Let us take the time to understand the basic finance terminology so as to manage our business better. This is Financial Ratios 101.
The balance sheet is an accountant’s snapshot of the firm’s accounting value on a particular date, as though the firm stood momentarily still. The balance sheet has two sides: on the left are the assets, and on the right the liabilities and stockholder’s equity. The balance sheet states, what the firm owns and how it is financed. The accounting definition that underlies the balance sheet and describes the “balance” is
Assets = Liabilities + stockholders’ equity.
Accounting liquidity has to do with the ease and quickness with which assets can be converted to cash (that is, “nearness to cash”). Current assets are the most liquid and include cash and those assets that will be turned into cash within a year from the date of the balance sheet.
Liabilities are obligations of the firm that require a payout of cash flow within a stipulated time period. Stockholders equity is a claim against the firm’s assets that is residual and not fixed. Stockholder’s equity is the residual difference between assets and liabilities.
Source: Corporate Finance by Stephen A. Ross and Randolph W. Westerfield, Copyright Ó 1988 by Times Mirror/ Mosby College Publication – The McGraw-Hill Publication. This material is reproduced with the permission of The McGraw-Hill Companies. ISBN:0-8016-4211-6
The income statement measures performance over a specific time period. The income statement definition as:
Revenue – Expenses = Income.
The income statement usually includes several sections. The operations sections report the firm’s revenues and expenses from principal operations. The non-operating section of the income statement includes, amongst other things, all financing costs such as interest expense.
Accounting liquidity measures financial liquidity and is often associated with net working capital. The most widely used measures of accounting liquidity are the current ratio and quick ration.
The current ratio is calculated by dividing current assets by current liabilities:
Current ratio = Total current assets / Total current liabilities
The quick ratio is computed by subtracting inventories from current assets and dividing the difference (called quick assets) by current liabilities:
Quick ratio = Quick assets / Total current liabilities
Activity ratios are constructed to measure how effectively the firm’s assets are being managed. Total asset turnover ratio is determined by dividing average total assets into total operating revenues for the accounting period. If the asset turnover is high, the firm is presumably using its assets effectively in generating sales. If the ratio is low, the firm is not using its assets up to its capacity and must either increase sales or dispose off some of the assets.
Total assets turnover = Total operating revenues / Total average assets
Receivable turnover ratio is calculated by dividing sales by average receivables during the accounting period. If the number of days in a year (365) is divided by the receivables turnover ratio, the average collection period can be determined. Net receivables are used for this calculation.
Receivable turnover ratio = Total operating revenues / Average receivables
Average collection period = Days in period / Receivables turnover
Inventory turnover is calculated by dividing average inventory into the cost of goods sold. Because inventory is always stated in terms of historical cost, it must be divided by cost of goods sold instead of sales. The inventory turnover ration can be converted into the days in inventory ratio by dividing it into the number of days in a year. The days in inventory ratio represents the number of days it takes to get the goods produced and sold. The days in inventory is called the “shelf life” for retail and wholesale trade firms.
Inventory turnover = Cost of goods sold / Average inventory
Days in inventory = Days in period / Inventory turnover
Financial Leverage is related to the extent to which a firm relies on debt financing when compared with equity. Measures of financial leverage are tools in determining the probability that the firm will default on its debt contracts. The more debt a firm has, the more likely it is that the firm will become unable to fulfill its contractual obligations. Thus too much debt can lead to a higher probability of insolvency and financial distress.
Debt ratio = Total debt / Total assets
Debt-equity ratio = Total debt / Total equity
Equity multiplier = Total assets / Total equity
Interest coverage = EBIT (Earnings before interest & taxes) / Interest expense
Profitability is one of the most difficult attributes of a firm to conceptualize and to measure. In general sense, accounting profits are the difference between revenues and costs. Unfortunately, there is no completely unambiguous way to know when a firm is profitable. Profit margin is computed by dividing total operating revenue into profits. Thus they express profits as a percentage of total operating revenue.
Net profit margin = Net income / Total operating revenue
Gross profit margin = EBIT / Total operating revenue
Net return on assets = Net income / Average total assets
Gross return on assets = EBIT / Average total assets
Return On Assets = Profit Margin X Asset turnover
Firms can increase ROA by increase profit margins or asset turnover.
Return on equity. This ratio (ROE) is defined as net income after interest and taxes divided by average common stockholders’ equity.
ROE = Net Income / Average stockholders’ equity
The most important difference between ROA and ROE is due to financial leverage.
ROE = Profit margin X Asset turnover X Equity multiplier
Payout ratio = Cash dividends / Net income
Retention ratio = Retained earnings / Net income
Retained earnings = Net income – Dividends
Market Value Ratios
Price-to-earnings (P/E) ratio: One way to calculate the P/E ratio is to divide the earnings per share of common stock for the latest year into the current market price.
Dividend yield is calculated by annualizing the last observed dividend payout of a firm and dividing it by the current market price.
Dividend yield = Dividend per share___ / Market price per share
Market-to-book (M/B) value and the Q ration. The market-to-book value ratio is calculated by dividing the market price per share by the book value per share. There is another ratio, called the Tobin’s Q ratio that is very much like the M/B ration. Tobin’s Q ration takes the market value of all the firm’s debt plus equity and divides by the replacement value of the firm’s assets. The Q ratio differs from the M/B ration in that the Q ratio uses the market value of debt plus equity. It also uses replacement value of all assets and not their historical cost value.
It should be noted that if the firm’s Q ratio is above 1 it has an incentive to invest that is probably greater than a firm with a Q ratio below 1.