Financial Ratios

Lecture 6

This lecture is part of Chapter 3:Evaluating a Company’s Performance

Today’s Lecture

Liquidity Ratios

Efficiency Ratios

Leverage Ratios

Profitability Ratios

Liquidity Ratios

Current Ratio

Quick Ratio

Liquidity is a measure of how quickly an asset can be converted to cash.

E.g. Accounts receivable = quite liquidBuilding = not very liquid

There are two important liquidity ratios:

Liquidity Ratios

Current Ratio:

Under normal circumstances, a company will pay its current liabilities (bills due) with its current assets. The ratio between the two is therefore a good indicator for how well a company can pay its bills.

Current Ratio =Current Assets

Current Liabilities

Liquidity RatiosCurrent Ratio:

A high current ratio means that the company should more easily be able to pay its bills. So that’s good to know if the company owes you money.But … if you’re an investor, too high a current ratio could mean that the company is not using its assets optimally.

Think a bit of it like water in a lake. Good to have some, bad to have none and so-so to have too much.

Liquidity Ratios

Current Ratio:

Most successful businesses have a current ratio of about 1.5 – 2.0.

Let’s have a look at the Balance Sheet of Lecture 2 again and add the current ratio.

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 830010 Total Current Assets 1950011 Plant and Equipment 80012 Accumulated Depreciation 50013 Net fixed assets 30014 Total Assets 19800

15 Liabilities and Owner's Equity16 Accounts Payable 760017 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Pretty good!

Liquidity Ratios

Quick Ratio:

While inventories are necessary for many businesses, they may at times be difficult to sell rapidly.It is therefore useful to also consider a current ratio that takes out inventory from the Current Assets.

Quick Ratio =Current Assets - Inventories

Current Liabilities

Liquidity Ratios

Quick Ratio:

The quick ratio is sometimes called acid-test ratio.

In general, a quick ratio of 1 is considered safe, but in some industries it may be much lower, e.g. in the car industry, 0.2 is common.

Let us enter this into the Balance Sheet as well…

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 80012 Accumulated Depreciation 50013 Net fixed assets 30014 Total Assets 19800

15 Liabilities and Owner's Equity16 Accounts Payable 760017 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Pretty good too!

Efficiency Ratios

As indicated by the name, efficiency ratios indicate how efficient a company is in its operation.Two of the most useful “turnover” ratios are:

• Inventory Turnover Ratio• Total Asset Turnover Ratio

Efficiency Ratios

Inventory Turnover Ratio

The inventory turnover ratio indicates how many times the inventory is ‘turned over’ in one year. In other words, it shows how quickly inventory can be sold.

Inventory TurnoverRatio

Cost of Goods Sold

Inventory=

Actually, it would be better to replace Inventory with Average Inventory (defined as beginning inventory + ending inventory)/2.

Efficiency Ratios

Inventory Turnover Ratio

Let us apply this to our Balance Sheet again.Only … the Cost of Goods sold are not on the Balance Sheet. We need to get this item from the Income Statement in Lecture one.

In general, a higher Inventory Turnover Rate is good but the number may differ greatly per industry. Dell, e.g, is somewhere above 40 but to many around 4 would already be good.

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 30014 Total Assets 19800

15 Liabilities and Owner's Equity16 Accounts Payable 760017 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Quite meager!

But! What happened here???

Interlude – Excel Worksheets

Excel can have several named worksheets. A worksheet is basically a spreadsheet on a single page with a name.

This means that we can avoid making a complicated single page spreadsheet with an area for the Balance Sheet, and area for the Income Statement and so on.Instead, we can make a separate worksheet for each. In the previous slide, I have added the Income Statement from Lecture 1 as a second worksheet.

Cells from other worksheets can be referred to by using the ! mark.

Efficiency Ratios

Total Asset Turnover Ratio

The Total Asset Turnover Ratio shows how well a company is able to generate sales (and hence hopefully profits) from the assets it owns.

It is defined as:

Asset TurnoverRatio

Sales

Total Assets=

Again we need to get the Sales from the Income Statement

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14

15 Liabilities and Owner's Equity16 Accounts Payable 760017 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Ouch!?

Leverage Ratios

Leverage in business refers to how much debt a company uses to finance its operations.The idea is that if a company can borrow money at say 7% and then use this money to make a 27% profit, it’s clever to take out the loan.

Two of the most important leverage ratios are:

• Total Debt Ratio• Debt to Equity Ratio

Leverage Ratios

Total Debt Ratio

The Total Debt Ratio shows how much of a company’s assets are financed through loans.

It is defined as:

Total DebtRatio

Total Debt

Total Assets=

Leverage Ratios

Total Debt Ratio

In general, a low Total Debt Ratio is good with the critical number being 1.

Smaller than one means that the company has more assets than debts.

Vice versa, larger than one mean that the company has more debts than assets. If this is the case you’d better hope they will not go out of business …

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14

15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 90018 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

So so..

Leverage Ratios

Debt to Equity Ratio

A favorite with many investors. It is similar to the Total Debt Ratio, but rather than dividing by the Total Assets, the Total Debt is divided by the Total Equity.

It is defined as:

Debt EquityRatio

Total Debt

Total Equity=

Leverage Ratios

Debt Equity Ratio

As with the Total Debt Ratio, a low Debt Equity Ratio is good with the critical number being 1.

Smaller than one means that the company has more equity than debts.Vice versa, larger than one mean that the company has more debts than equity.

Investors prefer this number since Equity is after all that which belongs to the stock holders.

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14

15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 120020 Total Liabilities 970021 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

So so too..

Profitability Ratios

PROFIT. Of course that’s what business is all about!

Three of the most commonly used profitability ratios are:

• Gross Profit Margin (Ratio or Percentage)• Operating Profit Margin (Ratio or Percentage)• Net Profit Margin (Ratio or Percentage)

Note: Though these are ratios they are often just called margin which generally refers to the difference between a certain cost and sales price (taken from the top).

Profitability Ratios

Gross Profit Margin

The Gross Profit Margin is the ‘gross’ difference between the actual cost of a product and its sales price.

It is defined as:

Gross ProfitMargin

Gross Profit

Sales=

Where Gross Profit = Sales – Cost of Sales

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14

15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 1200 Gross P. 0.36 =Income!D8/20 Total Liabilities 9700 Income!D621 Common Stock 600022 Retained Earnings 410023 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Profitability Ratios

Operating Profit Margin

The Gross Profit Margin is important but does not indicate how much (or whether) the company can make a profit from its running operations. This is indicated by the Operating Profit Margin:

Operating ProfitMargin

Net Operating Income

Sales=

Net Operating Income = EBIT (at least usually), the profit after taking all the expenses related to the daily running of the company into account. (Note: Depreciation and Amortization should be included)

Profitability Ratios

Operating Profit Margin

Since we did not separate Depreciation and Amortization out in our Income Statement, let’s leave this ratio for an exercise.

Profitability Ratios

Net Profit Margin

The Net Profit Margin tells you how many cents out of every dollar are actual profit and thus attributable to the shareholders.

Net ProfitMargin

Net Income

Sales=

Adding RatiosA B C D E F G

345

6 Assets Ratios:7 Cash and Equivalents 100008 Accounts Receivable 1200 Current 2.29 =G10/G189 Inventory 8300 Quick 1.32 =(G10-G9)/G1810 Total Current Assets 1950011 Plant and Equipment 800 Inventory 0.87 =Income!D7/12 Accumulated Depreciation 500 Balance!G913 Net fixed assets 300 Total As. 0.57 =Income!D6/14 Total Assets 19800 Balance!G14

15 Liabilities and Owner's Equity16 Accounts Payable 7600 Total De. 0.49 =G20/G1417 Other Current Liabilities 900 Debt-Eq. 0.96 =G20/G2318 Total Current Liabilities 850019 Long Term Debt 1200 Gross P. 0.36 =Income!D8/20 Total Liabilities 9700 Income!D621 Common Stock 6000 Net Prof. 0.19 =Income!D12/22 Retained Earnings 4100 Income!D623 Total Shareholder's Equity 1010024 Total Liabilities and owner's Equity 19800

Golden Win Double Dragon InternationalBalance Sheet, As of Dec 31 2000

Summary of Ratios

Current Ratio =Current Assets

Current Liabilities

Quick Ratio =Current Assets - Inventories

Current Liabilities

Inventory TurnoverRatio

Cost of Goods Sold

Inventory=

Asset TurnoverRatio

Sales

Total Assets=

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Summary of Ratios

Total DebtRatio

Total Debt

Total Assets=

Debt EquityRatio

Total Debt

Total Equity=

Gross ProfitMargin

Gross Profit

Sales=

Operating ProfitMargin

Net Operating Income

Sales=

Net ProfitMargin

Net Income

Sales=

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Key Points of the Day

We have seen how various Ratios can give insight into the performance, liquidity and profitability of a company

The Ratios can be calculated easily with Excel.