful intercompany comparisons, the
 companies must be in the same industry.

Market Information
Dividend yield
 Formula
 dividends per share
 market price per share
 Measures
 an investor’s return on the shares of a company from dividends
 Rule of thumb/interpretation
 Higher is better for investors who are seeking returns on the basis on dividend
 income. It is a useful measure to compare against other investments that make
 regular payments, such as bonds.

Common Share/Ordinary Share
Common share ratios are used to perform evaluations on a ―per common share outstanding basis. Note that under IFRS, the terminology is no longer ―common shares but rather ―ordinary shares.

Common Share/Ordinary Share
 Formula
 (net income  preferred dividends)
 avg # of ordinary shares outstanding
 Measures
 Net income allocated to each ordinary share of the company’s stock
 Rule of thumb/interpretation
 Higher is better, however, because of variations in the number of ordinary shares
 outstanding for each company, making direct intercompany comparisons is not
 meaningful; this is the only ratio that has a standard calculation and is directly
 subject to audit
 Variation
 Fullydiluted EPS shows the dilution of earnings if all ordinary share equivalent
 securities were converted into ordinary shares.

Common Share/Ordinary Share
Dividends per share
 Formula
 dividends paid
 avg # of shares outstanding
 Measures
 Dividends allocated to each share of the company’s stock outstanding
 Rule of thumb/interpretation
 Higher is better for investors who are seeking returns on the basis on dividend
 income. Because of variations in the number of ordinary shares outstanding for
 each company, making direct intercompany comparisons is not meaningful;
 ensure that the dividends per share being calculated include only the type of share
 you want to measure (e.g., ordinary dividends per share includes only ordinary
 dividends paid and ordinary shares outstanding)

Cash flow per share Ratio
 Formula
 cash flow from operations
 avg # of ordinary shares outstanding
 Measures
 Company’s financial strength; cash flow from operating activities allocated to
 each ordinary share of the company’s stock outstanding
 Rule of thumb/interpretation
 Higher is better, however, because of variations in the number of ordinary shares
 outstanding for each company, making direct intercompany comparisons is not
 meaningful; negative cash flow per share can indicate liquidity problems

Book value per share (equity value per share) Ratio
 Formula
 ordinary shareholders' equity
 avg # of ordinary shares outstanding
 Measures
 Ordinary equity allocated to each ordinary share of the company’s stock
 outstanding
 Rule of thumb/interpretation
 The relationship between the book value and the market value of a company is
 generally considered weak; also, because of variations in the number of ordinary
 shares outstanding for each company, making direct intercompany comparisons
 is not meaningful.
 It can be compared to other similar companies or, if the company is publicly
 traded, to the market value. Depending on the nature of the business, wide
 discrepancies should be investigated.

