Find International - Case 1

Financial Ratios in Brief

Generally speaking you should compute 3 years of ratios and, if possible, compare the most current ratio to either a competitor’s ratio or the industry-average ratio

Liquidity ratios

1. Current ratio – current assets/current liabilities

This ratio tells you if the firm has enough current assets to pay for its current liabilities. In general, higher is better but there are problems if a firm holds too many current assets since they are not generating revenues.

2. Quick ratio – (current assets-inventory)/current liabilities

Since inventory tends to be less liquid than most current assets, this is another liquidity measure telling you how able the firm is to meet its short-term obligations. In general, higher is better but the same issues are relevant as noted with the current ratio.

Activity ratios

3. Inventory turnover rate – Cost of goods sold/Inventory

This ratio tell you how many times in a year the firm turns over its inventory. A high ratio tells you that the firm is selling its inventory well, but there is a risk that if the ratio becomes too large, it will experience outages and lose sales.

4. Average collection period – Accounts receivable/daily revenue

This ratio tells you how many days it takes, on average, to collect the firm’s accounts receivable. While a higher ratio is generally better, a firm must also be aware that sales may be lost if the firm is too strict with its collection practices.

5. Asset turnover rate – Total revenues/total assets

This ratio tells you how many dollars of revenue is generated by the firm’s assets. In general, this is an asset efficiency measurement and the higher the ratio the better.

Debt ratios

6. Debt ratio - Total liabilities/total assets

This ratio tells you how reliant the firm is on debt in financing its assets. Debt is not necessarily a bad thing since it is a cheap source of funds; however, with increased debt, the firm faces risk of bankruptcy. Reasonable levels of debt are ideal.

7. Times interest earned – Operating income/interest expense

This ratio tells you how many times the firm can pay its annual interest expense with operating income. The higher the better. If a firm has a high debt ratio but also has a high times interest earned ratio, it is demonstrating an ability to manage its debt overall so there is less concern about debt usage.

Profitability ratios

8. Gross profit margin – Gross profit/total revenues

This ratio tells you how well the firm controls its cost of goods sold (COGS). A high ratio indicates that the firm has a healthy mark-up on its product and has more gross profit to cover its operating expenses.

9. Operating profit margin – Operating profit/total revenues

This ratio is a key ratio and tell you how well the firm controls both its COGS and its operating expenses. If the firm has a healthy gross profit margin and a low operating profit margin, then the firm is not controlling its operating expenses.

10. Net profit margin – Net profit/total revenues

The difference between operating profit and net profit, in simple terms, is taxes and interest expense. While we focus on the operating profit margin as a strong profitability ratio, this ratio is often cited in business news and should also be understood.

11. Earnings per share – Net income/# common stock shares (assuming no preferred stock)

This is another often-quoted ratio and it represents the net profit per share of stock. The higher this ratio, the better.