Financial Statement Analysis

(Ratio Analysis)

Ratio analysis is a useful way of gaining a "snapshot" picture of a company. These ratios can be
analyzed to identify the company's strengths and weaknesses and useful insights can be gained
through the process.
Very Important: However, it is important to realize this fact: the ratios have no financial
theory behind them. Theory tells us what SHOULD BE the case (or value). With financial ratios,
we have no way to identify a "theoretically best" value for any of the ratios. In fact, financial
ratios are nothing more than common sense measures that have been developed and evolved
over time. As such, they are imperfect measures and should be treated as such.
Use of the Ratios
When using ratios, think of yourself as a detective who is looking for clues (like the little guy at
the top of the page). Typically, ratios are excellent devices for uncovering clues about a
company's financial condition - but remember that clues simply raise more questions, not give
definite answers. Ratios tell us where to focus our attention and to ask relevant questions. We
never want to depend of just one ratio to draw a conclusion, the ratios are complementary and
one ratio can be used to confirm a suspicion raised by another ratio's value. It is only after
looking at a variety of different ratios that a picture of the company's financial condition begins
to form.
Types of Ratios
Financial ratios are generally grouped together by their purpose. Although there are many of
these classifications, the most commonly used groups are:
1. Liquidity
2. Debt (or Leverage)

3. Activity (or Turnover)

4. Profitability
Typically, you would not calculate the ratios in all of these categories for a single company.
Usually, you would approach the ratio analysis from the perspective of an individual interested
in one particular area. For example, assume that you show up for work one day and see a letter
on your desk. In the letter, a company named Dragon Celebrations, Inc., orders $30,000 of
merchandise from you on standard credit terms (which gives them up to 30 days to pay for the
order). Accompanying the letter is a set of audited financial statements for the company. You're
not familiar with Dragon Celebrations and don't have a previous business relationship with it.
Should you ship the merchandise to them?
Before doing so, you would like to determine the probability that they will pay you. You can
purchase the credit rating for the company from a credit bureau or standard credit reporting
agency. However, if you decide to do the analysis yourself, you can calculate the liquidity ratios
using the company's balance sheet information. These ratios will evaluate the liquidity of the
business and should offer valuable information as to the likelihood that Dragon will pay you
within the 30 day period.
Who Uses the Ratios?
Although generalizations are difficult here, here are some of the key users for the different
types of ratios:
1. Liquidity - short-term creditors
2. Debt - existing lenders or potential lenders
3. Activity - top management of the company
4. Profitability - both existing and potential investors in the company's common stock
Additional details on these classifications may be found on the "Commonly Used Ratios"
handout shown below.
Major Ratios
Here is a handout that shows eleven basic, commonly used ratios and their construction. The
second part of the handout describes nine more ratios that you may encounter, although they
are not as common as the previous group.
Commonly Used Ratios (see later in this document)

Although there are approximately 50 ratios that are used in practice, the ratios found on this
handout are used across a wide variety of industries and are a part of virtually any thorough
financial analysis of a company.
Ratio Analysis on the Web
Here is my favorite web site for looking up the value of companies' financial ratios and the
industry average for each ratio. It's a great site for financial analysis of companies.
After going to the company's homepage (see the link below), point to the "News and Markets"
heading at the top of the screen. A sub-menu will pop up; under the "Markets" heading, click
on "Stocks." On the next page's Search box, type in the ticker symbol for the company that you
want to look up. (If you don't know the ticker symbol, type in the company name and press
Search. The next page will allow you to type in the full company name.) When the company's
screen appears, click on the box for "Financials." You will then see a side-by-side comparison
(for the company, industry, sector, and S&P 500) of all the major ratios. It makes an analysis
easy and convenient.
Reuters
How Do We Use the Ratios?
There are two primary ways to use financial ratios:
1. Compare a ratio's value over several periods of time (trend analysis or time-series
analysis). If we see a deteriorating trend in any ratio's values over several quarters or
years, we can investigate to find the cause.
2. Compare the company's ratios to the industry average (cross-sectional analysis). A
single ratio value by itself usually means nothing - we need a standard, or benchmark, to
compare it to. This benchmark is usually the industry average (i.e., the ratio's average
value for all firms in the industry).
There are some people who believe that the industry average should not be used - that this
means that we are trying to be average (mediocre). They advocate that we should compare our
ratios to those of the leading firm in the industry and try to match the ratios of that company.
Although this argument has a certain plausibility, it ignores the fact that the leading firm often
has strengths that others in the industry will have trouble meeting (outstanding marketing,
superior management training programs, etc.). The industry average is probably a more useful
standard. After all, we aren't trying to match these ratios; we are trying to exceed the average
company's performance.

A Sample Comparison of Ratios

Click on the link to see a sample financial statement analysis for the restaurant industry.
A Particularly Useful Technique
A company's Return On Equity (ROE) ratio is one of the most commonly used ratios since it
measures exactly what investors want to know - how much the company is earning on every
dollar that investors put into the company. A particularly useful technique is to conduct a
DuPont analysis on the company, i.e., break down ROE into the sources of those profits. Do the
profits come from effective marketing techniques, strong control of costs, and effective pricing
(all highly desirable) or do they come from the company's high use of debt (a less desirable and
riskier way of increasing profits)?
Cautions About Using Ratios
When using ratios as a form of analysis, be very careful that you don't put more trust in them
than they deserve. After all, they are simply common sense measures with no financial theory
underlying them. In fact, ratios have significant problems associated with them that should
cause us to use them with caution:
1. Ratios don't prove that a problem exists or provide definite answers to any of our
questions. However they are very good at providing us with some guidance on the
future steps that our investigation should take. In other words, a ratio analysis indicates
symptoms of a problem and focuses our attention on potential problems that deserve
our attention. But they rarely provide us with firm answers; usually, the best that they
do is tell us what key questions we need to ask.
2. Realize that there may be significant differences between the characteristics of the
company and the "average" firm in the industry. For example, you may be analyzing
the financial statements of a steel manufacturer and want to compare the firm's ratios
to the the industry average. However, while primarily steel manufacturers, some of the
other firms in the industry may own their own captive finance companies, own railroad
lines for transportation of the finished steel, and own an insurance company for
diversification purposes. It is often very difficult to honestly say that we are comparing
apples with apples when the companies in the industry have substantially different
structures and characteristics.
3. Always make sure that you are calculating a ratio exactly as the industry average ratio
is calculated. There are many variations on how to calculate the various ratios. For
example, if you look in several finance textbooks, you can easily find differences in
suggested ways to calculate Return on Investment, Inventory Turnover, and the Quick
(or Acid Test) Ratio. Since we typically depend on an outside firm (e.g., Reuters, Dun &

Bradstreet, etc.) to provide us with the values of the industry average for each ratio, we
need to ensure that the formula that we are using for a ratio is the same formula that
the industry average source is using. For example, we may calculate the Inventory
Turnover ratio as (Cost of Goods Sold)/(Average Monthly Inventory) while the outside
source calculates it as (Annual Sales)/(Year Ending Inventory). Both versions are
commonly used.
4. Companies frequently don't have the same fiscal year. Some companies' fiscal year
ends on December 31st, others' end on September 30th, others' end on June 30th, etc..
If you are depending on the year-ending (end of the fiscal year) balance sheet's data,
this date may vary widely among firms in the same industry. This is especially true of
companies whose sales are highly seasonal. For example, two companies who
manufacture snowmobiles may have almost identical performance numbers for the
year. However, they will have vastly different inventory and accounts receivable levels
if one's year ends in June and the other's ends in December, resulting in considerable
differences in the values of a ratio analysis.
5. Companies' accounting practices may differ considerably. Companies have a great deal
of discretion in their accounting procedures, particularly with regard to depreciation
(straight line, double declining balance, etc.) and inventory (LIFO, FIFO, etc.). This makes
comparisons more difficult.
6. Be careful about depending too much on any one ratio. A ratio analysis is most
valuable when we evaluate a number of ratios of a certain type (liquidity, profitability,
etc.) and look for a pattern in the results.
7. Audited financial statements should be used whenever possible. Small businesses'
financial statements are often unaudited and may not be accurate.

Related Topics
Breakdown of ROE Using the DuPont Method
A Sample Ratio Comparison

A Comparison of Ratios

The table below contains some recent ratios of three companies in the restaurant industry.
(Sources: Reuters and Microsoft Investor) The first few lines of the table show the company
name, the ticker symbol, the headquarters' city, and the brand names owned by the company.
The ratios were compiled in early 2012 and are used here to illustrate the larger subject of
financial statement analysis.

Ratio Analysis of Selected Restaurant Companies

Brinker International (EAT), Dallas, TX, Chili's, Maggianos, On The Border, Macaroni Grill
YUM! Brands (YUM), Louisville, KY, Pizza Hut, KFC, Taco Bell, LJS (Long John Silver), A&W
Darden Restaurants (DRI), Orlando, FL, Olive Garden, Red Lobster, Longhorn Steakhouse, Bahama Breeze, seven Seas
Liquidity

Current Ratio
Quick Ratio

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

0.49
0.37

1.01
0.39

0.42
0.19

1.14
1.00

1.37
1.13

1.74
6.99

1.55
14.03

1.20
7.38

0.66
2.92

0.93
0.39

32.80
21.07
1.31

39.71
41.85
1.46

124.00
15.65
1.40

191.05
30.79
1.60

15.73
16.47
0.79

9.92
36.45

17.21
77.10

8.16
25.02

8.34
15.87

5.05
11.15

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector0

18.12
1.47

22.56
0.94

14.75
0.89

80.49
0.35

15.56
0.96

Debt (Leverage)

Total Debt to Equity

Interest Coverage
Turnover (Activity)

Receivable Turnover
Inventory Turnover
Asset Turnover
Profitability

Return on Assets (%)

Return on Equity (%)
Valuation Ratios

P/E Ratio
Beta

As we examine these ratios, we need to keep in mind that, although all three companies are in
the restaurant industry, YUM Brands (for the most part) is a fast-food company while the other
two are "sit down" restaurants.
A review of the ratios reveals the following about the companies:
Profitability Ratios
Profitability

Return on Assets (%)

Return on Equity (%)

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

9.92
36.45

17.21
77.10

8.16
25.02

8.34
15.87

5.05
11.15

As a potential investor, we may want to emphasize the Return on Equity (ROE) ratio a little
more than the Return on Assets (ROA). The return on equity tells us how much the company is
earning per dollar invested by the shareholders.

1. Current results: YUM! Brands is currently the most profitable of the three companies
(by both ratios that measure profits). All three are have an ROE greater than the
industry average. But these three companies are among the largest in the industry and,
when we compare to the industry average, we are comparing them to much smaller
companies. Since restaurant chains have considerable fixed operating expenses (i.e.,
operating leverage), we would expect the larger chains to be more profitable than
smaller ones. But, in order of ROE, YUM is the most profitable, Brinker is second, and
Darden is third.
Next, let's take a look at where these profits come from. In other words, are the company's
profits coming from sound management or are the ROE numbers being pushed up through the
heavy use of financial leverage (i.e., debt)?

Debt (or Leverage) Ratios

Debt (Leverage)

Total Debt to Equity

Interest Coverage

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

1.74
6.99

1.55
14.03

1.20
7.38

0.66
2.92

0.93
0.39

Brinker uses more debt (per dollar of equity) than either of the other two companies. This is an
indication that Brinker is pushing up its ROE through its use of debt more so than YUM or
Darden. In comparing YUM and Brinker, this makes YUM's ROE a little more impressive since
YUM has a higher ROE and a lower debt level. Brinker has been able to push its ROE up above
Darden's by magnifying its profits though the use of greater financial leverage. But higher debt
also means higher risk. The important question here is, "Have the companies taken on more
debt that they can repay?"
1. The Total Debt to Equity ratio values for all three companies are well above the industry
average. This is normally a red flag and an analyst should ask this question, "The
average firm in the industry believes that it can only support a debt level that is half the
level of these two companies. What makes me believe that these two can support such
a high debt load?" All three companies are benefiting from the higher debt levels, but
what about their ability to pay the principal and interest on this debt? For this, we need
to look at the Interest Coverage ratio for all three companies..
2. Interest Coverage: The Interest Coverage ratio measures the ability of the company to
pay the principal and interest on the debt. All three companies have ratios greater than
the industry average. (Some analysts use a rough rule-of-thumb that a minimum value
of 3.0 is needed to safely support the debt level.) While all three companies appear to
be safe in terms of being financially able to pay off its debt, YUM has the highest ratio
value and therefore appears to be the safest of the three by this measure.

So far, it appears that YUM may be the strongest of the three firms financially. It has the highest
level of profitability, is using its financial leverage appropriately to push up earnings, and can
safely meet its debt obligations. We now turn to the other ratios to see if they raise any red
flags for the companies.

Liquidity Ratios
Liquidity

Current Ratio
Quick Ratio

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

0.49
0.37

1.01
0.39

0.42
0.19

1.14
1.00

1.37
1.13

All three companies have lower ratios than the industry average. This is not surprising,
however, since this can be explained by two factors:
1. Stability of sales and cash flows: Being industry leaders, their sales and cash flows are
more stable than the smaller firms in the industry, thus they don't need as much cash on
hand. The purpose of liquidity is to make sure that you have enough money to pay your
bills when they come due and to handle sudden changes in fortunes. If you can predict
your cash flows pretty accurately, you don't need to keep as much cash on hand. And
its easier to predict cash flows accurately if you have the stability and maturity as a
result of being an industry leader.
2. Access to credit lines: Being large companies, these three have easy access to the credit
markets. Most companies of this size will have lines of credit, so they have been preapproved for any loans. There is no need to keep large amounts of cash on hand if you
can pick up the phone and have the bank transfer money into your bank account when
it is needed. (Technically, you would be "drawing down" the loan that was previously
approved.)

Turnover (or Activity) Ratios

Turnover (Activity)

Receivable Turnover
Inventory Turnover
Asset Turnover

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

32.80
21.07
1.31

39.71
41.85
1.46

124.00
15.65
1.40

191.05
30.79
1.60

15.73
16.47
0.79

1. Receivables Turnover is much higher than the industry average for all three companies,
so there are no apparent problems with collecting accounts receivable. But this ratio
can be a "trap" for analysts who aren't careful in studying the ratios. The restaurant
industry is largely a "cash" industry anyway with low amounts of credit granted to its

customers. So the receivables turnover ratio may not be meaningful for this industry.
Just as the inventory turnover ratio doesn't mean much for a service industry like hotels,
airlines, and accounting firms, the receivables turnover ratio doesn't mean much for a
cash-oriented business. So we will tend to "throw out" this ratio for the restaurant
industry and not give it much importance.
2. Inventory Turnover varies widely among the three companies, with YUM enjoying an
advantage over the other two. This shouldn't be surprising since YUM is in the fast-food
segment of the restaurant and the other two are "sit down" restaurant companies.
3. The Asset Turnover ratios of all three firms are below the industry average. Again, we
have to be careful with this ratio since we don't know how many of the restaurants are
franchised (and, therefore, its stores or fixed assets owned by the local franchisees) and
how many of the stores are company-owned (and therefore on the companies' books).

Valuation Ratios
Valuation Ratios

P/E Ratio
Beta

Brinker Intl.

YUM! Brands

Darden Rest.

Industry

Sector

18.12
1.47

22.56
0.94

14.75
0.89

80.49
0.35

15.56
0.96

1. P/E Ratio: As measured by the Price/Earnings Ratio, investors are slightly more
optimistic about YUM! Brands' future growth than Brinker or Darden. The higher P/E
ratio also means that, as investors, we have to pay a higher premium to buy YUM. This
premium means that, to buy one dollar of earnings, we have to pay approximately 50%
more for YUM than for Darden and 25% more for YUM than for Brinker.
2. Beta: Beta measures the volatility of the stock price (with 1.0 being the average for all
companies). Brinker International's stock is approximately 50% more volatile than its
two competitors, which makes it a riskier investment. Darden has the lowest beta with
YUM being a close second.
Summary
So what does our ratio analysis of the three companies tell us?
1. Brinker International - At the time of the review, Brinker had an impressive level of
profitability (ROE) although its heavy use of debt to push up these earnings should be
noted. The company is the riskiest of the three in terms of both interest coverage and its
stock's value of beta.
2. YUM! Brands - At the time of the review, YUM had the strongest financial position. It
had the highest level of profitability, a very strong ability to support its debt, and a low
volatility for its stock price. Unfortunately for potential investors, the company also has
the highest premium that must be paid for its stock. Is it worth a 50% premium in price?
Each individual investor would have to make that decision.

3. Darden Restaurants - At the time of the review, Darden had the lowest (but more than
industry-average) level of profitability, a strong ability to meet its debt service
payments, and a low volatility of its stock price.

Caveat: This financial statement analysis is for educational purposes only; it should not be used
as a reason to buy or sell any of the three stocks.

COMMONLY USED RATIOS

I. LIQUIDITY

Liquidity is defined as having enough cash (or near-cash assets) to pay your bills when they come due.
The liquidity ratios compare the assets that will be converted into cash soon (the numerator) to the bills
that will be coming due soon (the denominator).

You always want to compare the liquidity ratios to the industry average, but two other factors should be
considered as well:
The predictability (or stability) of the companys sales. If you know how much money will be received
each month, you dont need to keep as much cash on hand as you would otherwise. Companies with
highly unpredictable sales are always in danger of experiencing a sudden shortfall in sales, so they
need to keep more cash and liquid assets on hand.
The companys access to bank lines of credit or the credit markets. You dont need to keep as much
money on hand if you can just pick up the phone, call the bank, and have money deposited into your
account.

1.

Current Ratio -- The current ratio is the most commonly used measure of the liquidity of a
company. It is simply a common sense measure. The numerator is the value of assets that should
be converted into cash within the next year. The denominator is the amount of bills coming due
within the next year.

Current Ratio =

Current Assets
Current Liabilities

2.

Quick Ratio (or Acid Test Ratio) -- The quick ratio is a more restrictive measure than the current
ratio. The numerator consists of the most liquid current assets. It assumes a worst-case scenario
in which inventory cannot be sold.

The average for all manufacturing companies is about one (1.0). This average also varies a great
deal from one industry to another.

Quick Ratio =

Cash + Mkt.Securities + Acc. Receivable

Current Liabilities

A commonly used variation of the ratio is:

Quick Ratio =

Current Assets - Inventory

Current Liabilities

This is the version that you usually see in a standard finance textbook. But notice that this
variation may include some non-liquid assets in the numerator however, such as prepaid
expenses (like insurance premiums). This is the measurement that is actually used in practice
most frequently, although the first form is theoretically superior.

II. TURNOVER (or EFFICIENCY)

Turnover ratios measure the managements efficiency and effectiveness in managing the firms assets.
In general, sales (or a measure of sales, like cost of goods sold) will be in the numerator. You would like
for the value of the turnover ratios to be quite high (with the exception of the average collection period).

3.

Inventory Turnover -- Indicates the number of times a year that the firms inventory has been
replaced. A low ratio may indicate that the firm has some obsolete inventory, or that possibly,
the firm is simply overstocked on inventory. If the inventory turnover is 4 times per year, the
company is replacing its inventory approximately every 3 months; if its inventory turnover is 12
times per year, it is replacing its inventory approximately every 30 days (or 1 month).

The most commonly used form of the ratio is:

InventoryT urnover=

Sales
Inventory

A theoretically-superior variation of the formula is:

Inventory Turnover =

Cost of Goods Sold

Average of last 4 quarters' Inventory

This form of the ratio is better for two reasons:

Why substitute Cost of Goods Sold for Sales in the numerator? Inventory (in the
denominator) is shown on the companys books at cost; we would like to use a measure of
cost in the numerator as well (i.e., cost of goods sold) in order to get a fairer comparison.
Why substitute Average Inventory for Inventory in the denominator? The numerator is
measured over a period of time, like a year. The denominator should show the average
amount of inventory that was available for sale during this period. For example, assume
that sales increased rapidly during the year and that inventory increased dramatically as
well. We would not want to use year-ending inventory in the denominator, as it does not
accurately depict the amount of inventory that was available for sale.

4.

Accounts Receivable Turnover -- Indicates how quickly the company collects its accounts
receivable: the higher the turnover, the more quickly it collects its receivables.

AccountsReceivable Turnover=

Sales
AccountsReceivable

Notice that the formula assumes that all sales are on credit (and therefore go through accounts
receivable). It would be better to use credit sales in the numerator, if the value of credit sales is
available. But, if you compare the ratio to an industry average, just make sure that you are
using the same formula as your source for the industry average. You dont want to use credit
sales in the numerator if the industry average is calculated with total sales in the numerator.

5.

Average Collection Period Technically, this is not a turnover ratio: it is the accounts receivable
turnover divided into 365 days. It is an alternate measure of how quickly accounts receivable are
being collected. The ratio calculates how long (in days) that it takes the firm to collect its
receivables. (Use credit sales if available, since only credit sales go through the accounts
receivable account.)

Average Collection Period =

AccountsReceivable
Sales 365

If the A/R turnover is lower than the industry average (and the average collection period is higher
than the industry average), this just means that the company is collecting its receivables slower
than other firms in the industry. However, it is quite possible that the companys credit terms
may give its customers longer to pay than its competitors. So, rather than the industry average, it
is better to compare the companys average collection period to the terms that they sell on, if the
credit terms are known.

6.

Total Asset Turnover -- The purpose of investing in assets is to generate sales: the higher the
sales per dollar invested in total assets, the better. This ratio measures how efficiently the
management is achieving its goal.

TotalAsset Turnover=

Sales
TotalAssets

Major fault of the ratio: Total assets are made up of current assets and fixed assets. If the
companys fixed assets are old (and therefore almost fully depreciated), the value of net fixed
assets on the balance sheet will be quite small. This, in turn, will make total assets appear to be
small and the value of the ratio will be high. This implies that a company with old assets is
managing its assets quite efficiently. In fact, the company may not be managing its assets well at
all they are simply old and very depreciated. A company that has recently upgraded its assets by

investing in newer equipment may actually be better managed, but its total asset turnover ratio
will look inferior to the company with older assets. In spite of this, the total asset turnover ratio is
widely used; its simply important to know of its major deficiency when using it.

III. DEBT (OR LEVERAGE)

The debt, or leverage, ratios measure the ability of the firm to meet the principal and interest payments
on its debt. Keep in mind that debt is neither good nor bad; it is simply a tool. There are times that
heavy use of it is appropriate (e.g., when sales are going up) and there are times that it is detrimental
(when sales are going down). These ratios simply measure the extent to which the company is using
debt in financing the companys assets and whether it has gone too far by using so much debt that it is
having difficulty in paying the interest when it is due.

7.

Debt Ratio -- Indicates the percentage of the total assets that have been financed by debt.

Debt Ratio =

TotalDebt (or Liabilities)

TotalAssets

On the balance sheet, total assets must equal total liabilities and capital. In other words, total
assets are equal to the amount of the companys debt plus the amount of equity. Looked at
another way, the company is financed with a combination of debt and equity. So this ratio simply
measures the percentage of the total assets that are financed with debt. If the debt ratio is 40%,
this means that the company has financed 40% of its assets with debt (borrowed money) and 60%
with equity (investors money). This ratio is one way of measuring the financial leverage of the
company: the higher the debt ratio, the higher the degree of financial leverage that the company
has.

8.

Debt-to-Equity -- A variation of the debt ratio. Measures the money invested by creditors relative
to the money invested by the owners.

Debt - to - Equity Ratio =

TotalDebt (or Liabilities)

TotalEquity

This is just another way of measuring the degree of financial leverage. Notice that if the debt ratio
is 40%, this means that every $1.00 of total assets is financed with $0.40 in debt and $0.60 in
equity. If we knew that the debt ratio is 40%, could we figure out the value of the debt-to-equity
ratio? Sure, because we know that if debt is 40% of the assets, then equity must be the other
60%. Therefore, the debt-to-equity ratio is a ratio of 40/60, or 66.67%. Some financial analysts
prefer to use the debt ratio; others prefer to use the debt-to-equity ratio. It isnt necessary to use
both of them because they tell you the same information - just in a different form.

9.

Times Interest Earned (or Interest Coverage) - A key measure of the firms ability to meet its
interest payments on time.

TimesInterestEarned (or InterestCoverage) =

Net OperatingIncome(or E.B.I.T.)

InterestExpense

Notice that the numerator is the amount of earnings that is available to meet interest payments.
The denominator shows the amount of those interest payments. In other words, it is a ratio of
the amount of money that we have to the amount of money that we need (to pay the interest).
So a high ratio would indicate an ability to pay its interest without difficulty.

IV. PROFITABILITY

Since a major goal of the company is to attain a high level of profitability, we would like to see a high
value for these ratios. We can relate the companys profits to almost any item on the balance sheet or
income statement (e.g., net income to total assets, net income to common equity, net income to sales,
etc.)

10.

Return on Assets The primary purpose of investing in assets is to generate sales, which in turn
lead to profits. The return on assets ratio measures the profitability per dollar of investment in
the firm. Notice that the ratio doesnt say anything about how the assets are financed, i.e., where
the money comes from (either debt or equity). It simply wants to know how profitable the
company is per dollar invested in total assets (no matter where the money comes from to finance
those assets).

Return on Assets =

Earnings After Taxes

TotalAssets

Note: You will see a lot of variations in the numerator for this ratio: some analysts use earnings
before taxes (EBT), others will use earnings before interest and taxes (EBIT). The most common,
however, is earnings after taxes (EAT). Just make sure that, if you are comparing a companys
return on assets ratio to an industry average, you are calculating the ratio in the same manner as
your source for the industry average.
11.

Return on Equity This ratio looks at the companys profits from the standpoint of the companys
owners. It measures the profitability per dollar of investment in the firm by the owners.

Return on Equity =

Earnings After T axes

T otalEquity

Note: As with the previous ratio, you will see a lot of variations in the numerator for this ratio.
Again, just make sure that, if you are comparing a companys return on equity ratio to an industry
average, you are calculating the ratio in the same manner as your source for the industry average.

12.

Price-Earnings Ratio -- The price-earnings ratio is the most frequently used measure of a stocks
relative value. The price-earnings ratio tells us two things about a companys stock:
It is a measure of how optimistic investors are about the companys future growth in
earnings and dividends. The higher the P/E ratio, the more optimistic investors are about
the companys future prospects.
It is a measure of the premium that you have to pay for the stock. For example, if a stocks
P/E ratio is 35 and the average P/E for all stocks is 18, investors are having to pay a
considerable premium to acquire the stock (but may be getting a higher quality company).
On the other hand, if a stocks P/E ratio is 8, we are able to buy the stock at a discount
relative to other stocks (but may be getting an inferior company).

Price- Earnings Ratio =

Current market price of thecommonstock

Earnings per share (for thepast 12 months)

The P/E ratio is often used to help estimate the future price of the stock using this equation:
Pricen = [P/E ratio]n times [Earnings per share]n
where n refers to a specific year in the future.
For example, the price of a stock 3 years from now will be equal to the P/E ratio that the stock
has 3 years from now times the earnings (per share) that the stock has 3 years from now. That
is,
Price3 [P/E Ratio]3 * [Earnings per share]3
Price3 12 * $3.00 $36.00

If we can estimate the value of the P/E ratio 3 years from now and the earnings expected at that
time, we can use the equation to estimate the market price of the stock at that time.

ADDITIONAL RATIOS THAT YOU MAY ENCOUNTER

V. VALUATION

Valuation ratios help determine whether a stock is over-priced or under-priced relative to other stocks (or
relative to the basic earning power of the company). In general, we would like to purchase the items in
the denominators (earnings, cash flow, sales, etc.) for a low price. Therefore, we prefer to invest in
companies that have a low value for the following ratios.

13.

Price-to-Cash Flow Ratio The ultimate objective to investing is to earn a relatively high cash
flow. If we can purchase this high cash flow at a cheap price, so much the better. Therefore, we
would like to have invest in companies that have a low price-to-cash flow ratio.

Price- to - Cash Flow Ratio =

14.

Price-to-Sales Ratio This ratio helps to value a company that has no earnings and no dividends.
Also, the price-to-sales ratio may be more stable than the price/earnings ratio and, therefore,
more useful. Research also supports the idea that a portfolio of stocks that have a low price-tosales ratio may be an anomaly and outperform portfolios made up of high price-to-sales ratios.

Price- to - Sales Ratio =

15.

Current market price of thecommonstock

Cash flow per share

Current market price of thecommonstock

Sales per share (i.e.,[TotalSales]/[sh ares outstanding]

Price-to-Book Value Ratio This ratio relates the common stocks market value to its accounting
value as shown on the companys books. One major respected research study maintains that
stocks with a low price-to-book value ratio tend to outperform other portfolios.

Price- to - Book Ratio =

Current market price of thecommonstock

Common equity as shown on thebalance sheet

VI. MORE EFFICIENCY RATIOS

16.

Capital Spending-to-Depreciation This ratio assumes that the depreciation charges are an
accurate reflection of the physical wear-and-tear on the fixed assets, i.e., the rate at which the
fixed assets are being used up. Capital spending is the amount of money that is spent on the
purchase of new fixed assets. So a ratio of capital spending-to-depreciation would show whether
the fixed assets are being replaced at the same rate that they wear out. In other words, a ratio
value greater than 1.0 would indicate that the assets are being adequately replaced; a value of
less than 1.0 would indicate a shrinkage in the size of the fixed assets.

CapitalSpending - to - Depreciation =

CapitalSpending
Depreciation

VII. MORE DEBT (OR LEVERAGE) RATIOS

17.

EBITDA-to-Debt Service EBITDA (pronounced ee-bit-DAH) can be determined by adding interest

expense, taxes, and depreciation/amortization to earnings after taxes (i.e., EAT or net income).
EBITDA is therefore the amount of money that is available to meet any payment obligations (i.e.,
interest and principal payments) on the companys debt. (Debt service refers to these interest
and principal payments.)

Therefore, the ratio relates the amount of money that we have from this years cash flow that is
available to pay down the debt (and related interest) to the amount of required payments. A
ratio of 1.0 would be the bare minimum that would be required to meet these payments.
However, you would want a much larger cushion than this to ensure that the cash flow will not
drop to levels that are not sufficient to meet the debt payments.

EBITDA- to - Debt Service =

EAT Interestexpense Taxes Depreciation Amortization

Required interest payments Required principalpaymentson thedebt

VIII. MORE PROFITABILITY RATIOS

18.

Gross Profit Margin (or Gross Margin) By definition, gross profit is equal to total sales minus
cost of goods sold. Therefore, if the gross profit margin declines, it is an indication that one of
two things is likely happening:
The cost of goods sold are increasing, and the company is not able to pass along the higher
costs in the form of price increases (possibly due to a highly competitive marketplace), or
The company has reduced its prices, perhaps in an attempt to attract new customers and to
increase its market share.

Gross Profit Margin =

19.

Gross Profit
TotalSales

Net Profit Margin (or Net Margin) Whereas the gross profit margin measures the performance
of the companys operating managers, it doesnt say anything about the performance of the
companys financial managers. (Gross margin is affected only by the decisions of operating
managers with regard to pricing and cost control; it isnt affected by decisions on how to finance
the company.) The net profit margin measures the combined performance of both the operating
and financial managers.

Net Profit Margin =

20.

Earnings AfterTaxes
TotalSales

Return on Investment Return on investment could be stated as the return on long-term

investment funds. Investment here refers to the total long-term sources of funds to a company,
i.e., long-term liabilities, preferred stock, and common equity. The current liabilities are a
temporary source of financing and may vary considerably over the course of a year; the providers
of long-term funds have made a commitment to the company and provide the permanent
financing for the firm.
Return on Investment=

Earnings After Taxes

Long - term Liabilites PreferredStock Common Equity