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FinancialRatios

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FinancialRatios

Financialratiosareusefulindicatorsofafirm'sperformanceandfinancialsituation.

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Mostratioscanbecalculatedfrominformationprovidedbythefinancialstatements.
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Financialratioscanbeusedtoanalyzetrendsandtocomparethefirm'sfinancials
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tothoseofotherfirms.Insomecases,ratioanalysiscanpredictfuturebankruptcy.
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Financialratioscanbeclassifiedaccordingtotheinformationtheyprovide.The
Reprints
followingtypesofratiosfrequentlyareused:
TermsofUse
Liquidityratios
Assetturnoverratios
Financialleverageratios
Profitabilityratios
Dividendpolicyratios

LiquidityRatios
Liquidityratiosprovideinformationaboutafirm'sabilitytomeetitsshortterm
financialobligations.Theyareofparticularinteresttothoseextendingshortterm
credittothefirm.Twofrequentlyusedliquidityratiosarethecurrentratio(or
workingcapitalratio)andthequickratio.
Thecurrentratioistheratioofcurrentassetstocurrentliabilities:
CurrentRatio =

CurrentAssets
CurrentLiabilities

Shorttermcreditorspreferahighcurrentratiosinceitreducestheirrisk.
Shareholdersmaypreferalowercurrentratiosothatmoreofthefirm'sassetsare
workingtogrowthebusiness.Typicalvaluesforthecurrentratiovarybyfirmand
industry.Forexample,firmsincyclicalindustriesmaymaintainahighercurrent
ratioinordertoremainsolventduringdownturns.
Onedrawbackofthecurrentratioisthatinventorymayincludemanyitemsthat
aredifficulttoliquidatequicklyandthathaveuncertainliquidationvalues.Thequick
ratioisanalternativemeasureofliquiditythatdoesnotincludeinventoryinthe
currentassets.Thequickratioisdefinedasfollows:
QuickRatio =

CurrentAssetsInventory
CurrentLiabilities

Thecurrentassetsusedinthequickratioarecash,accountsreceivable,andnotes
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receivable.Theseassetsessentiallyarecurrentassetslessinventory.Thequick
ratiooftenisreferredtoastheacidtest.
Finally,thecashratioisthemostconservativeliquidityratio.Itexcludesallcurrent
assetsexceptthemostliquid:cashandcashequivalents.Thecashratioisdefined
asfollows:
CashRatio =

Cash+MarketableSecurities
CurrentLiabilities

Thecashratioisanindicationofthefirm'sabilitytopayoffitscurrentliabilitiesif
forsomereasonimmediatepaymentweredemanded.

AssetTurnoverRatios
Assetturnoverratiosindicateofhowefficientlythefirmutilizesitsassets.They
sometimesarereferredtoasefficiencyratios,assetutilizationratios,orasset
managementratios.Twocommonlyusedassetturnoverratiosarereceivables
turnoverandinventoryturnover.
Receivablesturnoverisanindicationofhowquicklythefirmcollectsitsaccounts
receivablesandisdefinedasfollows:
ReceivablesTurnover =

AnnualCreditSales
AccountsReceivable

Thereceivablesturnoveroftenisreportedintermsofthenumberofdaysthat
creditsalesremaininaccountsreceivablebeforetheyarecollected.Thisnumberis
knownasthecollectionperiod.Itistheaccountsreceivablebalancedividedbythe
averagedailycreditsales,calculatedasfollows:
AverageCollectionPeriod =

AccountsReceivable
AnnualCreditSales/365

Thecollectionperiodalsocanbewrittenas:
AverageCollectionPeriod =

365
ReceivablesTurnover

Anothermajorassetturnoverratioisinventoryturnover.Itisthecostofgoodssold
inatimeperioddividedbytheaverageinventorylevelduringthatperiod:
InventoryTurnover =

CostofGoodsSold
AverageInventory

Theinventoryturnoveroftenisreportedastheinventoryperiod,whichisthe
numberofdaysworthofinventoryonhand,calculatedbydividingtheinventoryby
theaveragedailycostofgoodssold:
InventoryPeriod =
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AverageInventory
AnnualCostofGoodsSold/365
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Theinventoryperiodalsocanbewrittenas:
InventoryPeriod =

365
InventoryTurnover

Otherassetturnoverratiosincludefixedassetturnoverandtotalassetturnover.

FinancialLeverageRatios
Financialleverageratiosprovideanindicationofthelongtermsolvencyofthefirm.
Unlikeliquidityratiosthatareconcernedwithshorttermassetsandliabilities,
financialleverageratiosmeasuretheextenttowhichthefirmisusinglongterm
debt.
Thedebtratioisdefinedastotaldebtdividedbytotalassets:
DebtRatio =

TotalDebt
TotalAssets

Thedebttoequityratioistotaldebtdividedbytotalequity:
DebttoEquityRatio =

TotalDebt
TotalEquity

Debtratiosdependontheclassificationoflongtermleasesandontheclassification
ofsomeitemsaslongtermdebtorequity.
Thetimesinterestearnedratioindicateshowwellthefirm'searningscancoverthe
interestpaymentsonitsdebt.Thisratioalsoisknownastheinterestcoverageand
iscalculatedasfollows:
InterestCoverage =

EBIT
InterestCharges

whereEBIT=EarningsBeforeInterestandTaxes

ProfitabilityRatios
Profitabilityratiosofferseveraldifferentmeasuresofthesuccessofthefirmat
generatingprofits.
Thegrossprofitmarginisameasureofthegrossprofitearnedonsales.Thegross
profitmarginconsidersthefirm'scostofgoodssold,butdoesnotincludeother
costs.Itisdefinedasfollows:
GrossProfitMargin =

SalesCostofGoodsSold
Sales

Returnonassetsisameasureofhoweffectivelythefirm'sassetsarebeingusedto
generateprofits.Itisdefinedas:
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ReturnonAssets =

NetIncome
TotalAssets

Returnonequityisthebottomlinemeasurefortheshareholders,measuringthe
profitsearnedforeachdollarinvestedinthefirm'sstock.Returnonequityis
definedasfollows:
ReturnonEquity =

NetIncome
ShareholderEquity

DividendPolicyRatios
Dividendpolicyratiosprovideinsightintothedividendpolicyofthefirmandthe
prospectsforfuturegrowth.Twocommonlyusedratiosarethedividendyieldand
payoutratio.
Thedividendyieldisdefinedasfollows:
DividendYield =

DividendsPerShare
SharePrice

Ahighdividendyielddoesnotnecessarilytranslateintoahighfuturerateofreturn.
Itisimportanttoconsidertheprospectsforcontinuingandincreasingthedividend
inthefuture.Thedividendpayoutratioishelpfulinthisregard,andisdefinedas
follows:
PayoutRatio =

DividendsPerShare
EarningsPerShare

UseandLimitationsofFinancialRatios
Attentionshouldbegiventothefollowingissueswhenusingfinancialratios:
Areferencepointisneeded.Totobemeaningful,mostratiosmustbe
comparedtohistoricalvaluesofthesamefirm,thefirm'sforecasts,orratios
ofsimilarfirms.
Mostratiosbythemselvesarenothighlymeaningful.Theyshouldbeviewed
asindicators,withseveralofthemcombinedtopaintapictureofthefirm's
situation.
Yearendvaluesmaynotberepresentative.Certainaccountbalancesthatare
usedtocalculateratiosmayincreaseordecreaseattheendoftheaccounting
periodbecauseofseasonalfactors.Suchchangesmaydistortthevalueofthe
ratio.Averagevaluesshouldbeusedwhentheyareavailable.
Ratiosaresubjecttothelimitationsofaccountingmethods.Different
accountingchoicesmayresultinsignificantlydifferentratiovalues.

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