# Financial Ratios

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 Author: kikyboo ID: 179164 Filename: Financial Ratios Updated: 2012-10-23 19:34:52 Tags: FNR Folders: Description: List of Financial Ratios Show Answers:

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1. 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.
2. Liquidity Ratios
are used to evaluate the company’s ability to meet its short-term obligations.

• - Current Ratio
• - Quick Ratio
3. Liquidity Ratios
Current Ratio
• Formula:
• current assets
• current Liabilities

• Measures:
• the company's short-term 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.
4. 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 short-term investments in marketable securities).

• Variation:
• Sometimes quick assets will be calculated more simply as current assets less inventories.

A related and ultra-conservative measure, the cash ratio, divides only cash and cash equivalents by current liabilities.
5. 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
6. 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).
7. 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.
8. 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.
9. 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 labour-intensive. 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
10. Profitability and return
Profitability and return ratios (sometimes called efficiency ratios) are used to evaluate management’s overall effectiveness in generating an adequate return.
11. 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.
12. 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.
13. 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.
14. 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 labour-intensive. 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.
15. 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
16. 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.
17. 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.
18. Debt-to-equity
• 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 debt-to-equity 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 off-balance-sheet liabilities that should be included in the
• numerator for your analysis.
19. 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.
20. Times interest earned
• Formula
•        EBIT
• interest expense

• Measures
• how many times the company’s interest charges have been covered by its pre-tax
• 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.
21. Fixed charges coverage
Formula

• Measures
• how many times the company’s fixed charges have been covered by its pre-tax
• 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.
22. Market Information
Price-earnings (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 inter-company comparisons, the
• companies must be in the same industry.
23. 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.
24. 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.
25. 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 inter-company comparisons is not
• meaningful; this is the only ratio that has a standard calculation and is directly
• subject to audit

• Variation
• Fully-diluted EPS shows the dilution of earnings if all ordinary share equivalent
• securities were converted into ordinary shares.
26. 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 inter-company 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)
27. 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 inter-company comparisons is not
• meaningful; negative cash flow per share can indicate liquidity problems
28. 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 inter-company 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.

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