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Net worth is the amount by which assets exceed liabilities. Net worth is a
concept applicable to individuals and businesses as a key measure of how much
an entity is worth. A consistent increase in net worth indicates good financial
health; conversely, net worth may be depleted by annual operating losses or a
substantial decrease in asset values relative to liabilities. In the business context,
net worth is also known as book value or shareholders' equity.
Assume that five years later, the couple's financial position is as follows -
residence value $225,000, investment portfolio $120,000, savings $20,000,
automobile and other assets $15,000; mortgage loan balance $80,000, car loan
$0 (paid off). The net worth would now be $300,000.
In other words, the couple's net worth has gone up by $35,000 despite the
decrease in the value of their residence and car, because this decline is more
than offset by increases in other assets (such as the investment portfolio and
savings) as well as the decrease in their liabilities.
Shareholders' equity is equal to a firm's total assets minus its total liabilities and
is one of the most common financial metrics employed by analysts to determine
the financial health of a company. Shareholders' equity represents the net value
of a company, or the amount that would be returned to shareholders if all the
company's assets were liquidated and all its debts repaid.
Liquidity ratios measure a company's ability to pay debt obligations and its
margin of safety through the calculation of metrics including the current ratio,
quick ratio and operating cash flow ratio. Current liabilities are analyzed in
relation to liquid assets to evaluate the coverage of short-term debts in an
emergency. Bankruptcy analysts and mortgage originators use liquidity ratios to
evaluate going concern issues, as liquidity measurement ratios indicate cash
flow positioning.
Current Ratio
The current ratio is a liquidity ratio that measures a company's ability to pay
short-term and long-term obligations. To gauge this ability, the current ratio
considers the current total assets of a company (both liquid and illiquid) relative
to that company’s current total liabilities.
Quick Ratio
The quick ratio measures the dollar amount of liquid assets available for each
dollar of current liabilities. Thus, a quick ratio of 1.5 means that a company has
$1.50 of liquid assets available to cover each $1 of current liabilities. The higher
the quick ratio, the better the company's liquidity position.
The average collection period is the approximate amount of time that it takes for
a business to receive payments owed in terms of accounts receivable. The
average collection period is calculated by dividing the average balance of
accounts receivable by total net credit sales for the period and multiplying the
quotient by the number of days in the period.
Calculated as:
Where:
Days = Total amount of days in period
AR = Average amount of accounts receivables
Credit Sales = Total amount of net credit sales during period
Average payment period means the average period taken by the company in
making payments to its creditors. It is computed by dividing the number of
working days in a year by creditors turnover ratio. Some other formulas for its
computation are give below:
Formula:
Average inventory days means the average days which are taken by the
company to convernet the inventory into goods and sale them or sale the
inentories. It is computed by average inentories in a year and multiply with
working days in year and diving with net Sales.
Formula:
The cash conversion cycle (CCC) measures the number of days a company's
cash is tied up in the production and sales process of its operations and the
benefit it derives from payment terms from its creditors. The shorter this cycle,
the more liquid the company's working capital position is. The CCC is also
known as the "cash" or "operating" cycle.
Formula:
CCC= ACP+AID-APP
Formula 7.15
Gross profit margin = gross profit
net sales
Where:
Gross profit = net sales - cost of goods
sold
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X100
X100
EBIT / Interest
Efficiency Ratios
Efficiency ratios also called activity ratios measure how well companies utilize
their assets to generate income. Efficiency ratios often look at the time it takes
companies to collect cash from customer or the time it takes companies to
convert inventory into cash—in other words, make sales. These ratios are used
by management to help improve the company as well as outside investors and
creditors looking at the operations of profitability of the company.
Efficiency ratios go hand in hand with profitability ratios. Most often when
companies are efficient with their resources, they become profitable. Wal-Mart
is a good example. Wal-Mart is extremely good at selling low margin products
at high volumes. In other words, they are efficient at turning their assets. Even
though they don't make much profit per sale, they make a ton of sales. Each little
sale adds up.
This ratio shows how efficient a company is at collecting its credit sales from
customers. Some companies collect their receivables from customers in 90 days
while other take up to 6 months to collect from customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as
well. Companies are more liquid the faster they can covert their receivables into
cash.
Formula
The accounts payable turnover ratio indicates how many times a company pays
off its suppliers during an accounting period. It also measures how a company
manages paying its own bills. A higher ratio is generally more favorable as
payables are being paid more quickly. When placed on a trend graph accounts
payable turnover analysis becomes simplified: the line raises and lowers just as
the ratio does. Common adaptations used to calculate accounts payable
turnover yield results like accounts payable turnover ratio in days, A/P turnover
in days, and more. A useful tool in managing and measuring the efficiency of
paying bills is a Flash Report.
The asset turnover ratio is an efficiency ratio that measures a company's ability
to generate sales from its assets by comparing net sales with average total assets.
In other words, this ratio shows how efficiently a company can use its assets to
generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to
show how many sales are generated from each dollar of company assets. For
instance, a ratio of .5 means that each dollar of assets generates 50 cents of sales.
Formula
The asset turnover ratio is calculated by dividing net sales by average total
assets.
Inventory Turnover Ratio
The inventory turnover ratio is an efficiency ratio that shows how effectively
inventory is managed by comparing cost of goods sold with average inventory
for a period. This measures how many times average inventory is "turned" or
sold during a period. In other words, it measures how many times a company
sold its total average inventory dollar amount during the year. A company with
$1,000 of average inventory and sales of $10,000 effectively sold its 10 times
over.
This ratio is important because total turnover depends on two main components
of performance. The first component is stock purchasing. If larger amounts of
inventory are purchased during the year, the company will have to sell greater
amounts of inventory to improve its turnover. If the company can't sell these
greater amounts of inventory, it will incur storage costs and other holding costs.
Formula
The inventory turnover ratio is calculated by dividing the cost of goods sold for
a period by the average inventory for that period.
Profitability Ratios
Investors and creditors can use profitability ratios to judge a company's return on
investment based on its relative level of resources and assets. In other words,
profitability ratios can be used to judge whether companies are making enough
operational profit from their assets. In this sense, profitability ratios relate to
efficiency ratios because they show how well companies are using thier assets to
generate profits. Profitability is also important to the concept of solvency and
going concern.
Here are some of the key ratios that investors and creditors consider when
judging how profitable a company should be:
Gross Margin
Gross margin tells you about the profitability of your goods and services. It
tells you how much it costs you to produce the product. It is calculated by
dividing your gross profit (GP) by your net sales (NS) and multiplying the
quotient by 100:
Operating Margin
Operating margin takes into account the costs of producing the product or
services that are unrelated to the direct production of the product or services,
such as overhead and administrative expenses. It is calculated by dividing your
operating profit (OP) by your net sales (NS) and multiplying the quotient by
100:
The profit margin ratio, also called the return on sales ratio or gross profit ratio,
is a profitability ratio that measures the amount of net income earned with each
dollar of sales generated by comparing the net income and net sales of a
company. In other words, the profit margin ratio shows what percentage of sales
are left over after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can
convert sales into net income. Investors want to make sure profits are high
enough to distribute dividends while creditors want to make sure the company
has enough profits to pay back its loans. In other words, outside users want to
know that the company is running efficiently. An extremely low profit margin
formula would indicate the expenses are too high and the management needs to
budget and cut expenses.
Formula
The profit margin ratio formula can be calculated by dividing net income by net
sales.
Return on Assets
Return on assets measures how effectively the company produces income from
its assets. You calculate it by dividing net income (NI) for the current year by
the value of all the company's assets (A) and multiplying the quotient by 100:
Return on Equity
Return on equity measures how much a company makes for each dollar that
investors put into it. You calculate it by taking the net income earned (NI) by the
amount of money invested by shareholders (SI) and multiplying the quotient by
100: