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AAII Journal > September 2012
16 Financial Ratios for Analyzing a Company’s
Strengths and Weaknesses
Read Comments (13)
by Joe Lan, CFA
In the previous installments of AAII’s Financial Statement Analysis series, I discussed the three most commonly used
financial statements—the income statement, balance sheet and cash flow statement.
In this installment of the series, I take an in-depth look at the most commonly used financial ratios. Click here for a
downloadable spreadsheet that automatically calculates these ratios using financial statement inputs that you provide.
Click here for detailed explanations on creating the ratios for Stock Investor Pro users.
Ratio Analysis
Over the years, investors and analysts have developed numerous analytical tools, concepts and techniques to compare
the relative strengths and weaknesses of companies. These tools, concepts and techniques form the basis of
fundamental analysis.
Ratio analysis is a tool that was developed to perform quantitative analysis on numbers found on financial statements.
Ratios help link the three financial statements together and offer figures that are comparable between companies and
across industries and sectors. Ratio analysis is one of the most widely used fundamental analysis techniques.
However, financial ratios vary across different industries and sectors and comparisons between completely different
types of companies are often not valid. In addition, it is important to analyze trends in company ratios instead of solely
emphasizing a single period’s figures.
What is a ratio? It’s a mathematical expression relating one number to another, often providing a relative comparison.
Financial ratios are no different—they form a basis of comparison between figures found on financial statements. As
with all types of fundamental analysis, it is often most useful to compare the financial ratios of a firm to those of other
companies.
Financial ratios fall into several categories. For the purpose of this analysis, the commonly used ratios are grouped into
four categories: activity, liquidity, solvency and profitability. Also, for the sake of consistency, the data in the financial
statements created for the prior installments of the Financial Statement Analysis series will be used to illustrate the
ratios. Table 1 shows the formulas with examples for each of the ratios discussed.
Activity Ratios
Activity ratios are used to measure how efficiently a company utilizes its assets. The ratios provide investors with an
idea of the overall operational performance of a firm.
As you can see from Table 1, the activity ratios are “turnover” ratios that relate an income statement line item to a
balance sheet line item. As explained in my previous articles, the income statement measures performance over a
specified period, whereas the balance sheet presents data as of one point in time. To make the items comparable for
use in activity ratios, an average figure is calculated for the balance sheet data using the beginning and ending
reported numbers for the period (quarter or year).
The activity ratios measure the rate at which the company is turning over its assets or liabilities. In other words, they
present how many times per year inventory is replenished or receivables are collected.
Inventory turnover
Inventory turnover is calculated by dividing cost of goods sold by average inventory. A higher turnover than the industry
average means that inventory is sold at a faster rate, signaling inventory management effectiveness. Additionally, a
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high inventory turnover rate means less company resources are tied up in inventory. However, there are usually two
sides to the story of any ratio. An unusually high inventory turnover rate can be a sign that a company’s inventory is too
lean, and the firm may be unable to keep up with any increased demand. Furthermore, inventory turnover is very
industry-specific. In an industry where inventory gets stale quickly, you should seek out companies with high inventory
turnover.
In our example in Table 1, the inventory turnover ratio of 2.6x means that inventory was “turned over” or replenished
2.6 times during a period of one year. (This equates to inventory being turned over once every 140 days, or 365 days ÷
2.6.) The inventory figure used, $190 million, is calculated using a beginning inventory of $180 million on December 31,
2010, and an ending inventory of $200 million on December 31, 2011. The $190 million represents the average
inventory held during 2011, the time period when $500 million was generated in cost of goods sold.
Going forward, a decrease in inventory or an increase in cost of goods sold will increase the ratio, signaling improved
inventory efficiency (selling the same amount of goods while holding less inventory or selling more goods while holding
the same amount of inventory).
Receivables turnover
The receivables turnover ratio is calculated by dividing net revenue by average receivables. This ratio is a measure of
how quickly and efficiently a company collects on its outstanding bills. The receivables turnover indicates how many
times per period the company collects and turns into cash its customers’ accounts receivable.
In Table 1, the receivables turnover is 7.8x, signaling that, on average, receivables were fully collected 7.8 times during
the period or once every 47 days (365 ÷ 7.8).
Once again, a high turnover compared to that of peers means that cash is collected more quickly for use in the
company, but be sure to analyze the turnover ratio in relation to the firm’s competitors. A very high receivables turnover
ratio can also mean that a company’s credit policy is too stringent, causing the firm to miss out on sales opportunities.
Alternatively, a low or declining turnover can signal that customers are struggling to pay their bills.
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Payables turnover
Payables turnover measures how quickly a company pays off the money owed to suppliers. The ratio is calculated by
dividing purchases (on credit) by average payables.
Our payables turnover of 5.8x suggests that, on average, the firm used and paid off the credit extended 5.8 times
during the period or once every 63 days (365 days ÷ 5.8). The payables turnover increases as more purchases are
made or as a company decreases its accounts payable.
A high number compared to the industry average indicates that the firm is paying off creditors quickly, and vice versa.
An unusually high ratio may suggest that a firm is not utilizing the credit extended to them, or it could be the result of
the company taking advantage of early payment discounts. A low payables turnover ratio could indicate that a company
is having trouble paying off its bills or that it is taking advantage of lenient supplier credit policies.
Be sure to analyze trends in the payables turnover ratio, as a change in a single period can be caused by timing issues
such as the firm acquiring additional inventory for a large purchase or to gear up for a high sales season. Also
understand that industry norms can vary dramatically.
Asset turnover
Asset turnover measures how efficiently a company uses its total assets to generate revenues. The formula to calculate
this ratio is simply net revenues divided by average total assets. Our asset turnover ratio of 0.72x indicates that the firm
generates $0.72 of revenue for every $1 of assets that the company owns.
A low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is operating in a capitalintensive environment. Additionally, it may point to a strategic choice by management to use a more capital-intensive
(as opposed to a more labor-intensive) approach.
Table 1. Financial Ratio Formulas & Examples
Example data comes from the income statement, balance sheet and cash flow statement found in the Financial Statement
Analysis columns in the March, May and July 2012 issues of the AAII Journal, which are linked here.
Dollar amounts are in millions of dollars.
Activity Ratios
Inventory turnover
Receivables turnover
Payables turnover
Asset turnover
=
cost of goods sold ÷ average inventory
=
$500 ÷ $190 = 2.6x
=
net revenue ÷ average receivables
=
$1,000 ÷ $128.5 = 7.8x
=
purchases* ÷ average payables
=
$520 ÷ $90 = 5.8x
=
net revenues ÷ average total assets
=
$1,000 ÷ $1,391 = 0.72x
=
current assets ÷ current liabilities
=
$685 ÷ $750 = 0.91x
=
(cash + short-term marketable securities + accounts receivable) ÷ current liabilities
=
$340 ÷ $750 = 0.45x
=
(cash + short-term marketable securities) ÷ current liabilities
=
$200 ÷ $750 = 0.27x
=
total liabilities ÷ total assets
=
$1,067 ÷ $1,485 = 0.72, or 72%
=
total debt* ÷ (total debt* + total shareholder’s equity)
=
$517 ÷ $935 = 0.55, or 55%
=
total debt* ÷ total shareholder’s equity
=
$517 ÷ $418 = 1.24, or 124%
=
earnings before interest and taxes* ÷ interest payments
=
$230 ÷ $100 = 2.3x
=
gross income ÷ net revenue
=
$500 ÷$1,000 = 0.5, or 50%
=
operating income ÷ net revenue
=
$180 ÷ $1,000 = 0.18, or 18%
=
net income ÷ net revenue
=
$82.75 ÷ $1,000 = 0.083, or 8.3%
=
net income ÷ total assets
=
$82.75 ÷ $1,485 = 0.056, or 5.6%
=
net income ÷ total stockholder’s equity
=
$82.75 ÷ $418 = 0.20, 20%
=
cost of goods sold + ending inventory – beginning inventory
=
$500 + $200 – $180 = $520
=
notes payable + current portion of long-term debt + long-term debt
=
$100 + $150 + $267 = $517
=
net income + income taxes + interest expense
=
$82.75 + $47.25 + $100 = $230
Liquidity Ratios
Current ratio
Quick ratio
Cash ratio
Solvency Ratios
Debt-to-assets ratio
Debt-to-capital ratio
Debt-to-equity ratio
Interest coverage ratio
Profitability Ratios
Gross profit margin
Operating profit margin
Net profit margin
Return on assets (ROA)
Return on equity (ROE)
*calculated terms:
purchases
total debt
earnings before interest and taxes
Liquidity Ratios
Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios. They are especially
important to creditors. These ratios measure a firm’s ability to meet its short-term obligations.
The level of liquidity needed varies from industry to industry. Certain industries are more cash-intensive than others.
For example, grocery stores will need more cash to buy inventory constantly than software firms, so the liquidity ratios
of companies in these two industries are not comparable to each other. It is also important to note a company’s trend in
liquidity ratios over time.
Current ratio
The current ratio measures a company’s current assets against its current liabilities. The current ratio indicates if the
company can pay off its short-term liabilities in an emergency by liquidating its current assets. Current assets are found
at the top of the balance sheet and include line items such as cash and cash equivalents, accounts receivable and
inventory, among others.
A low current ratio indicates that a firm may have a hard time paying their current liabilities in the short run and
deserves further investigation. A current ratio under 1.00x, for example, means that even if the company liquidates all
of its current assets, it would still be unable to cover its current liabilities. In our example, the firm is operating with a
very low current ratio of 0.91x. It indicates that if the firm liquidated all of its current assets at the recorded value, it
would only be able to cover 91% of its current liabilities.
A high ratio indicates a high level of liquidity and less chance of a cash squeeze. A current ratio that is too high,
however, may indicate that the company is carrying too much inventory, allowing accounts receivables to balloon with
lax payment collection standards or simply holding too much in cash. Although these issues will not typically lead to
insolvency, they will inevitably hurt the company’s bottom line.
Quick ratio
The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio compares the cash, short-term
marketable securities and accounts receivable to current liabilities. The thought behind the quick ratio is that certain line
items, such as prepaid expenses, have already been paid out for future use and cannot be quickly and easily converted
back to cash for liquidity purposes. In our example, the quick ratio of 0.45x indicates that the company can only cover
45% of current liabilities by using all cash-on-hand, liquidating short-term marketable securities and monetizing
accounts receivable.
The major line item excluded in the quick ratio is inventory, which can make up a large portion of current assets but
may not easily be converted to cash. During times of stress, high inventories across all companies in the industry may
make selling inventory difficult. In addition, if company stockpiles are overly specialized or nearly obsolete, they may be
worth significantly less to a potential buyer. Consider Apple Inc. (AAPL), for example, which is known to use specialized
parts for its products. If the company needed to quickly liquidate inventory, the stockpiles it is carrying may be worth a
great deal less than the inventory figure it carries on its accounting books.
Cash ratio
The most conservative liquidity ratio is the cash ratio, which is calculated as simply cash and short-term marketable
securities divided by current liabilities. Cash and short-term marketable securities represent the most liquid assets of a
firm. Short-term marketable securities include short-term highly liquid assets such as publicly traded stocks, bonds and
options held for less than one year. During normal market conditions, these securities can easily be liquidated on an
exchange. The cash ratio in Table 1 is 0.27x, which suggests that the firm can only cover 27% of its current liabilities
with its cash and short-term marketable securities.
Although this ratio is generally considered the most conservative and very reliable, it is possible that even short-term
marketable securities can experience a significant drop in prices during market crises.
Solvency Ratios
Solvency ratios measure a company’s ability to meet its longer-term obligations. Analysis of solvency ratios provides
insight on a company’s capital structure as well as the level of financial leverage a firm is using.
Some solvency ratios allow investors to see whether a firm has adequate cash flows to consistently pay interest
payments and other fixed charges. If a company does not have enough cash flows, the firm is most likely overburdened
with debt and bondholders may force the company into default.
Debt-to-assets ratio
The debt-to-assets ratio is the most basic solvency ratio, measuring the percentage of a company’s total assets that is
financed by debt. The ratio is calculated by dividing total liabilities by total assets. A high number means the firm is
using a larger amount of financial leverage, which increases its financial risk in the form of fixed interest payments. In
our example in Table 1, total liabilities accounts for 72% of total assets.
Debt-to-capital ratio
The debt-to-capital ratio is very similar, measuring the amount of a company’s total capital (liabilities plus equity) that is
provided by debt (interesting bearing notes and short- and long-term debt). Once again, a high ratio means high
financial leverage and risk. Although financial leverage creates additional financial risk by increased fixed interest
payments, the main benefit to using debt is that it does not dilute ownership. In theory, earnings are split among fewer
owners, creating higher earnings per share. However, the increased financial risk of higher leverage may hold the
company to stricter debt covenants. These covenants could restrict the company’s growth opportunities and ability to
pay or raise dividends.
Debt-to-equity ratio
The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the amount of equity capital it
uses. A ratio of 1.00x indicates that the firm uses the same amount of debt as equity and means that creditors have
claim to all assets, leaving nothing for shareholders in the event of a theoretical liquidation.
For our example, total debt used in the numerator includes short- and long-term interest-bearing debt. This ratio can
also be calculated using only long-term debt in the numerator.
Interest coverage ratio
The interest coverage ratio, also known as times interest earned, measures a company’s cash flows generated
compared to its interest payments. The ratio is calculated by dividing EBIT (earnings before interest and taxes) by
interest payments.
In the example used in Table 1, the interest coverage ratio of 2.3x indicates that the firm’s earnings before interest and
taxes are 2.3 times its interest obligations for the period. The higher the figure, the less chance a company has of
failing to meet its debt repayment obligations. A high figure means that a company is generating strong earnings
compared to its interest obligations.
With interest coverage ratios, it’s important to analyze them during good and lean years. Most companies will show
solid interest coverage during strong economic cycles, but interest coverage may deteriorate quickly during economic
downturns.
Profitability Ratios
Profitability ratios are arguably the most widely used ratios in investment analysis. These ratios include the ubiquitous
“margin” ratios, such as gross, operating and net profit margins. These ratios measure the firm’s ability to earn an
adequate return. When analyzing a company’s margins, it is always prudent to compare them against those of the
industry and its close competitors.
Margins will vary among industries. Companies operating in industries where products are mostly “commodities”
(products easily replicated by other firms) will typically have low margins. Industries that offer unique products with high
barriers to entry generally have high margins. In addition, companies may hold key competitive advantages leading to
increased margins.
Gross profit margin
Gross profit margin is simply gross income (revenue less cost of goods sold) divided by net revenue. The ratio reflects
pricing decisions and product costs. The 50% gross margin for the company in our example shows that 50% of
revenues generated by the firm are used to pay for the cost of goods sold.
For most firms, gross profit margin will suffer as competition increases. If a company has a higher gross profit margin
than is typical of its industry, it likely holds a competitive advantage in quality, perception or branding, enabling the firm
to charge more for its products. Alternatively, the firm may also hold a competitive advantage in product costs due to
efficient production techniques or economies of scale. Keep in mind that if a company is a first mover and has high
enough margins, competitors will look for ways to enter the marketplace, which typically forces margins downward.
Operating profit margin
Operating profit margin is calculated by dividing operating income (gross income less operating expenses) by net
revenue. The operating margin in Table 1 is 18%, which suggests that for every $1 of revenues generated, $0.18 is left
after deducting cost of goods sold and operational expenses. Operating expenses include costs such as administrative
overhead and other costs that cannot be attributed to single product units.
Operating margin examines the relationship between sales and management-controlled costs. Increasing operating
margin is generally seen as a good sign, but investors should simply be looking for strong, consistent operating
margins.
Net profit margin
Net profit margin compares a company’s net income to its net revenue. This ratio is calculated by dividing net income,
or a company’s bottom line, by net revenue. It measures a firm’s ability to translate sales into earnings for
shareholders. Once again, investors should look for companies with strong and consistent net profit margins.
In our example, the net profit margin of 8.3% suggests that for every $1 of revenue generated by the firm, $0.083 is
created for the shareholders.
ROA and ROE
Two other profitability ratios are also widely used—return on assets (ROA) and return on equity (ROE).
Return on assets is calculated as net income divided by total assets. It is a measure of how efficiently a firm utilizes its
assets. A high ratio means that the company is able to efficiently generate earnings using its assets. As a variation,
some analysts like to calculate return on assets from pretax and pre-interest earnings using EBIT divided by total
assets.
While return on assets measures net income, which is return to equity holders, against total assets, which can be
financed by debt and equity, return on equity measures net income less preferred dividends against total stockholder’s
equity. This ratio measures the level of income attributed to shareholders against the investment that shareholders put
into the firm. It takes into account the amount of debt, or financial leverage, a firm uses. Financial leverage magnifies
the impact of earnings on ROE in both good and bad years. If there are large discrepancies between the return on
assets and return on equity, the firm may be incorporating a large amount of debt. In that case, it is prudent to closely
examine the liquidity and solvency ratios.
The firm in our example in Table 1 has an ROA of 5.6%, indicating that for every $1 of company assets, the firm is
generating $0.056 in net income. The ROE in our example of 20% suggests that for every $1 in shareholder’s equity,
the firm is generating $0.20 in net income.
Conclusion
Ratio analysis is a form of fundamental analysis that links together the three financial statements commonly produced
by corporations. Ratios provide useful figures that are comparable across industries and sectors. Using financial ratios,
investors can develop a feel for a company’s attractiveness based on its competitive position, financial strength and
profitability.
Custom Field Editor
Creating and Saving Ratios in Stock Investor
Pro
Creating the ratios discussed in this article for use in Stock Investor Pro allows
you to quickly pull them up for any company in the database. This overview
shows you how to create the ratios to access them through Stock Investor Pro
views.
Start by opening the Custom Field Editor by going to go Tools and selecting
Custom Field Editor, by pressing Alt-C, or by clicking on the Custom Field Editor
icon in the toolbar. The Custom Field Editor is where all the ratios are created.
Field Picker Box
To create each of the ratios, the ratio formula must be entered into the
expression box. For instance, when creating inventory turnover ratio, which is
calculated by taking cost of goods sold and dividing by average inventory, first
click in the expression box and select cost of goods sold from the field picker
box. Cost of goods sold is an income statement item, so it is found by expanding
the Income Statement – Annual category. To expand any category, click on the
plus sign next to category in the field picker window. In our example, we select
Cost of Goods Sold Y1, which provides the cost of goods sold figure for the most
recently completed fiscal year. After selecting cost of goods sold, click Add Field
and the data point will appear in the expression box. Next, press the division symbol and it will also appear in the
expression box. The denominator of the inventory turnover equation is average inventory, which requires the average
of the beginning and ending inventories for the period. In order to properly enter the denominator, start by inputting two
open parentheses by pressing the open parentheses button twice. Expand the Income Statement – Annual category,
select Inventory Y1 and press Add Field. Once again, the data field will appear in the expression box. Next, click on the
addition symbol and confirm that it appeared in the expression box. Select Inventory Y2 (the inventory figure at the end
of the fiscal year two years ago) and click on Add Field. After checking to see that the data field appeared in the
expression box, click on the end parentheses sign. Next, select the divisor sign again and then click on the end
parenthesis sign one more time. The denominator of the expression should look like this: ([Inventory Y1] + [Inventory
Y2]) / 2). The denominator adds the ending inventory one and two fiscal years ago and then divides by two, which is
the average inventory during that period. The entire expression should now be complete and look like this: [Cost of
goods sold 12m] / (([Inventory Y1] + [Inventory Y2]) / 2).
Inventory Turnover Expression
You can also simply type this expression in. Please note that it must be typed
into the expression box exactly as it shows up here or the function will not work
properly. After finishing the inventory turnover expression, click on Verify. The
program notifies you if the expression is valid or invalid. If the expression is
valid, you can save and name it by clicking on the Save As button. If the
expression is invalid, it means you did not enter in the expression correctly. In
our example, we named the expression Inventory Turnover Ratio.
View Editor
The remaining ratios are created in the
same manner. If you know the ratio
formula, you can easily create them in
Stock Investor Pro. The difficulty lies in
knowing which category each of the data
fields resides in. For help finding each
data point, refer to the Help menu, which
includes all the data fields offered in the
program. A summary is provided for each
data point along with their categories.
Ratio View
After creating your ratios, the program allows you to create a view to access the
ratios quickly and easily. To create a view, open the View Editor by clicking on
View Editor from the Tools pulldown menu. The newly created custom fields are
all stored in the Custom Fields category. Expand this category and select the
ratios you want to be included in your view and press Add, then select Save and
name your view. In our example, we include the Company Name and Inventory
Turnover Ratio. After creating your view, pull it up by selecting it from the View
pulldown menu. As you can see, I selected the Buffett (Hagstrom) screen and
the newly created Ratio View. I am shown the companies passing the Buffett
(Hagstrom) screen and the Inventory ratio of each company.
—Joe Lan
Analysis Series
Other Articles in the Financial Statement
Introduction to Financial Statement Analysis, January 2012
The Income Statement: From Net Revenue to Net Income, March 2012
The Balance Sheet: Assets, Debts and Equity, May 2012
The Cash Flow Statement: Tracing the Sources and Uses of Cash, July 2012
→ Joe Lan, CFA is a former financial analyst for AAII.
Discussion
Steven Sears from IA posted over 6 years ago:
Another great article! It is good to underscore the vast differences between industries. I look forward to receiving the hard copy to keep on my desk. Thank You!
Thomas Dean from ON posted over 5 years ago:
This article omits value ratios: Price to Earnings, Price to Cash Flow, Price to Book, Price to Sales.
Joe Lan from IL posted over 5 years ago:
We have yet to discuss valuation ratios and ROE in detail and will likely do that in a future article.
Doug from Ithaca, NY posted over 5 years ago:
The Debt-to-Equity ratio section doesn't seem right to me:
----Debt-to-equity ratio
The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses
the same amount of debt as equity and means that creditors have claim to all assets, leaving nothing for shareholders in the event of a theoretical liquidation.
----Given that Equity = Assets - Liabilities, I would think that a debt-to-ASSETS ratio of 1.00x would be the case where creditors have claim to all assets, leaving nothing
for shareholders in a liquidation.
A debt-to-equity ratio of 1.00x implies (by the above equation) that Assets are twice liabilities; so there IS something left for shareholders in the event of a liquidation.
I think the debt-to-equity ratio is useful as a sensitive index of LEVERAGE, given that additional debt increases assets in the same amount as liabilities, but leaves
equity unchanged.
Raj from NJ posted over 5 years ago:
Agree with Doug. As long as the Assets > Liabilities, wont there be something (theoretically) left over for shareholders?
In practice, there is cost associated with liquidation and the amount leftover (Assets - Liabilities) will have to be significant enough to repay the shareholders.
Great article as the previous four and look forward to more!
Gerrie Griffin from IL posted over 5 years ago:
Great article. Gave me a clear understanding of what basic ratios measure and how to calculate them. Thanks!
Alex from CA posted over 5 years ago:
Would you consider some ratios for evaluating
Dividends & the companies ability to continue making them(Common and/or Preferred) in various industries (MLP'S, REITS,Utilities, Financial,
all Others)
Doug Dudley from AZ posted over 5 years ago:
Thanks, Doug. I am just catching up and the comment about "leaving nothing for shareholders in the event of a theoretical liquidation" would have bugged me, too.
I am also enjoying these articles. Much more interesting as a retired investor than a working accountant.
Nord from California posted over 4 years ago:
It would be great if the standard ratios were already preprogramed in Stock Investor Pro.
Ron from Ohio posted over 4 years ago:
Hello Joe
great article.
which of the above ratio's would be considered the best, or the number rule of thumb to keep an eye on?
how can we as investors now that the numbers reported by companies are "accurate" .. so many different accounting standards.
Sorry for beginner questions.
Ron
Paul Courchene from NH posted over 2 years ago:
I wish articles such as this were published or available as a "Print Version". I often sit in my Easy Chair and read things from your Web Site, and sometimes print the
content out, so that I can walk through it with a pencil or Pen.
And make points that i want to remember ...
How about a "Printable Version?" ...
A Happy AAII Camper
A. Smith from OH posted over 2 years ago:
Would like to see a lot more of this type of information. A series of this type info would be of tremendous value.
Donald Levy from NY posted 8 months ago:
This a simple and brief overview of the ratio, I am looking forward to Part 2 of this presentation. Please also include some of the ratio for buying stocks.
Sorry, you cannot add comments while on a mobile device or while printing.
© 2018 The American Association of Individual Investors
This content originally appeared in the AAII Journal
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Financial Ratios
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Financial ratios are useful indicators of a firm's performance and financial situation.
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Most ratios can be calculated from information provided by the financial statements.
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Financial ratios can be used to analyze trends and to compare the firm's financials to
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those of other firms. In some cases, ratio analysis can predict future bankruptcy.
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Financial ratios can be classified according to the information they provide. The
Terms
of Use
following types of ratios frequently are used:
•
•
•
•
•
Liquidity ratios
Asset turnover ratios
Financial leverage ratios
Profitability ratios
Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term
financial obligations. They are of particular interest to those extending short-term
credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working
capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
Current Ratio
=
Current Assets
Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk.
Shareholders may prefer a lower current ratio so that more of the firm's assets are
working to grow the business. Typical values for the current ratio vary by firm and
industry. For example, firms in cyclical industries may maintain a higher current ratio
in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that are
difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio
is an alternative measure of liquidity that does not include inventory in the current
assets. The quick ratio is defined as follows:
Quick Ratio
=
Current Assets - Inventory
Current Liabilities
The current assets used in the quick ratio are cash, accounts receivable, and notes
receivable. These assets essentially are current assets less inventory. The quick ratio
often is referred to as the acid test.
Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current
assets except the most liquid: cash and cash equivalents. The cash ratio is defined as
follows:
Cash Ratio
=
Cash + Marketable Securities
Current Liabilities
The cash ratio is an indication of the firm's ability to pay off its current liabilities if for
some reason immediate payment were demanded.
Asset Turnover Ratios
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They
sometimes are referred to as efficiency ratios, asset utilization ratios, or asset
management ratios. Two commonly used asset turnover ratios are receivables
turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts
receivables and is defined as follows:
Annual Credit Sales
=
Receivables Turnover
Accounts Receivable
The receivables turnover often is reported in terms of the number of days that credit
sales remain in accounts receivable before they are collected. This number is known
as the collection period. It is the accounts receivable balance divided by the average
daily credit sales, calculated as follows:
=
Average Collection Period
Accounts Receivable
Annual Credit Sales / 365
The collection period also can be written as:
Average Collection Period
=
365
Receivables Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in
a time period divided by the average inventory level during that period:
Inventory Turnover
=
Cost of Goods Sold
Average Inventory
The inventory turnover often is reported as the inventory period, which is the number
of days worth of inventory on hand, calculated by dividing the inventory by the
average daily cost of goods sold:
Inventory Period
=
Average Inventory
Annual Cost of Goods Sold / 365
The inventory period also can be written as:
Inventory Period
365
=
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-term solvency of the firm.
Unlike liquidity ratios that are concerned with short-term assets and liabilities,
financial leverage ratios measure the extent to which the firm is using long term debt.
The debt ratio is defined as total debt divided by total assets:
Debt Ratio
=
Total Debt
Total Assets
The debt-to-equity ratio is total debt divided by total equity:
Debt-to-Equity Ratio
=
Total Debt
Total Equity
Debt ratios depend on the classification of long-term leases and on the classification of
some items as long-term debt or equity.
The times interest earned ratio indicates how well the firm's earnings can cover the
interest payments on its debt. This ratio also is known as the interest coverage and is
calculated as follows:
Interest Coverage
=
EBIT
Interest Charges
where EBIT = Earnings Before Interest and Taxes
Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at
generating profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross
profit margin considers the firm's cost of goods sold, but does not include other costs.
It is defined as follows:
Gross Profit Margin
=
Sales - Cost of Goods Sold
Sales
Return on assets is a measure of how effectively the firm's assets are being used to
generate profits. It is defined as:
Return on Assets
=
Net Income
Total Assets
Return on equity is the bottom line measure for the shareholders, measuring the
profits earned for each dollar invested in the firm's stock. Return on equity is defined
as follows:
=
Return on Equity
Net Income
Shareholder Equity
Dividend Policy Ratios
Dividend policy ratios provide insight into the dividend policy of the firm and the
prospects for future growth. Two commonly used ratios are the dividend yield and
payout ratio.
The dividend yield is defined as follows:
Dividend Yield
=
Dividends Per Share
Share Price
A high dividend yield does not necessarily translate into a high future rate of return. It
is important to consider the prospects for continuing and increasing the dividend in
the future. The dividend payout ratio is helpful in this regard, and is defined as
follows:
Payout Ratio
=
Dividends Per Share
Earnings Per Share
Use and Limitations of Financial Ratios
Attention should be given to the following issues when using financial ratios:
• A reference point is needed. To to be meaningful, most ratios must be
compared to historical values of the same firm, the firm's forecasts, or ratios of
similar firms.
• Most ratios by themselves are not highly meaningful. They should be viewed as
indicators, with several of them combined to paint a picture of the firm's
situation.
• Year-end values may not be representative. Certain account balances that are
used to calculate ratios may increase or decrease at the end of the accounting
period because of seasonal factors. Such changes may distort the value of the
ratio. Average values should be used when they are available.
• Ratios are subject to the limitations of accounting methods. Different accounting
choices may result in significantly different ratio values.
Finance > Financial Ratios
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HCA312 Week 4 Assignment
Comparative Data
Prior to beginning this assignment, review Chapter 14 and 15 in the course textbook, Health Care
Finance: Basic Tools for the Nonfinancial Managers, 5th edition. These two chapters will assist you in
responding accurately to the questions in the table.
Instructions:
Complete the following table by writing detailed and thorough responses to the questions. Provide
examples where indicated. Once the document template is completed, you should have at least two
pages. APA formatted citations and references are required. Cite the sources per in the narrative and list
the reference in the last box of the table.
What is meant by
common sizing?
Provide an
example:
What is meant by
Trend Analysis?
Provide an
example:
What is the
difference
between
forecasting and
projecting?
What are the three
common types of
forecasts in a
Healthcare
Organization?
Name the three
criteria that must
be met for true
comparability.
Discuss each.
What elements of
consistency
should be
considered?
Provide an
example:
Discuss the
importance of
comparative data
and explain the
healthcare
manager’s
responsibility
when comparing
data
Name the four
common uses of
Comparative Data.
Discuss each.
Explain
Standardized Data
Provide an
example.
List your
References:
REQUIRED

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