M3 2: Discussion—Applied Ratio Analysis

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Key Ratios - Definitions

KEY FINANCIAL STATEMENT RATIOS rev. 3-19-2010 rev. Feb 2010
Liquidity ratios Example:
A "2.0 to 1" ratio means that there is If current liabilities are rising faster
Current Ratio Current Assets 2.0 to 1 $2.00 of current assets for every $1 than the current assets from which
Current Liabilities in current liabilities, which suggests they must be paid, company could
that short-term creditors can be become insolvent (unable to pay
reasonably sure of being paid. its debts) and eventually bankrupt.
Quick Ratio Quick Assets * 0.9 to 1 Indicates extent to which claims of If Current Ratio is OK, but Quick Ratio
"Acid Test" Current Liabilities short-term creditors are covered by is low or declining, the cause may
"quick" assets*. be excessive nonliquid inventory.
* Quick assets include Cash, Marketable Securities, and Accounts Receivable (excludes Inventory)
Asset Management Ratios
Number of times per year If the turnover ratio is decreasing
Accts Receivable Sales (credit only) 6.0 times receivables were generated or avg number of days to collect is
Turnover Accounts receivable and then paid ("turned over") increasing or is substantially greater
than credit terms (e.g. "30 days, net"),
Avg Number of 365 (days in year) 60.8 days Number of days customers are then credit and collection policies may
Days to Collect A/R turnover ratio taking to pay need to be strengthened.
Number of times merchandise
Inventory Cost of Goods Sold* 4.0 times items are sold and restocked
Turnover Inventory* ("turned over") per year. If the turnover ratio is decreasing
or number of days in Inventory is
* Some publications use "Sales" as the numerator, and /or average inventory as denominator increasing , inventory may becoming
outdated, and possibly overstated
Avg Number of 365 (days in year) 91.3 days Number of days inventory remains
Days in Inventory Inv. turnover ratio unsold
Debt (Leverage) (Long-term Solvency) Ratios
Debt to Total Liabilities 0.50 The portion of the total financing Debt to Assets and Debt to Equity
Assets Total Assets supplied by creditors as opposed to are alternative benchmarks that
the owner-stockholders. measure long-term solvency. Higher
ratios (high leverage) mean greater
Debt to Total Liabilities 1.5 The financing supplied by creditors risk that cash flows from operations
Equity Total Equity as compared to financing supplied will be insufficient to cover interest
by the owner-stockholders. and principal payments.
Times interest EBIT* 3.2 Measures the extent to which operat- Low ratio = low margin of safety,
Earned Interest expense ing income can decline before firm is and can make it difficult to borrow.
unable to meet interest payments
* EBIT means "Earnings before Interest and Taxes"
Profitability Ratios (not applicable if net loss)
Net Profit Net Income 5.1% Net income as a percentage of sales. Low percentage = low safety
Margin (%) Sales (net) If trend is down, product costs and/or margin: higher risk that a decline in
operating expenses are rising faster sales will erase profits and result
than sales. in a net loss.
Gross Profit Gross Profit 35.2% Gross Profit as a percentage of sales. A low or declining Gross Profit %
on Sales (%) Sales (net) If low or declining, product costs may indicates less ability to sell goods
be increasing and/or selling prices at intended selling price, or rising
decreasing (steeper discounts). cost of goods, or both.
Return Operating Income* 15.3% Measures how well management A low or declining rate could mean
on Assets (%) Total Operating Assets is managing assets to generate that assets are not being utilized
aka ROI profit from operations. effectively.
Return Net Income ** 18.4% Measures rate of return on stockholders Low return could be caused by high
on Equity (%) Total Equity ** investment. (However, "dividend yield" debt i.e., high interest expense.
for stockholders is generally much less.)
* Some publications use Net income (after tax) instead of Operating income (i.e., earnings before interest and income tax, or EBIT)
** If preferred stock exists, subtract Preferred Dividends from Net Income; and also subtract Preferred Stock from Total Equity
Market Value Ratios
Earnings per Net Income * $1.23 EPS is the "real" measure of profitability EPS can decline despite an
Share (EPS) Common shares outstanding used by potential investors (not used increase in total earnings, and thus
by creditors). drive down the market price per
* If preferred stock exists, subtract Preferred Dividends from Net Income. share.
Price/Earnings Market Price 16.5 times The multiple-times-earnings that High P/E ratio means that investors
Ratio (P/E) EPS * investors are willing to pay, based on perceive good growth potential -- but
their perception of future share price. they could be (and often are) wrong.
* If EPS is negative, ratio is "not applicable"

Key Ratios - Blank

KEY FINANCIAL STATEMENT RATIOS
THIS YEAR LAST YEAR
Amounts Answer Amounts Answer
Liquidity ratios
Current Ratio
Current Assets = =
Current Liabilities
Quick Ratio, or
"Acid Test" Quick Assets* = =
Current Liabilities
* Quick assets include Cash, Marketable Securities, and Accounts Receivable (excludes Inventory)
Inventory Cost of Goods Sold
Turnover Inventory*
Accts Receivable Sales
Turnover Accts Receivable*
* Textbooks generally use "average" for the year (beginning + ending) / 2, but it's OK to use ending only
Debt (Leverage) (Long-term Solvency) Ratios
Debt to Total Liabilities = =
Assets Total Assets
Debt to Total Liabilities = =
Equity Total Equity
Times interest EBIT* = =
Earned Interest expense
* EBIT means "Earnings before Interest and Taxes"
Profitability Ratios (not applicable if net loss)
Net Profit Net Income = =
Margin (%) Sales
Gross Profit Gross Profit = =
on Sales (%) Sales
Return Net Operating Income = =
on Assets (%) Total Operating Assets
aka ROI
Return Net Income = =
on Equity (%) Total Equity
Market Value Ratios
Earnings per Net Income = =
Share (EPS) No. shares outstanding
Price/Earnings* Market Price = prior year not required
Ratio (P/E) EPS
* P/E ratio changes daily with market price. If EPS is negative, ratio is "not applicable". Use "Basic" , not "Diluted".