11

RatiosRatios

Two types:Two types:Liquidity ratios (Solvency Liquidity ratios (Solvency

ratios)ratios) Profitability ratiosProfitability ratios

Single ratio by itself is not Single ratio by itself is not very meaningfulvery meaningful

22

Liquidity RatiosLiquidity Ratios

Measure the short-term Measure the short-term ability of the business to ability of the business to pay its debts. pay its debts.

WHO CARES?WHO CARES?Short-term creditors such Short-term creditors such as bankers and suppliers.as bankers and suppliers.

33

Current ratioCurrent ratio Acid-test ratioAcid-test ratio Debt ratioDebt ratio Equity ratioEquity ratio Collection PeriodCollection Period Inventory turnoverInventory turnover Times Interest Earned ratioTimes Interest Earned ratio

Liquidity Ratios

44

Current RatioCurrent Ratio

Indicates short-term Indicates short-term debt-paying abilitydebt-paying ability

Current AssetsCurrent Liabilities

55

Acid-Test RatioAcid-Test Ratio

Indicates immediate Indicates immediate short-term debt-paying short-term debt-paying abilityability

Total current assets (less inventory and prepaid expenses)

Current Liabilities

66

Debt RatioDebt Ratio

Proportion of total assets that Proportion of total assets that areare

financed with borrowed financed with borrowed money.money.

Total LiabilitiesTotal Liabilities Total AssetsTotal Assets

77

Equity RatioEquity Ratio

Proportion of total assetsProportion of total assetsfinanced with shareholder’s financed with shareholder’s

moneymoney

Total equityTotal equityTotal assetsTotal assets

88

Collection PeriodCollection Period

How many days’ sales are How many days’ sales are represented by Account Receivablesrepresented by Account Receivables

Accounts ReceivableAccounts ReceivableAverage Charge sales / dayAverage Charge sales / day

99

Inventory Turnover RatioInventory Turnover Ratio

Number of times a business has been able to sell and replace its inventory in one year

Cost of Goods SoldAverage Inventory

1010

Company’s ability to cover Company’s ability to cover itsits

interest expenseinterest expense

Net IncomeNet Income

Interest ExpenseInterest Expense

Times Interest EarnedTimes Interest Earned

1111

Solvency RatiosSolvency Ratios

Measure the ability of the Measure the ability of the enterprise to survive over a enterprise to survive over a long period of timelong period of time

WHO CARES?WHO CARES?Long-term creditors and Long-term creditors and stockholdersstockholders

1212

Debt to total assets ratioDebt to total assets ratio Times interest earned ratioTimes interest earned ratio Cash debt coverage ratioCash debt coverage ratio Free cash flowFree cash flow

Solvency Ratios

1313

Debt to Total Assets RatioDebt to Total Assets Ratio

Indicates % of total assets Indicates % of total assets provided by creditorsprovided by creditors

Total Liabilities Total Liabilities

Total AssetsTotal Assets

Illustration 14-24

1414

Times Interest Earned RatioTimes Interest Earned Ratio

Indicates company’s ability to Indicates company’s ability to meet interest payments as meet interest payments as they come duethey come due

Income Before Interest Income Before Interest

Expense & Income TaxExpense & Income Tax

Interest ExpenseInterest Expense

Illustration 14-25

1515

Cash Debt Coverage RatioCash Debt Coverage Ratio

Indicates long-term debt-Indicates long-term debt-paying ability (cash basis)paying ability (cash basis)

Cash provided by operationsCash provided by operations Average total liabilitiesAverage total liabilities

Illustration 14-26

1616

Profitability RatiosProfitability Ratios

Measure the income or operating success of Measure the income or operating success of an enterprise for a given period of timean enterprise for a given period of time

WHO CARES? WHO CARES? EverybodyEverybody

WHY? WHY? A company’s income affects:A company’s income affects: its ability to obtain debt and equity its ability to obtain debt and equity

financingfinancing its liquidity positionits liquidity position its ability to growits ability to grow

1717

Return on assets ratioReturn on assets ratio Profit margin ratioProfit margin ratio Assets turnover ratioAssets turnover ratio Gross profit rateGross profit rate Operating expenses to sales ratioOperating expenses to sales ratio Cash return on sales ratioCash return on sales ratio

Profitability Ratios

1818

Return On Assets RatioReturn On Assets Ratio

Reveals the amount of Reveals the amount of net income generated by net income generated by each dollar investedeach dollar invested

Net incomeAverage total assets

Higher value suggests favorable efficiency.Higher value suggests favorable efficiency.

Illustration 14-30

1919

Profit Margin Ratio Profit Margin Ratio

Indicates net income Indicates net income generated by each dollar of generated by each dollar of salessales

Higher value suggests favorable return on Higher value suggests favorable return on each dollar of sales.each dollar of sales.

Illustration 14-31

Net incomeNet sales

2020

Asset Turnover RatioAsset Turnover Ratio

Indicates how efficiently Indicates how efficiently assets are used to assets are used to generate salesgenerate sales

Net salesNet sales

Average total assetsAverage total assets

Illustration 14-32

2121

Gross Profit RateGross Profit Rate

Indicates margin between Indicates margin between selling price and cost of selling price and cost of good soldgood sold

Gross profitGross profit

Net salesNet sales

Illustration 14-34

2222

Operating ExpensesOperating Expensesto Sales Ratioto Sales Ratio

Indicates the cost Indicates the cost incurred to support each incurred to support each dollar of salesdollar of sales

Operating expensesOperating expenses

Net salesNet sales

Illustration 14-35

2323

Cash Return on Sales RatioCash Return on Sales Ratio

Indicates net cash flow Indicates net cash flow generated by each dollar of generated by each dollar of salessales

Cash provided by operationsNet sales

Illustration 14-36

2424

EstimatesEstimates Financial statements are based on Financial statements are based on

estimates. estimates. – allowance for uncollectible accountsallowance for uncollectible accounts– depreciationdepreciation– costs of warrantiescosts of warranties– contingent lossescontingent losses

To the extent that these estimates are To the extent that these estimates are inaccurate, the financial ratios and inaccurate, the financial ratios and percentages are also inaccurate.percentages are also inaccurate.

2525

CostCost Traditional financial statements are based on Traditional financial statements are based on

historical cost and are not adjusted for price historical cost and are not adjusted for price level changes. level changes.

This needs to be considered when relying on This needs to be considered when relying on them for analysis.them for analysis.

Also, by the time financial statements are Also, by the time financial statements are prepared for a company, time has passed (i.e. prepared for a company, time has passed (i.e. December 31 numbers are being reported to December 31 numbers are being reported to the public on March 20the public on March 20thth ! The amount listed for ! The amount listed for Assets is likely no longer the same or what was Assets is likely no longer the same or what was profitable at December 31 may no longer be !)profitable at December 31 may no longer be !)

2626

Alternative Accounting Alternative Accounting MethodsMethods One company may use the FIFO method, while One company may use the FIFO method, while

another company in the same industry may another company in the same industry may use LIFO. use LIFO.

If the inventory is significant for both If the inventory is significant for both companies, it is unlikely that their current ratios companies, it is unlikely that their current ratios are comparable. are comparable.

In addition to differences in inventory costing In addition to differences in inventory costing methods, differences also exist in reporting methods, differences also exist in reporting such items as depreciation, depletion, and such items as depreciation, depletion, and amortization.amortization.