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Liquidity Ratio

Current Ratio

The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off
its short-term liabilities with its current assets. The current ratio is an important measure of
liquidity because short-term liabilities are due within the next year.

This means that a company has a limited amount of time in order to raise the funds to
pay for these liabilities. Current assets like cash, cash equivalents, and marketable securities can
easily be converted into cash in the short term. This means that companies with larger amounts
of current assets will more easily be able to pay off current liabilities when they become due
without having to sell off long-term, revenue generating assets.

Formula:

The current ratio is calculated by dividing current assets by current liabilities. This ratio is
stated in numeric format rather than in decimal format. Here is the calculation:

GAAP requires that companies separate current and long-term assets and liabilities on
the balance sheet. This split allows investors and creditors to calculate important ratios like the
current ratio. On U.S. financial statements, current accounts are always reported before long-
term accounts.

Analysis

The current ratio helps investors and creditors understand the liquidity of a company and how
easily that company will be able to pay off its current liabilities. This ratio expresses a firm's
current debt in terms of current assets. So a current ratio of 4 would mean that the company
has 4 times more current assets than current liabilities.

A higher current ratio is always more favorable than a lower current ratio because it shows the
company can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually means
the company isn't making enough from operations to support activities. In other words, the
company is losing money. Sometimes this is the result of poor collections of accounts receivable.

The current ratio also sheds light on the overall debt burden of the company. If a company
is weighted down with a current debt, its cash flow will suffer.

Example

Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is applying
for loans to help fund his dream of building an indoor skate rink. Charlie's bank asks for his
balance sheet so they can analyze his current debt levels. According to Charlie's balance sheet he
reported $100,000 of current liabilities and only $25,000 of current assets. Charlie's current ratio
would be calculated like this:

As you can see, Charlie only has enough current assets to pay off 25 percent of his current
liabilities. This shows that Charlie is highly leveraged and highly risky. Banks would prefer a
current ratio of at least 1 or 2, so that all the current liabilities would be covered by the current
assets. Since Charlie's ratio is so low, it is unlikely that he will get approved for his loan.

Acid-Test Ratio/Quick Ratio

The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company
to pay its current liabilities when they come due with only quick assets. Quick assets are current
assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents,
short-term investments or marketable securities, and current accounts receivable are considered
quick assets.

Short-term investments or marketable securities include trading securities and available


for sale securities that can easily be converted into cash within the next 90 days. Marketable
securities are traded on an open market with a known price and readily available buyers. Any
stock on the New York Stock Exchange would be considered a marketable security because they
can easily be sold to any investor when the market is open.
The quick ratio is often called the acid test ratio in reference to the historical use of acid
to test metals for gold by the early miners. If the metal passed the acid test, it was pure gold. If
metal failed the acid test by corroding from the acid, it was a base metal and of no value.
The acid test of finance shows how well a company can quickly convert its assets into cash
in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.

Formula

The quick ratio is calculated by adding cash, cash equivalents, short-term investments,
and current receivables together then dividing them by current liabilities.

Sometimes company financial statements do not give a breakdown of quick assets on the
balance sheet. In this case, you can still calculate the quick ratio even if some of the quick asset
totals are unknown. Simply subtract inventory and any current prepaid assets from the current
asset total for the numerator. Here is an example.

Analysis

The acid test ratio measures the liquidity of a company by showing its ability to pay off its
current liabilities with quick assets. If a firm has enough quick assets to cover its total current
liabilities, the firm will be able to pay off its obligations without having to sell off any long-term
or capital assets.

Since most businesses use their long-term assets to generate revenues, selling off these
capital assets will not only hurt the company it will also show investors that current operations
are not making enough profits to pay off current liabilities.

Higher quick ratios are more favorable for companies because it shows there are more
quick assets than current liabilities. A company with a quick ratio of 1 indicates that quick assets
equal current assets. This also shows that the company could pay off its current liabilities without
selling any long-term assets. An acid ratio of 2 shows that the company has twice as many quick
assets than current liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More assets will be
easily converted into cash if need be. This is a good sign for investors, but an even better sign to
creditors because creditors want to know they will be paid back on time.

Example

Let us assume Carole's Clothing Store is applying for a loan to remodel the storefront. The
bank asks Carole for a detailed balance sheet, so it can compute the quick ratio. Carole's balance
sheet included the following accounts:

• Cash: $10,000
• Accounts Receivable: $5,000
• Inventory: $5,000
• Stock Investments: $1,000
• Prepaid taxes: $500
• Current Liabilities: $15,000

The bank can compute Carole's quick ratio like this.

As you can see Carole's quick ratio is 1.07. This means that Carole can pay off all of her
current liabilities with quick assets and still have some quick assets left over.

Now let's assume the same scenario except Carole did not provide the bank with a detailed
balance sheet. Instead Carole's balance sheet only included these accounts:

• Inventory: $5,000
• Prepaid taxes: $500
• Total Current Assets: $21,500
• Current Liabilities: $15,000

Since Carole's balance sheet doesn't include the breakdown of quick assets, the bank can
compute her quick ratio like this:
Cash Ratio

The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm's ability to
pay off its current liabilities with only cash and cash equivalents. The cash ratio is much more
restrictive than the current ratio or quick ratio because no other current assets can be used to
pay off current debt--only cash.

This is why many creditors look at the cash ratio. They want to see if a company maintains
adequate cash balances to pay off all of their current debts as they come due. Creditors also like
the fact that inventory and accounts receivable are left out of the equation because both of these
accounts are not guaranteed to be available for debt servicing. Inventory could take months or
years to sell and receivables could take weeks to collect. Cash is guaranteed to be available for
creditors.

Formula

The cash coverage ratio is calculated by adding cash and cash equivalents and dividing
by the total current liabilities of a company.

Most companies’ list cash and cash equivalents together on their balance sheet, but some
companies list them separately. Cash equivalents are investments and other assets that can be
converted into cash within 90 days. These assets are so close to cash that GAAP considers them
an equivalent.

Current liabilities are always shown separately from long-term liabilities on the face of
the balance sheet.

Analysis

The cash ratio shows how well a company can pay off its current liabilities with only cash
and cash equivalents. This ratio shows cash and equivalents as a percentage of current liabilities.
A ratio of 1 means that the company has the same amount of cash and equivalents as it
has current debt. In other words, in order to pay off its current debt, the company would have to
use all of its cash and equivalents. A ratio above 1 means that all the current liabilities can be
paid with cash and equivalents. A ratio below 1 means that the company needs more than just
its cash reserves to pay off its current debt.

As with most liquidity ratios, a higher cash coverage ratio means that the company is more
liquid and can more easily fund its debt. Creditors are particularly interested in this ratio because
they want to make sure their loans will be repaid. Any ratio above 1 is considered to be a good
liquidity measure.

Example

Sophie's Palace is a restaurant that is looking to remodel its dining room. Sophie is asking
her bank for a loan of $100,000. Sophie's balance sheet lists these items:

• Cash: $10,000
• Cash Equivalents: $2,000
• Accounts Payable: $5,000
• Current Taxes Payable: $1,000
• Current Long-term Liabilities: $10,000

Sophie's cash ratio is calculated like this:

As you can see, Sophie's ratio is .75. This means that Sophie only has enough cash and
equivalents to pay off 75 percent of her current liabilities. This is a fairly high ratio which means
Sophie maintains a relatively high cash balance during the year.

Obviously, Sophie's bank would look at other ratios before accepting her loan application,
but based on this coverage ratio, Sophie would most likely be accepted.
Solvency Ratios

Debt Ratio

Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its
total assets. In a sense, the debt ratio shows a company's ability to pay off its liabilities with its
assets. In other words, this shows how many assets the company must sell in order to pay off all
of its liabilities.

This ratio measures the financial leverage of a company. Companies with higher levels of
liabilities compared with assets are considered highly leveraged and more risky for lenders. This
helps investors and creditors analysis the overall debt burden on the company as well as the
firm's ability to pay off the debt in future, uncertain economic times.

Formula

The debt ratio is calculated by dividing total liabilities by total assets. Both of these
numbers can easily be found the balance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation. The debt
ratio shows the overall debt burden of the company—not just the current debt.

Analysis

The debt ratio is shown in decimal format because it calculates total liabilities as a
percentage of total assets. As with many solvency ratios, a lower ratios is more favorable than a
higher ratio.

A lower debt ratio usually implies a more stable business with the potential of longevity
because a company with lower ratio also has lower overall debt. Each industry has its own
benchmarks for debt, but .5 is reasonable ratio.

A debt ratio of .5 is often considered to be less risky. This means that the company has
twice as many assets as liabilities. Or said a different way, this company's liabilities are only 50
percent of its total assets. Essentially, only its creditors own half of the company's assets and the
shareholders own the remainder of the assets.
A ratio of 1 means that total liabilities equals total assets. In other words, the company
would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly
leverage firm. Once its assets are sold off, the business no longer can operate.

The debt ratio is a fundamental solvency ratio because creditors are always concerned
about being repaid. When companies borrow more money, their ratio increases creditors will no
longer loan them money. Companies with higher debt ratios are better off looking to equity
financing to grow their operations.

Example

Dave's Guitar Shop is thinking about building an addition onto the back of its existing
building for more storage. Dave consults with his banker about applying for a new loan. The bank
asks for Dave's balance to examine his overall debt levels.

The banker discovers that Dave has total assets of $100,000 and total liabilities of
$25,000. Dave's debt ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as
many assets as he has liabilities. This is a relatively low ratio and implies that Dave will be able to
pay back his loan. Dave shouldn't have a problem getting approved for his loan.

Equity Ratio

The equity ratio is an investment leverage or solvency ratio that measures the amount of
assets that are financed by owners' investments by comparing the total equity in the company
to the total assets.

The equity ratio highlights two important financial concepts of a solvent and sustainable
business. The first component shows how much of the total company assets are owned outright
by the investors. In other words, after all of the liabilities are paid off, the investors will end up
with the remaining assets.

The second component inversely shows how leveraged the company is with debt. The
equity ratio measures how much of a firm's assets were financed by investors. In other words,
this is the investors' stake in the company. This is what they are on the hook for. The inverse of
this calculation shows the amount of assets that were financed by debt. Companies with higher
equity ratios show new investors and creditors that investors believe in the company and are
willing to finance it with their investments.

Formula

The equity ratio is calculated by dividing total equity by total assets. Both of these
numbers truly include all of the accounts in that category. In other words, all of the assets and
equity reported on the balance sheet are included in the equity ratio calculation.

Analysis

In general, higher equity ratios are typically favorable for companies. This is usually the
case for several reasons. Higher investment levels by shareholders shows potential shareholders
that the company is worth investing in since so many investors are willing to finance the
company. A higher ratio also shows potential creditors that the company is more sustainable and
less risky to lend future loans.

Equity financing in general is much cheaper than debt financing because of the interest
expenses related to debt financing. Companies with higher equity ratios should have less
financing and debt service costs than companies with lower ratios.
As with all ratios, they are contingent on the industry. Exact ratio performance depends on
industry standards and benchmarks.

Example

Tim's Tech Company is a new startup with a number of different investors. Tim is looking
for additional financing to help grow the company, so he talks to his business partners about
financing options. Tim's total assets are reported at $150,000 and his total liabilities are $50,000.
Based on the accounting equation, we can assume the total equity is $100,000. Here is Tim's
equity ratio.
As you can see, Tim's ratio is .67. This means that investors rather than debt are currently
funding more assets. 67 percent of the company's assets are owned by shareholders and not
creditors. Depending on the industry, this is a healthy ratio.

Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt
to total equity. The debt to equity ratio shows the percentage of company financing that comes
from creditors and investors. A higher debt to equity ratio indicates that more creditor financing
(bank loans) is used than investor financing (shareholders).

Formula

The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt
to equity ratio is considered a balance sheet ratio because all of the elements are reported on
the balance sheet.

Analysis

Each industry has different debt to equity ratio benchmarks, as some industries tend to
use more debt financing than others. A debt ratio of .5 means that there are half as many
liabilities as there is equity. In other words, the assets of the company are funded 2-to-1 by
investors to creditors. This means that investors own 66.6 cents of every dollar of company assets
while creditors only own 33.3 cents on the dollar.

A debt to equity ratio of 1 would mean that investors and creditors have an equal stake
in the business assets.

A lower debt to equity ratio usually implies a more financially stable business. Companies
with a higher debt to equity ratio are considered more risky to creditors and investors than
companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since
debt financing also requires debt servicing or regular interest payments, debt can be a far more
expensive form of financing than equity financing. Companies leveraging large amounts of debt
might not be able to make the payments.
Creditors view a higher debt to equity ratio as risky because it shows that the investors
have not funded the operations as much as creditors have. In other words, investors do not have
as much skin in the game as the creditors do. This could mean that investors don't want to fund
the business operations because the company is not performing well. Lack of performance might
also be the reason why the company is seeking out extra debt financing.

Example

Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its
property. The shareholders of the company have invested $1.2 million. Here is how you calculate
the debt to equity ratio.

Times Interest Earned Ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a
coverage ratio that measures the proportionate amount of income that can be used to cover
interest expenses in the future.

In some respects the times interest ratio is considered a solvency ratio because it
measures a firm's ability to make interest and debt service payments. Since these interest
payments are usually made on a long-term basis, they are often treated as an ongoing, fixed
expense. As with most fixed expenses, if the company cannot make the payments, it could go
bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.

Formula

The times interest earned ratio is calculated by dividing income before interest and
income taxes by the interest expense.
Both of these figures can be found on the income statement. Interest expense and
income taxes are often reported separately from the normal operating expenses for solvency
analysis purposes. This also makes it easier to find the earnings before interest and taxes or EBIT.
Analysis
The times interest ratio is stated in numbers as opposed to a percentage. The ratio
indicates how many times a company could pay the interest with its before tax income, so
obviously the larger ratios are considered more favorable than smaller ratios.

In other words, a ratio of 4 means that a company makes enough income to pay for its
total interest expense 4 times over. Said another way, this company's income is 4 times higher
than its interest expense for the year.

As you can see, creditors would favor a company with a much higher interest ratio
because it shows the company can afford to pay its interest payments when they come due.
Higher ratios are less risky while lower ratios indicate credit risk.

Example

Tim's Tile Service is a construction company that is currently applying for a new loan to
buy equipment. The bank asks Tim for his financial statements before they will consider his loan.
Tim's income statement shows that he made $500,000 of income before interest expense and
income taxes. Tim's overall interest expense for the year was only $50,000. Tim's time interest
earned ratio would be calculated like this:

As you can see, Tim has a ratio of ten. This means that Tim's income is 10 times greater
than his annual interest expense. In other words, Tim can afford to pay additional interest
expenses. In this respect, Tim's business is less risky and the bank shouldn't have a problem
accepting his loan.

Cash Coverage Ratio

The cash coverage ratio is useful for determining the amount of cash available to pay for
a borrower's interest expense, and is expressed as a ratio of the cash available to the amount of
interest to be paid. To show a sufficient ability to pay, the ratio should be substantially greater
than 1:1.
To calculate the cash coverage ratio, take the earnings before interest and taxes (EBIT)
from the income statement, add back to it all non-cash expenses included in EBIT (such as
depreciation and amortization), and divide by the interest expense. The formula is:

Earnings Before Interest and Taxes + Non-Cash Expenses


Interest Expense

For example, the controller of the Anderson Boat Company (ABC) is concerned that the
company has recently taken on a great deal of debt to pay for a leveraged buyout, and wants to
ensure that there is enough cash to pay for its new interest burden. The company is generating
earnings before interest and taxes of $1,200,000 and it records annual depreciation of $800,000.
ABC is scheduled to pay $1,500,000 in interest expenses in the coming year. Based on this
information, ABC has the following cash coverage ratio:

$1,200,000 EBIT + $800,000 Depreciation


$1,500,000 Interest Expense
= 1.33 cash coverage ratio

The calculation reveals that ABC can pay for its interest expense, but has very little cash
left for any other payments.

There may be a number of additional non-cash items to subtract in the numerator of the
formula. For example, there may have been substantial charges in a period to increase reserves
for sales allowances, product returns, bad debts, or inventory obsolescence. If these non-cash
items are substantial, be sure to include them in the calculation. Also the interest expense in the
denominator should only include the actual interest expense to be paid - if there is a premium or
discount to the amount being paid, it is not a cash payment, and so should not be included in the
denominator.

Activity Ratios

Turnovers

Asset Turnover Ratio

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.

Net sales, found on the income statement, are used to calculate this ratio returns and
refunds must be backed out of total sales to measure the truly measure the firm's assets' ability
to generate sales.

Average total assets are usually calculated by adding the beginning and ending total asset
balances together and dividing by two. This is just a simple average based on a two-yearbalance
sheet. A more in-depth, weighted average calculation can be used, but it is not necessary.

Analysis

This ratio measures how efficiently a firm uses its assets to generate sales, so a higher
ratio is always more favorable. Higher turnover ratios mean the company is using its assets more
efficiently. Lower ratios mean that the company isn't using its assets efficiently and most likely
have management or production problems.

For instance, a ratio of 1 means that the net sales of a company equals the average total
assets for the year. In other words, the company is generating 1 dollar of sales for every dollar
invested in assets.

Like with most ratios, the asset turnover ratio is based on industry standards. Some
industries use assets more efficiently than others. To get a true sense of how well a company's
assets are being used, it must be compared to other companies in its industry.

The total asset turnover ratio is a general efficiency ratio that measures how efficiently a
company uses all of its assets. This gives investors and creditors an idea of how a company is
managed and uses its assets to produce products and sales.

Sometimes investors also want to see how companies use more specific assets like fixed
assets and current assets. The fixed asset turnover ratio and the working capital ratio are
turnover ratios similar to the asset turnover ratio that are often used to calculate the efficiency
of these asset classes.
Example

Sally's Tech Company is a tech startup company that manufactures a new tablet
computer. Sally is currently looking for new investors and has a meeting with an angel investor.
The investor wants to know how well Sally uses her assets to produce sales, so he asks for
her financial statements.

Here is what the financial statements reported:

 Beginning Assets: $50,000


 Ending Assets: $100,000
 Net Sales: $25,000
The total asset turnover ratio is calculated like this:

As you can see, Sally's ratio is only .33. This means that for every dollar in assets, Sally
only generates 33 cents. In other words, Sally's start up in not very efficient with its use of 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.

The second component is sales. Sales have to match inventory purchases otherwise the
inventory will not turn effectively. That's why the purchasing and sales departments must be in
tune with each other.
Formula

The inventory turnover ratio is calculated by dividing the cost of goods sold for a period
by the average inventory for that period.

Average inventory is used instead of ending inventory because many companies'


merchandise fluctuates greatly throughout the year. For instance, a company might purchase a
large quantity of merchandise January 1 and sell that for the rest of the year. By December almost
the entire inventory is sold and the ending balance does not accurately reflect the company's
actual inventory during the year. Average inventory is usually calculated by adding the beginning
and ending inventory and dividing by two. The cost of goods sold is reported on the income
statement.

Analysis

Inventory turnover is a measure of how efficiently a company can control its merchandise,
so it is important to have a high turn. This shows the company does not overspend by buying too
much inventory and wastes resources by storing non-salable inventory. It also shows that the
company can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company's inventory is. Think about
it. Inventory is one of the biggest assets a retailer reports on its balance sheet. If this inventory
can't be sold, it is worthless to the company. This measurement shows how easily a company can
turn its inventory into cash.

Creditors are particularly interested in this because inventory is often put up as collateral
for loans. Banks want to know that this inventory will be easy to sell.
Inventory turns vary with industry. For instance, the apparel industry will have higher turns than
the exotic car industry.

Example

Donny's Furniture Company sells industrial furniture for office buildings. During the
current year, Donny reported cost of goods sold on its income statement of $1,000,000. Donny's
beginning inventory was $3,000,000 and its ending inventory was $4,000,000. Donny's turnover
is calculated like this:
As you can see, Donny's turnover is .29. This means that Donny only sold roughly a third
of its inventory during the year. It also implies that it would take Donny approximately 3 years to
sell his entire inventory or complete one turn. In other words, Danny does not have very good
inventory control.

Accounts Receivable Turnover Ratio

Accounts receivable turnover is an efficiency ratio or activity ratio that measures how
many times a business can turn its accounts receivable into cash during a period. In other words,
the accounts receivable turnover ratio measures how many times a business can collect its
average accounts receivable during the year.

A turn refers to each time a company collects its average receivables. If a company had
$20,000 of average receivables during the year and collected $40,000 of receivables during the
year, the company would have turned its accounts receivable twice because it collected twice
the amount of average receivables.

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 convert their receivables into cash.

Formula

Accounts receivable turnover is calculated by dividing net credit sales by the average
accounts receivable for that period.
The reason net credit sales are used instead of net sales is that cash sales don't create
receivables. Only credit sales establish a receivable, so the cash sales are left out of the
calculation. Net sales simply refers to sales minus returns and refunded sales.

The net credit sales can usually be found on the company's income statement for the year
although not all companies report cash and credit sales separately. Average receivables is
calculated by adding the beginning and ending receivables for the year and dividing by two. In a
sense, this is a rough calculation of the average receivables for the year.

Analysis

Since the receivables turnover ratio measures a business' ability to efficiently collect its
receivables, it only makes sense that a higher ratio would be more favorable. Higher ratios mean
that companies are collecting their receivables more frequently throughout the year. For
instance, a ratio of 2 means that the company collected its average receivables twice during the
year. In other words, this company is collecting is money from customers every six months.

Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect
cash from customers sooner, it will be able to use that cash to pay bills and other obligations
sooner.

Accounts receivable turnover is also an indication of the quality of credit sales and
receivables. A company with a higher ratio shows that credit sales are more likely to be collected
than a company with a lower ratio. Since accounts receivable are often posted as collateral for
loans, quality of receivables is important.

Example

Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to
all of his main customers. At the end of the year, Bill's balance sheet shows $20,000 in accounts
receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year's balance sheet
showed $10,000 of accounts receivable.

The first thing we need to do in order to calculate Bill's turnover is to calculate net credit
sales and average accounts receivable. Net credit sales equals gross credit sales minus returns
(75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by averaging
beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Bill's accounts receivable turnover ratio for the year can be like this.
As you can see, Bill's turnover is 3.33. This means that Bill collects his receivables about
3.3 times a year or once every 110 days. In other words, when Bill makes a credit sale, it will take
him 110 days to collect the cash from that sale.

Accounts Payable Turnover Ratio

The accounts payable turnover ratio is a liquidity ratio that shows a company's ability to
pay off its accounts payable by comparing net credit purchases to the average accounts payable
during a period. In other words, the accounts payable turnover ratio is how many times a
company can pay off its average accounts payable balance during the course of a year.

This ratio helps creditors analyze the liquidity of a company by gauging how easily a
company can pay off its current suppliers and vendors. Companies that can pay off supplies
frequently throughout the year indicate to creditor that they will be able to make regular interest
and principle payments as well.

Vendors also use this ratio when they consider establishing a new line of credit or floor
plan for a new customer. For instance, car dealerships and music stores often pay for their
inventory with floor plan financing from their vendors. Vendors want to make sure they will be
paid on time, so they often analyze the company's payable turnover ratio.

Formula

The accounts payable turnover formula is calculated by dividing the total purchases by
the average accounts payable for the year.

The total purchases number is usually not readily available on any general purpose
financial statement. Instead, total purchases will have to be calculated by adding the ending
inventory to the cost of goods sold and subtracting the beginning inventory. Most companies will
have a record of supplier purchases, so this calculation may not need to be made.

The average payables is used because accounts payable can vary throughout the year.
The ending balance might be representative of the total year, so an average is used. To find the
average accounts payable, simply add the beginning and ending accounts payable together and
divide by two.

Analysis

Since the accounts payable turnover ratio indicates how quickly a company pays off its
vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a
business. As with most liquidity ratios, a higher ratio is almost always more favorable than a lower
ratio.

A higher ratio shows suppliers and creditors that the company pays its bills frequently and
regularly. It also implies that new vendors will get paid back quickly. A high turnover ratio can be
used to negotiate favorable credit terms in the future.

As with all ratios, the accounts payable turnover is specific to different industries. Every
industry has a slightly different standard. This ratio is best used to compare similar companies in
the same industry.

Example

Bob's Building Suppliers buys constructions equipment and materials from wholesalers
and resells this inventory to the general public in its retail store. During the current year Bob
purchased $1,000,000 worth of construction materials from his vendors. According to Bob's
balance sheet, his beginning accounts payable was $55,000 and his ending accounts payable was
$958,000.

Here is how Bob's vendors would calculate his payable turnover ratio:

As you can see, Bob's average accounts payable for the year was $506,500 (beginning plus
ending divided by 2). Based on this formula Bob's turnover ratio is 1.97. This means that Bob pays
his vendors back on average once every six months of twice a year. This is not a high turnover
ratio, but it should be compared to others in Bob's industry.
Periods

Inventory Turnover Period

You can also divide the result of the inventory turnover calculation into 365 days to arrive at
days of inventory on hand, which may be a more understandable figure. Thus, a turnover rate
of 4.0 becomes 91 days of inventory. This is known as the inventory turnover period.

Accounts Receivable Collection Period | Days Sales Outstanding

A comparison of the receivables to the sales activity of a business is called the accounts
receivable collection period or days sales outstanding. This comparison is used to evaluate how
long customers are taking to pay a company. A low figure is considered best, since it means that
a business is locking up less of its funds in accounts receivable, and so can use the funds for other
purposes. Also, when receivables remain unpaid for a reduced period of time, there is less risk of
payment default by customers.

Days sales outstanding is most useful when compared to the standard number of days
that customers are allowed before payment is due. Thus, a DSO figure of 40 days might initially
appear excellent, until you realize that the standard payment terms are only five days. DSO can
also be compared to the industry standard, or to the average DSO for the top performers in the
industry, to judge collection performance.

A combination of prudent credit granting and robust collections activity is indicated when
the DSO figure is only a few days longer than the standard payment terms. From a management
perspective, it is easiest to spot collection problems at a gross level by tracking DSO on a trend
line, and watching for a sudden spike in the measurement in comparison to what was reported
in prior periods.

To calculate DSO, divide 365 days into the amount of annual credit sales to arrive at credit
sales per day, and then divide this figure into the average accounts receivable for the
measurement period. Thus, the formula is:

Average accounts receivable


Annual sales ÷ 365 days

For example, the controller of Oberlin Acoustics, maker of the famous Rhino brand of
electric guitars, wants to derive the days sales outstanding for the company for the April
reporting period. In April, the beginning and ending accounts receivable balances were $420,000
and $540,000 respectively. The total credit sales for the 12 months ended April 30 were
$4,000,000. The controller derives the following DSO calculation from this information:
($420,000 Beginning receivables + $540,000 Ending receivables) ÷ 2
$4,000,000 Credit sales ÷ 365 Days
=
$480,000 Average accounts receivable
$10,959 Credit sales per day
= 43.8 Days

The correlation between the annual sales figure used in the calculation and the average
accounts receivable figure may not be close, resulting in a misleading DSO number. For example,
if a company has seasonal sales, the average receivable figure may be unusually high or low on
the measurement date, depending on where the company is in its season billings. Thus, if
receivables are unusually low when the measurement is taken, the DSO days will appear
unusually low, and vice versa if the receivables are unusually high. There are two ways to
eliminate this problem:

 Annualize receivables. Generate an average accounts receivable figure that spans the entire, full-
year measurement period.

 Measure a shorter period. Adopt a rolling quarterly DSO calculation, so that sales for the past
three months are compare to average receivables for the past three months. This approach is
most useful when sales are highly variable throughout the year.
Whatever measurement methodology is adopted for DSO, be sure to use it consistently from
period to period, so that the results will be comparable on a trend line.

Accounts Payable Days Formula

The accounts payable days formula measures the number of days that a company takes
to pay its suppliers. If the number of days increases from one period to the next, this indicates
that the company is paying its suppliers more slowly, and may be an indicator of worsening
financial condition. A change in the number of payable days can also indicate altered payment
terms with suppliers, though this rarely has more than a slight impact on the total number of
days, since the terms must be altered for many suppliers to alter the ratio to a meaningful extent.

If a company is paying its suppliers very quickly, it may mean that the suppliers are
demanding fast payment terms, either because short terms are part of their business models or
because they feel the company is too high a credit risk to allow longer payment terms.
To calculate accounts payable days, summarize all purchases from suppliers during the
measurement period, and divide by the average amount of accounts payable during that period.

The formula is:


Total supplier purchases
(Beginning accounts payable + Ending accounts payable) / 2
This formula reveals the total accounts payable turnover. Then divide the resulting
turnover figure into 365 days to arrive at the number of accounts payable days.

The formula can be modified to exclude cash payments to suppliers, since the numerator
should include only purchases on credit from suppliers. Otherwise, the number of payable days
will appear to be too low. However, the amount of up-front cash payments to suppliers is
normally so small that this modification is not necessary.

As an example, the controller of ABC Company wants to determine the company's


accounts payable days for the past year. In the beginning of this period, the beginning accounts
payable balance was $800,000, and the ending balance was $884,000. Purchases for the last 12
months were $7,500,000. Based on this information, the controller calculates the accounts
payable turnover as:

$7,500,000 Purchases
($800,000 Beginning payables + $884,000 Ending payables) / 2
=
$7,500,000 Purchases
$842,000 Average accounts payable
= 8.9 Accounts payable turnover

Thus, ABC's accounts payable turned over 8.9 times during the past year. To calculate the
accounts payable turnover in days, the controller divides the 8.9 turns into 365 days, which yields:
365 Days / 8.9 Turns = 41 Days

There are some issues to be aware of when using this calculation. Companies sometimes
measure accounts payable days by only using the cost of goods sold in the numerator. This is
incorrect, since there may be a large amount of selling and administrative expenses that should
also be included in the numerator. If a company only uses the cost of goods sold in the numerator,
this results in an excessively small number of payable days.

Profitability

Margins

Operating Margin Ratio

The operating margin ratio, also known as the operating profit margin, is a profitability
ratio that measures what percentage of total revenues is made up by operating income. In other
words, the operating margin ratio demonstrates how much revenues are left over after all the
variable or operating costs have been paid. Conversely, this ratio shows what proportion of
revenues is available to cover non-operating costs like interest expense.

This ratio is important to both creditors and investors because it helps show how strong
and profitable a company's operations are. For instance, a company that receives 30 percent of
its revenue from its operations means that it is running its operations smoothly and this income
supports the company. It also means this company depends on the income from operations. If
operations start to decline, the company will have to find a new way to generate income.

Conversely, a company that only converts 3 percent of its revenue to operating income
can be questionable to investors and creditors. The auto industry made a switch like this in the
1990's. GM was making more money on financing cars than actually building and selling the cars
themselves. Obviously, this did not turn out very well for them. GM is a prime example of why
this ratio is important.

Formula

The operating margin formula is calculated by dividing the operating income by the net
sales during a period.

Operating income, also called income from operations, is usually stated separately on the
income before income from non-operating activities like interest and dividend income. Many
times operating income is classified as earnings before interest and taxes. Operating income can
be calculated by subtracting operating expenses, depreciation, and amortization from gross
income or revenues.

The revenue number used in the calculation is just the total, top-line revenue or net sales
for the year.

Analysis

The operating profit margin ratio is a key indicator for investors and creditors to see how
businesses are supporting their operations. If companies can make enough money from their
operations to support the business, the company is usually considered more stable. On the other
hand, if a company requires both operating and non-operating income to cover the operation
expenses, it shows that the business' operating activities are not sustainable.
A higher operating margin is more favorable compared with a lower ratio because this
shows that the company is making enough money from its ongoing operations to pay for its
variable costs as well as its fixed costs.

For instance, a company with an operating margin ratio of 20 percent means that for
every dollar of income, only 20 cents remains after the operating expenses have been paid. This
also means that only 20 cents is left over to cover the non-operating expenses.

Example

If Christie's Jewelry Store sells custom jewelry to celebrities all over the country. Christie
reports the follow numbers on her financial statements:
Net Sales: $1,000,000
Cost of Goods Sold: $500,000
Rent: $15,000
Wages: $100,000
Other Operating Expenses: $25,000

Here is how Christie would calculate her operating margin.

As you can see, Christie's operating income is $360,000 (Net sales – all operating
expenses). According to our formula, Christie's operating margin .36. This means that 64 cents
on every dollar of sales is used to pay for variable costs. Only 36 cents remains to cover all non-
operating expenses or fixed costs.

It is important to compare this ratio with other companies in the same industry. The gross
margin ratio is a helpful comparison.

Gross Margin Ratio

Gross margin ratio is a profitability ratio that compares the gross margin of a business to
the net sales. This ratio measures how profitable a company sells its inventory or merchandise.
In other words, the gross profit ratio is essentially the percentage markup on merchandise from
its cost. This is the pure profit from the sale of inventory that can go to paying operating
expenses.
Gross margin ratio is often confused with the profit margin ratio, but the two ratios are
completely different. Gross margin ratio only considers the cost of goods sold in its calculation
because it measures the profitability of selling inventory. Profit margin ratio on the other hand
considers other expenses.

Formula

Gross margin ratio is calculated by dividing gross margin by net sales.

The gross margin of a business is calculated by subtracting cost of goods sold from net
sales. Net sales equals gross sales minus any returns or refunds. The broken down formula looks
like this:

Analysis

Gross margin ratio is a profitability ratio that measures how profitable a company can sell
its inventory. It only makes sense that higher ratios are more favorable. Higher ratios mean the
company is selling their inventory at a higher profit percentage.

High ratios can typically be achieved by two ways. One way is to buy inventory very cheap.
If retailers can get a big purchase discount when they buy their inventory from
the manufacturer or wholesaler, their gross margin will be higher because their costs are down.

The second way retailers can achieve a high ratio is by marking their goods up higher. This
obviously has to be done competitively otherwise goods will be too expensive and customers will
shop elsewhere.

A company with a high gross margin ratios mean that the company will have more money
to pay operating expenses like salaries, utilities, and rent. Since this ratio measures the profits
from selling inventory, it also measures the percentage of sales that can be used to help fund
other parts of the business. Here is another great explanation.

Example

Assume Jack's Clothing Store spent $100,000 on inventory for the year. Jack was able to
sell this inventory for $500,000. Unfortunately, $50,000 of the sales were returned by customers
and refunded. Jack would calculate his gross margin ratio like this.
As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel industry.
This means that after Jack pays off his inventory costs, he still has 78 percent of his sales revenue
to cover his operating costs.

Profit Margin Ratio

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.

The return on sales ratio is often used by internal management to set performance goals
for the future.

Formula

The profit margin ratio formula can be calculated by dividing net income by net sales.

Net sales is calculated by subtracting any returns or refunds from gross sales. Net income
equals total revenues minus total expenses and is usually the last number reported on the income
statement.
Analysis

The profit margin ratio directly measures what percentage of sales is made up of net
income. In other words, it measures how much profits are produced at a certain level of sales.

This ratio also indirectly measures how well a company manages its expenses relative to
its net sales. That is why companies strive to achieve higher ratios. They can do this by either
generating more revenues why keeping expenses constant or keep revenues constant and lower
expenses.
Since most of the time generating additional revenues is much more difficult than cutting
expenses, managers generally tend to reduce spending budgets to improve their profit ratio.

Like most profitability ratios, this ratio is best used to compare like sized companies in the
same industry. This ratio is also effective for measuring past performance of a company.

Example

Trisha's Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to
the public. Last year Trisha had the best year in sales she has ever had since she opened the
business 10 years ago. Last year Trisha's net sales were $1,000,000 and her net income was
$100,000.

Here is Trisha's return on sales ratio.

As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that
with this year's numbers of $800,000 of net sales and $200,000 of net income.

This year Trisha may have made less sales, but she cut expenses and was able to convert
more of these sales into profits with a ratio of 25 percent.

Returns

Return on Sales – ROS

Return on sales, often called the operating profit margin, is a financial ratio that calculates
how efficiently a company is at generating profits from its revenue. In other words, it measures
a company’s performance by analyzing what percentage of total company revenues are actually
converted into company profits.

Investors and creditors are interested in this efficiency ratio because it shows the
percentage of money that the company actually makes on its revenues during a period. They can
use this calculation to compare company performance from one period to the next or compare
two different sized companies’ performance for a given period.

These attributes make this equation extremely useful for investors because they can
analyze the current performance trends of a business as well as compare them with other
companies in the industry no matter the size. In other words, a Fortune 500 company could be
compared with a regional firm to see which is able to operate more efficiently and turn revenue
dollars into profit dollars without regard to non-operating activities.
Let’s take a look at how to calculate the return on sales ratio.

Formula

The return on sales formula is calculated by dividing the operating profit by the net sales
for the period.

Keep in mind that the equation does not take into account non-operating activities like
taxes and financing structure. For example, income tax expense and interest expense are not
included in the equation because they are not considered operating expenses. This lets investors
and creditors understand the core operations of the business and focus on whether the main
operations are profitable or not.

Analysis

Since the return on sales equation measures the percentage of sales that are converted
to income, it shows how well the company is producing its core products or services and how
well the management teams is running it.

You can think of ROS as both an efficiency and profitability ratio because it is an indicator
of both metrics. It measures how efficiently a company uses its resources to convert sales into
profits. For instance, a company that generates $1,000,000 in net sales and requires $900,000 of
resources to do so is not nearly as efficient as a company that can generate the same about of
revenues by only using $500,000 of operating expenses. The more efficient management is a
cutting expenses, the higher the ratio.

It also measures the profitability of a company’s operating. As revenues and efficiency


increases, so do profits. Investors tend to use this iteration of the formula to calculate growth
projects and forecasts. For example, based on a certain percentage, investors could calculate the
potential profits if revenues doubled or tripled.
Let’s take a look at an example.

Example

Assume Jim’s Bowling Alley generates $500,000 of business each year and shows
operating profit of $100,000 before any taxes or interest expenses are accounted for. Jim would
calculate his ROS ratio like this:

As we can see, Jim converts 20 percent of his sales into profits. In other words, Jim spends
80 percent of the money he collects from customers to run the business. If Jim wants to increase
his net operating income, he can either focus on reducing expenses or increasing revenues.
If Jim can reduce these expenses while maintaining his revenues, his company will be more
efficient and as a result will be more profitable. Sometimes, however, it isn’t possible to reduce
expenses lower than a certain amount. In this case, Jim should strive for higher revenue numbers
while keeping the expenses the same. Both of these strategies will help make Jim’s Bowling Alley
more successful.

Return on Assets Ratio – ROA

The return on assets ratio, often called the return on total assets, is a profitability ratio
that measures the net income produced by total assets during a period by comparing net income
to the average total assets. In other words, the return on assets ratio or ROA measures how
efficiently a company can manage its assets to produce profits during a period.

Since company assets' sole purpose is to generate revenues and produce profits, this ratio
helps both management and investors see how well the company can convert its investments in
assets into profits. You can look at ROA as a return on investment for the company since capital
assets are often the biggest investment for most companies. In this case, the company invests
money into capital assets and the return is measured in profits. In short, this ratio measures how
profitable a company's assets are.
Formula

The return on assets ratio formula is calculated by dividing net income by average total
assets.

This ratio can also be represented as a product of the profit margin and the total asset
turnover.

Either formula can be used to calculate the return on total assets. When using the first
formula, average total assets are usually used because asset totals can vary throughout the year.
Simply add the beginning and ending assets together on the balance sheet and divide by two to
calculate the average assets for the year. It might be obvious, but it is important to mention that
average total assets is the historical cost of the assets on the balance sheet without taking into
consideration the accumulated depreciation. The net income can be found on the income
statement.

Analysis

The return on assets ratio measures how effectively a company can earn a return on its
investment in assets. In other words, ROA shows how efficiently a company can convert the
money used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the
costs of acquiring the assets in the return calculation by adding back interest expense in the
formula.

It only makes sense that a higher ratio is more favorable to investors because it shows
that the company is more effectively managing its assets to produce greater amounts of net
income. A positive ROA ratio usually indicates an upward profit trend as well. ROA is most useful
for comparing companies in the same industry as different industries use assets differently. For
instance, construction companies use large, expensive equipment while software companies use
computers and servers.

Example

Charlie's Construction Company is a growing construction business that has a few


contracts to build storefronts in downtown Chicago. Charlie's balance sheet shows beginning
assets of $1,000,000 and an ending balance of $2,000,000 of assets. During the current year,
Charlie's company had net income of $20,000,000. Charlie's return on assets ratio looks like this.

As you can see, Charlie's ratio is 1,333.3 percent. In other words, every dollar that Charlie
invested in assets during the year produced $13.3 of net income. Depending on the economy,
this can be a healthy return rate no matter what the investment is.
Investors would have to compare Charlie's return with other construction companies in
his industry to get a true understanding of how well Charlie is managing his assets.

Return on Equity Ratio

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm
to generate profits from its shareholders investments in the company. In other words, the return
on equity ratio shows how much profit each dollar of common stockholders' equity generates.
So a return on 1 means that every dollar of common stockholders' equity generates 1 dollar of
net income. This is an important measurement for potential investors because they want to see
how efficiently a company will use their money to generate net income.

ROE is also an indicator of how effective management is at using equity financing to fund
operations and grow the company.

Formula

The return on equity ratio formula is calculated by dividing net income by shareholder's
equity.
Most of the time, ROE is computed for common shareholders. In this case, preferred
dividends are not included in the calculation because these profits are not available to common
stockholders. Preferred dividends are then taken out of net income for the calculation.
Also, average common stockholder's equity is usually used, so an average of beginning and
ending equity is calculated.

Analysis

Return on equity measures how efficiently a firm can use the money from shareholders
to generate profits and grow the company. Unlike other return on investment ratios, ROE is a
profitability ratio from the investor's point of view—not the company. In other words, this ratio
calculates how much money is made based on the investors' investment in the company, not the
company's investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this indicates
that the company is using its investors' funds effectively. Higher ratios are almost always better
than lower ratios, but have to be compared to other companies' ratios in the industry. Since every
industry has different levels of investors and income, ROE can't be used to compare companies
outside of their industries very effectively.

Many investors also choose to calculate the return on equity at the beginning of a period
and the end of a period to see the change in return. This helps track a company's progress and
ability to maintain a positive earnings trend.

Example

Tammy's Tool Company is a retail store that sells tools to construction companies across
the country. Tammy reported net income of $100,000 and issued preferred dividends of $10,000
during the year. Tammy also had 10,000, $5 par common shares outstanding during the year.
Tammy would calculate her return on common equity like this:

As you can see, after preferred dividends are removed from net income Tammy's ROE is
1.8. This means that every dollar of common shareholder's equity earned about $1.80 this year.
In other words, shareholders saw a 180 percent return on their investment. Tammy's ratio is
most likely considered high for her industry. This could indicate that Tammy's is a growing
company.
An average of 5 to 10 years of ROE ratios will give investors a better picture of the growth
of this company.

Company growth or a higher ROE doesn't necessarily get passed onto the investors
however. If the company retains these profits, the common shareholders will only realize this
gain by having an appreciated stock.

SHE/Marketability

Earnings Per Share

Earning per share, also called net income per share, is a market prospect ratio that
measures the amount of net income earned per share of stock outstanding. In other words, this
is the amount of money each share of stock would receive if all of the profits were distributed to
the outstanding shares at the end of the year.

Earnings per share is also a calculation that shows how profitable a company is on a
shareholder basis. So a larger company's profits per share can be compared to smaller company's
profits per share. Obviously, this calculation is heavily influenced on how many shares are
outstanding. Thus, a larger company will have to split its earning amongst many more shares of
stock compared to a smaller company.

Formula

Earnings per share or basic earnings per share is calculated by subtracting preferred
dividends from net income and dividing by the weighted average common shares outstanding.
The earnings per share formula looks like this.

You will notice that the preferred dividends are removed from net income in the earnings
per share calculation. This is because EPS only measures the income available to
common stockholders. Preferred dividends are set-aside for the preferred shareholders and can't
belong to the common shareholders.

Most of the time earning per share is calculated for year-end financial statements. Since
companies often issue new stock and buy back treasury stock throughout the year, the weighted
average common shares are used in the calculation. The weighted average common shares
outstanding is can be simplified by adding the beginning and ending outstanding shares and
dividing by two.

Analysis

Earnings per share is the same as any profitability or market prospect ratio. Higher
earnings per share is always better than a lower ratio because this means the company is more
profitable and the company has more profits to distribute to its shareholders.

Although many investors don't pay much attention to the EPS, a higher earnings per share
ratio often makes the stock price of a company rise. Since so many things can manipulate this
ratio, investors tend to look at it but don't let it influence their decisions drastically.

Example

Quality Co. has net income during the year of $50,000. Since it is a small company, there
are no preferred shares outstanding. Quality Co. had 5,000 weighted average shares outstanding
during the year. Quality's EPS is calculated like this.

As you can see, Quality's EPS for the year is $10. This means that if Quality distributed
every dollar of income to its shareholders, each share would receive 10 dollars.

Payout Ratio

Dividend Payout Ratio

The dividend payout ratio measures the percentage of net income that is distributed to
shareholders in the form of dividends during the year. In other words, this ratio shows the portion
of profits the company decides to keep to fund operations and the portion of profits that is given
to its shareholders.

Investors are particularly interested in the dividend payout ratio because they want to
know if companies are paying out a reasonable portion of net income to investors. For instance,
most startup companies and tech companies rarely give dividends at all. In fact, Apple, a company
formed in the 1970s, just gave its first dividend to shareholders in 2012.
Conversely, some companies want to spur investors' interest so much that they are willing
to pay out unreasonably high dividend percentages. Inventors can see that these dividend rates
can't be sustained very long because the company will eventually need money for its operations.

Formula

The dividend payout formula is calculated by dividing total dividend by the net income of
the company.

This calculation will give you the overall dividend ratio. Both the total dividends and the
net income of the company will be reported on the financial statements.

You can also calculate the dividend payout ratio on a share basis by dividing the dividends
per share by the earnings per share.

Obviously, this calculation requires a little more work because you must figure out
the earnings per share as well as divide the dividends by each outstanding share. Both of these
formulas will arrive at the same answer however.

Analysis

Since investors want to see a steady stream of sustainable dividends from a company, the
dividend payout ratio analysis is important. A consistent trend in this ratio is usually more
important than a high or low ratio.

Since it is for companies to declare dividends and increase their ratio for one year, a single
high ratio does not mean that much. Investors are mainly concerned with sustainable trends. For
instance, investors can assume that a company that has a payout ratio of 20 percent for the last
ten years will continue giving 20 percent of its profit to the shareholders.

Conversely, a company that has a downward trend of payouts is alarming to investors.


For example, if a company's ratio has fallen a percentage each year for the last five years might
indicate that the company can no longer afford to pay such high dividends. This could be an
indication of poor operating performance.

Generally, more mature and stable companies tend to have a higher ratio than newer
startup companies.
Example

Joe's Kitchen is a restaurant change that has several shareholders. Joe reported $10,000
of net income on his income statement for the year. Joe's issued $3,000 of dividends to its
shareholders during the year. Here is Joe's dividend payout ratio calculation.

As you can see, Joe is paying out 30 percent of his net income to his shareholders.
Depending on Joe's debt levels and operating expenses, this could be a sustainable rate since the
earnings appear to support a 30 percent ratio.

Retention Rate

The retention rate, sometimes called the plowback ratio, is a financial ratio that measures
the amount of earnings or profits that are added to retained earnings at the end of the year. In
other words, the retention rate is the percentage of profits that are withheld by the company
and not distributed as dividends at the end of the year.

This is an important measurement because it shows how much a company is reinvesting


in its operations. Without a steady reinvestment rate, company growth would be completely
dependent on financing from investors and creditors.

In a sense the retention ratio is the opposite of the dividend payout ratio because it shows
how much money the company chooses to keep in its bank account; whereas, the dividend
payout ratio computes the percentage of profits that a company choose to distribute to its
shareholders. The plowback ratio increases retained earnings while the dividend payout ratio
decreases retained earnings.

Formula

The retention rate is calculated by subtracting the dividends distributed during the period
from the net income and dividing the difference by the net income for the year.
The numerator of this equation calculates the earnings that were retained during the
period since all the profits that are not distributed as dividends during the period are kept by the
company. You could simplify the formula by rewriting it as earnings retained during the period
divided by net income.

Analysis

Since companies need to retain some portion of their profits in order to continue to
operate and grow, investors value this ratio to help predict where companies will be in the future.
Apple, for instance, only started paying dividends in the early 2010s. Up until then, the company
retained all of its profits every year.

This is true about most tech companies. They rarely give dividends because they want to
reinvest and continue to grow at a steady rate. The opposite is true about established companies
like GE. GE gives dividends every year to it shareholders.

Higher retention rates are not always considered good for investors because this usually
means the company doesn't give as much dividends. It might mean that the stock is continually
appreciating because of company growth however. This ratio helps illustrate the difference
between a growth stock and an earnings stock.

Example

Ted's TV Company earned $100,000 of net income during the year and decided to
distribute $20,000 of dividends to its shareholders. Here is how Ted would calculate his plowback
ratio.
As you can see, Ted's rate of retention is 80 percent. In other words, Ted keeps 80 percent
of his profits in the company. Only 20 percent of his profits are distributed to shareholders.
Depending on his industry this could a standard rate or it could be high.

Dividend Yield Ratio

The dividend yield is a financial ratio that measures the amount of cash dividends
distributed to common shareholders relative to the market value per share. The dividend yield is
used by investors to show how their investment in stock is generating either cash flows in the
form of dividends or increases in asset value by stock appreciation.

Investors invest their money in stocks to earn a return either by dividends or stock
appreciation. Some companies choose to pay dividends on a regular basis to spur investors'
interest. These shares are often called income stocks. Other companies choose not to issue
dividends and instead reinvest this money in the business. These shares are often called growth
stocks.

Investors can use the dividend yield formula to help analyze their return on investment
in stocks.

Formula

The dividend yield formula is calculated by dividing the cash dividends per share by the
market value per share.

Cash dividends per share are often reported on the financial statements, but they are also
reported as gross dividends distributed. In this case, you'll have to divide the gross dividends
distributed by the average outstanding common stock during that year.
The shares' market value is usually calculated by looking at the open stock exchange price
as of the last day of the year or period.

Analysis

Investors use the dividend yield formula to compute the cash flow they are getting from
their investment in stocks. In other words, investors want to know how much dividends they are
getting for every dollar that the stock is worth.

A company with a high dividend yield pays its investors a large dividend compared to the
fair market value of the stock. This means the investors are getting highly compensated for their
investments compared with lower dividend yielding stocks.

A high or low dividend yield is relative to the industry of the company. As I mentioned
above, tech companies rarely give dividends at all. So even a small dividend might produce a high
dividend yield ratio for the tech industry. Generally, investors want to see a yield as high as
possible.

Example

Stacy's Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly Hills.
Stacy's is listed on a smaller stock exchange and the current market price per share is $15. As of
last year, Stacy paid $15,000 in dividends with 1,000 shares outstanding. Stacy's yield is computed
like this.

As you can see, Stacy's yield is one dollar. This means that Stacy's investors receive 1 dollar
in dividends for every dollar they have invested in the company. In other words, the investors are
getting a 100 percent return on their investment every year Stacy maintains this dividend level.

Price Earnings P/E Ratio

The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market
prospect ratio that calculates the market value of a stock relative to its earnings by comparing
the market price per share by the earnings per share. In other words, the price earnings ratio
shows what the market is willing to pay for a stock based on its current earnings.
Investors often use this ratio to evaluate what a stock's fair market value should be by
predicting future earnings per share. Companies with higher future earnings are usually expected
to issue higher dividends or have appreciating stock in the future.

Obviously, fair market value of a stock is based on more than just predicted future
earnings. Investor speculation and demand also help increase a share's price over time.

The PE ratio helps investors analyze how much they should pay for a stock based on its
current earnings. This is why the price to earnings ratio is often called a price multiple or earnings
multiple. Investors use this ratio to decide what multiple of earnings a share is worth. In other
words, how many times earnings they are willing to pay.

Formula

The price earnings ratio formula is calculated by dividing the market value price per share
by the earnings per share.

This ratio can be calculated at the end of each quarter when quarterly financial
statements are issued. It is most often calculated at the end of each year with the annual financial
statements. In either case, the fair market value equals the trading value of the stock at the end
of the current period.

The earnings per share ratio is also calculated at the end of the period for each share
outstanding. A trailing PE ratio occurs when the earnings per share is based on previous period.
A leading PE ratios occurs when the EPS calculation is based on future predicted numbers. A
justified PE ratio is calculated by using the dividend discount analysis.

Analysis

The price to earnings ratio indicates the expected price of a share based on its earnings.
As a company's earnings per share being to rise, so does their market value per share. A company
with a high P/E ratio usually indicated positive future performance and investors are willing to
pay more for this company's shares.

A company with a lower ratio, on the other hand, is usually an indication of poor current
and future performance. This could prove to be a poor investment.
In general a higher ratio means that investors anticipate higher performance and growth
in the future. It also means that companies with losses have poor PE ratios.

An important thing to remember is that this ratio is only useful in comparing like
companies in the same industry. Since this ratio is based on the earnings per share calculation,
management can easily manipulate it with specific accounting techniques.

Example

The Island Corporation stock is currently trading at $50 a share and its earnings per share
for the year is 5 dollars. Island's P/E ratio would be calculated like this:

As you can see, the Island's ratio is 10 times. This means that investors are willing to pay
10 dollars for every dollar of earnings. In other words, this stock is trading at a multiple of ten.

Since the current EPS was used in this calculation, this ratio would be considered a trailing
price earnings ratio. If a future predicted EPS was used, it would be considered a leading price to
earnings ratio.

Du Pont
1 return on Assets????

2. DuPont Analysis

The Dupont analysis also called the Dupont model is a financial ratio based on the return
on equity ratio that is used to analyze a company's ability to increase its return on equity. In other
words, this model breaks down the return on equity ratio to explain how companies can increase
their return for investors.

The Dupont analysis looks at three main components of the ROE ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage
Based on these three performances measures the model concludes that a company can
raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets
more effectively.

The Dupont Corporation developed this analysis in the 1920s. The name has stuck with it
ever since.

Formula

The Dupont Model equates ROE to profit margin, asset turnover, and financial leverage.
The basic formula looks like this.

Since each one of these factors is a calculation in and of itself, a more explanatory formula
for this analysis looks like this.

Every one of these accounts can easily be found on the financial statements. Net income
and sales appear on the income statement, while total assets and total equity appear on the
balance sheet.

Analysis

This model was developed to analyze ROE and the effects different business performance
measures have on this ratio. So investors are not looking for large or small output numbers from
this model. Instead, they are looking to analyze what is causing the current ROE. For instance, if
investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the
problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.

Once the problem area is found, management can attempt to correct it or address it with
shareholders. Some normal operations lower ROE naturally and are not a reason for investors to
be alarmed. For instance, accelerated depreciation artificially lowers ROE in the beginning
periods. This paper entry can be pointed out with the Dupont analysis and shouldn't sway an
investor's opinion of the company.
Example

Let's take a look at Sally's Retailers and Joe's Retailers. Both of these companies operate
in the same apparel industry and have the same return on equity ratio of 45 percent. This model
can be used to show the strengths and weaknesses of each company. Each company has the
following ratios:

Ratio Sally Joe


Profit Margin 30% 15%
Total Asset Turnover .50 6.0
Financial Leverage 3.0 .50

As you can see, both companies have the same overall ROE, but the companies'
operations are completely different.

Sally's is generating sales while maintaining a lower cost of goods as evidenced by its
higher profit margin. Sally's is having a difficult time turning over large amounts of sales.

Joe's business, on the other hand, is selling products at a smaller margin, but it is turning
over a lot of products. You can see this from its low profit margin and extremely high asset
turnover.

This model helps investors compare similar companies like these with similar
ratios. Investorscan then apply perceived risks with each company's business model.

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