Financial Analysis/ Ratios
AC499: Bachelors Capstone in Accounting | Unit 4
Unit 4 Practice Financial Report Analysis Liquidity ratios
Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash
needs.
The current ratio is also called the working capital ratio, as working capital is the difference between current
assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using
current assets. The current ratio is calculated by dividing current assets by current liabilities.
Current Ratio = Current Assets / Current Liabilities
The acid-test ratio is also called the quick ratio. Quick assets are defined as cash, marketable (or short-
term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts.
These assets are considered to be very liquid (easy to obtain cash from the assets) and therefore, available for
immediate use to pay obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities.
Acid-Text Ratio = Quick Assets / Current Liabilities
The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of
receivables to understand how often the company turns them into cash. It may also indicate the company
needs to establish a line of credit with a financial institution to ensure the company has access to cash when it
needs to pay its obligations.
The receivables turnover ratio calculates the number of times in an operating cycle (normally one year) the
company collects its receivable balance. It is calculated by dividing net credit sales by the average net
receivables. Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average
net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net
receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a
reasonable basis for the company's operations should be used such as monthly or quarterly.
Receivables Turnover = Net Credit Sales / Average Net Receivables
The average collection period (also known as day's sales outstanding) is a variation of receivables
turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used
to evaluate the effectiveness of a company's credit and collection policies. A rule of thumb is the average
collection period should not be significantly greater than a company's credit term period. The average
collection period is calculated by dividing 365 by the receivables turnover ratio.
Average Collection Period = 365 days / Receivables Turnover
AC499: Bachelors Capstone in Accounting | Unit 4
The inventory turnover ratio measures the number of times the company sells its inventory during the period.
It is calculated by dividing the cost of goods sold by average inventory. Average inventory is calculated by
adding beginning inventory and ending inventory and dividing by 2. If the company is cyclical, an average
calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Day's sales on hand is a variation of the inventory turnover. It calculates the number of day's sales being
carried in inventory. It is calculated by dividing 365 days by the inventory turnover ratio.
Day’s Sales on Hand = 365 days / Inventory Turnover
Profitability ratios measure a company's operating efficiency, including its ability to generate income and
therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing.
Profit margin. The profit margin ratio, also known as the operating performance ratio, measures the
company's ability to turn its sales into net income. To evaluate the profit margin, it must be compared to
competitors and industry statistics. It is calculated by dividing net income by net sales.
Profit Margin = Net Income/Net Sales
The asset turnover ratio measures how efficiently a company is using its assets. The turnover value varies by
industry. It is calculated by dividing net sales by average total assets.
Asset Turnover = Net Sales / Average Total Assets
The return on assets (ROA) ratio (ROA) is considered an overall measure of profitability. It measures how
much net income was generated for each $1 of assets the company has. ROA is a combination of the profit
margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average
total assets or by multiplying the profit margin ratio times the asset turnover ratio.
Return on Assets = Net Income / Average Total Assets OR
Return on Assets = Profit Margin X Asset Turnover
Net income / Average total assets = (Net Income / Net Sales) X (Net Sales / Average Total Assets)
The return on common stockholders' equity (ROE) measures how much net income was earned relative to
each dollar of common stockholders' equity. It is calculated by dividing net income by average common
stockholders' equity. In a simple capital structure (only common stock outstanding), average common
stockholders' equity is the average of the beginning and ending stockholders' equity.
AC499: Bachelors Capstone in Accounting | Unit 4
Return on common stockholders’ equity = Net Income / Average Common Stockholders’ Equity
In a complex capital structure, net income is adjusted by subtracting the preferred dividend requirement, and
common stockholders' equity is calculated by subtracting the par value (or call price, if applicable) of the
preferred stock from total stockholders' equity.
Return on common stockholders’ equity = Net Income – Preferred Dividends / Average Common Stockholders’ Equity
Earnings per share (EPS) represents the net income earned for each share of outstanding common stock. In
a simple capital structure, it is calculated by dividing net income by the number of weighted average common
shares outstanding.
Earnings Per Share = Net Income / Weighted Average Common Shares Outstanding
The price-earnings ratio (P/E) is quoted in the financial press daily. It represents the investors' expectations
for the stock. A P/E ratio greater than 15 has historically been considered high.
Price-Earnings ratio = Market price per common share / Earnings per share
The payout ratio identifies the percent of net income paid to common stockholders in the form of cash
dividends. It is calculated by dividing cash dividends by net income.
Payout Ratio = Cash Dividends / Net Income
A more stable and mature company is likely to pay out a higher portion of its earnings as dividends. Many
startup companies and companies in some industries do not pay out dividends. It is important to understand
the company and its strategy when analyzing the payout ratio.
Another indicator of how a corporation performed is the dividend yield. It measures the return in cash
dividends earned by an investor on one share of the company's stock. It is calculated by dividing dividends
paid per share by the market price of one common share at the end of the period.
Dividend Yield = Dividends Paid Per Share / Market Price of One Share Common Stock at End of Period
A low dividend yield could be a sign of a high growth company that pays little or no dividends and reinvests
earnings in the business or it could be the sign of a downturn in the business. It should be investigated so the
investor knows the reason it is low.
AC499: Bachelors Capstone in Accounting | Unit 4
Solvency ratios are used to measure long-term risk and are of interest to long-term creditors and
stockholders.
The debt to total assets ratio calculates the percent of assets provided by creditors. It is calculated by
dividing total debt by total assets. Total debt is the same as total liabilities.
Debt to total assets ration = Total debs / Total assets
The times interest earned ratio is an indicator of the company's ability to pay interest as it comes due. It is
calculated by dividing earnings before interest and taxes (EBIT) by interest expense.
Times interest earned = Income* Before Interest Expense and Income Tax Expense (EBIT) / Interest Expense
*also called earnings
A times interest earned ratio of 2–3 or more indicates that interest expense should reasonably be covered. If
the times interest earned ratio is less than two it will be difficult to find a bank to loan money to the business.