Measure the firm’s ability to meet short-term financial obligations. These ratios measure the firm’s ability to continue to stay in business and to ensure that the firm has enough cash and short-term assets, such as accounts receivables and inventories, to meet short-term financial obligations, such as accounts payables and notes payables. The short term is either one accounting period or one year, whichever is shorter.
Current Ratio = Current Assets/Current Liabilities - Going concern ratio that indicates how many short-term assets the company has for each dollar of short-term liabilities
Quick Ratio = (Current assets – inventories)/Current Liabilities - Distress ratio that measures the company’s ability to meet short-term financial obligations when inventory is not being converted to accounts receivable and cash
Asset Management Ratios
Measure the efficiency of the firm in the use of assets. If a firm holds excess assets, these excess assets will increase the cost of funds and the increased cost of funds will reduce profitability. If asset levels are too low, sales opportunities may be lost, which reduces profitability.
Days sales outstanding = Receivables/( Annual sales/365) - Average number of days to collect accounts receivable
Inventory turnover = Sales/Inventory - Number of dollars of sales generated each year for each dollar of inventory which measures sales efficiency and measures the number of times a year that inventory is sold
Net fixed assets = Sales/Fixed Assets - Number of dollars of sales generated each year for each dollar of net fixed assets
Total assets turnover = Sales/Total Assets - Number of dollars of sales generated each year for each dollar of total assets
Financial Leverage Ratios (Debt Management Ratios)
Indicate the extent to which a company uses debt to finance assets. The use of debt will increase a firm’s return on equity (ROE) if the firm earns more on its assets than the interest rate on debt and, at the same time, increased financial leverage will increase the variability of net income.
Total debt ratio = Total Debt/Total Assets - Proportion of assets financed with fixed costs financing debt. Proportion of funds provided by creditors and debt holders. Includes both current liabilities and long-term debt. Creditors and bond holders prefer a lower debt ratio.
Debt to Equity Ratio = Total Debt/Owner’s Equity - A higher ratio indicates more financial leverage and more risk
Equity multiplier = Total Assets/Owner’s Equity - Indicates how many additional dollars of assets the company can buy for each additional dollar of equity
Times interest earned = EBIT/Interest - Indicates the extent that EBIT can drop before the company does not have sufficient earnings to cover interest expense. Failure to make interest payments is an act of bankruptcy
Measure a company’s overall efficiency and analyze the relationship between sales and expenses.
Operating Margin = EBIT/Sales - Ratio of the difference between revenues and operating costs and sales . Operating profit per dollar of sales.
Basic earning power = EBIT/Total Assets - Difference between revenues and operating costs and total assets
Net profit margin = Net Income/Sales - Measures the overall operating efficiency of the company. Proportion of revenue earned by the company
Return on assets = Net Income/Total Assets
Return on equity = Net Income/Owner’s Equity - Proportion of profit generated for each dollar of equity
Market based Ratios
Show the value placed on the company by shareholders. Value of the firm is equal to the market capitalization (number of shares outstanding * price per share) of the firm.
Earnings per share = Net Income/Number of shares outstanding – Net Income earned for each share
Price-to-earnings (P/E) = Market Price per share/Earnings per share - Number of dollars investors are willing to pay for each dollar of earnings
Book value per share = Owner’s Equity/Number of shares outstanding - Stock price based on the accounting value of the firm
Market to book value = Stock price per share/ Book value per share – Number of dollars that investors are willing to pay for each dollar of assets in the company
Dividends per share = Dividends/Number of shares outstanding - Proportion of net income paid in dividends
Dividend yield = Dividend per share/Stock Price
Payout ratio = Dividend per share/ Earnings per share
Retention ratio = (1 – payout ratio)