LESSON 8 - BUSINESS BASICS PART I - BUSINESS TYPES, ETHICS & LAW, ECONOMICS, FINANCE & ACCOUNTING

Financial Analysis Tools - Ratios

 

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Statements alone will let you see dollar amounts; however, you also need to analyze these statements by relating the account values to one another.  Financial ratios are the most common way to do this.  A ratio is a calculation of just a simple division problem that shows the relationship between two values.   Financial ratios are used to show the relationship of two financial statement accounts to measure a company’s performance, and whether it is creditworthy.  Here are a few of the most common ratios so you can get an idea on how it all works:

 

 

LIQUIDITY RATIOS

 

Liquidity ratios demonstrate a company's ability to pay its current obligations.  Some of the best-known measures of a company's liquidity include:

 

Current ratio = Current Assets ÷ Current Liabilities:  Also known as working capital ratio.  It measures the ability of a company to pay its near-term obligations. The general rule of thumb is a current ratio of 2.0 or better.  Using the balance sheet example shown earlier for the year 2008, the total current assets of $325,000 with $117,000 in current liabilities would have a 4.2 current ratio ($325,000 ÷ $82,000 = 4.2). 

 

Quick ratio = Quick Assets (cash + marketable securities + receivables) ÷ Current Liabilities:  Also known as an acid test.  This is a stricter definition of the company's ability to make payments on current obligations.  Ideally, this ratio should be 1.0 or better.  Using the balance sheet example shown earlier for the year 2008, the cash plus the marketable securities plus the account receivables would equal $195,000 ($45,000 + $65,000 + 85,000) with  $82,000 in current liabilities.  The quick ratio is 2.4 ($195,000 ÷ $82,000 = 2.4).

 

Accounts Receivables Turnover = Net Sales ÷ Accounts Receivable: Also known as Sales to Receivables.  It measures the annual turnover (the number of times the receivables went through a cycle of being created and collected, thus turned over, in a period) of accounts receivable.  Essentially, Accounts Receivable Turnover is the average amount of time that it takes a given client or group of clients to pay outstanding invoices after they are generated and mailed to the customer.  It is best to use average accounts receivable to avoid seasonality effects by adding the AR at the beginning of a period from the balance sheet to the AR at the end of a period, and divide the sum by two.  A high number reflects a short lapse of time between sales and the collection of cash, while a low number means collections take longer.  Using the income statement and balance sheet examples shown earlier for the year 2008, the Sales is $15,500,000 with $85,000 in accounts receivable (on the balance sheet).  The Accounts Receivables Turnover = 182 times ($15,500,000 ÷ $85,000  = 182).  See the Collection Period below to associate this turnover number with the average number of days it takes the company to collect its receivables.

 

Collection Period = 365 ÷ Accounts Receivables Turnover:  This measures the average number of days the company's receivables are outstanding between the date of credit sale and collection of cash.  For example, the turnover as described above is 182 times.  The result would be 365 ÷ 182 = 2 average days to pay.  Whether this is good or bad depends on the industry norms and credit terms established.

 

Annual Inventory Turnover = COGS for the Year ÷ Average Inventory Balance:  This shows how efficiently the company is managing its production, warehousing, and distribution of product considering its volume of sales.  Higher ratios, over six or seven times per year, are generally thought to be better, although extremely high inventory turnover may indicate a narrow selection and possibly lost sales.  A low inventory turnover rate, on the other hand, means that the company is paying to keep a large inventory, and may be overstocking or carrying obsolete items.  For example, the COGS from the income statement are $9,900,000 and the Average inventory balance on the balance sheet is $85,000.  The Annual Inventory Turnover = 116 ($9,900,000 ÷ $85,000 = 116).  See the Inventory holding period below to associate this turnover number with the average number of days that elapse between finished goods production and sale of product.

 

Inventory holding period = 365 ÷ Annual Inventory Turnover:  Also known as Days’ Sales on Hand.  This calculates the number of days, on average, that elapse between finished goods production and sale of product.  For example, lets say that the turnover as described above is 116 times, then the result would be 365 ÷ 116 = 3.1 average days worth of sales in inventory.  Whether this is good or bad is the comparison with the industry norms.

 

 

 

LEVERAGE RATIOS

 

Leverage Ratios are used to understand a company's ability to meet it long term financial obligations.  These can also be considered as Solvency Ratios which measures the capability of a compnay to pay its bills on time.

 

Debt-to-Equity ratio = Total Liabilities ÷ Total Owners' Equity:  This indicates what proportion of debt (trade credit, liabilities, and borrowings) and equity (shareholders purchased stock and earnings reinvested into the company rather than taken as dividends) that the company is using to finance its assets.  A company is generally considered safer if it has a low debt to equity ratio.  In general, debt should be 1.0 or less which means that half of the company’s total financing, or less, comes from debt.  Using the example from the above balance sheet for 2008, the Debt-to-equity ratio would be 1.0 ($347,000 ÷ $338,500 = 1.0).

 

Debt ratio = Long Term Debt ÷ Total Assets:  This compares the company’s long-term debt to the company’s total financial resources.  A debt ratio greater than 1.0 means the company has negative net worth, and is technically bankrupt.  Using the example from the above balance sheet for 2008, the debt ratio would be 0.13 ($90,000 ÷ $685,500 = 0.13).  This tells us 13% of the company’s total financial resources are in the form of long-term debt.  The lower the number the better, and if it starts to reach 50%, you want to be sure the company has a reliable earnings stream.

 

Earnings Before Interest and Taxes (or EBIT, pronounced e-bit) = Revenue - Operating Expenses or OPEX:  This is not a ratio, however, it is important and needs to be explained before going on to other ratios (it is also a non-GAAP metric). EBIT is an indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and interest.  It is used quite frequently in business financial conversations with the goal to become EBIT positive.  EBIT is also sometimes referred to as "operating earnings," "operating profit," and "operating income," which can be found on the income statement.  Using the example income statement above for the year 2008, it would look like:  $15,500,000 (Revenue) – $9,900,000 (COGS) - $3,300,000 (SG&A) - $11,000 (Depreciation) = $2,289,000

 

Earnings before interest, taxes, depreciation and amortization (or EBITDA pronounced E-bih-dah):  The same as EBIT, however, it takes the process further by removing two non-cash items from the equation; depreciation (meaning the gradual reduction of the value of a tangible item) and amortization (meaning the gradual reduction of the value of a non-tangible item).  EBITDA is used when evaluating a company's ability to earn a profit, and it is often used in stock analysis. Using the example income statement above for the year 2008, it would look like:  $15,500,000 (Revenue) – $9,900,000 (COGS) - $3,300,000 (SG&A) = $2,300,000

 

Times Interest Earned (TIE) Ratio = Earnings Before Interest and Taxes (EBIT or Operating Income) ÷ Interest Expense:  Also referred to as "interest coverage ratio" and "fixed-charged coverage."  A metric used to measure the company's ability to pay the interest on long-term debt.  You use EBIT because you want to measure the capability to pay the interest expense out of operating income before you deduct interest out of that income.  You use income before taxes because interest is tax-deductible.  In general, a higher interest coverage ratio means that the small business is able to take on additional debt.  EBIT of at least three to four times interest earned is considered safe.  Bankers and other creditors closely examine this ratio.  Using the dollar amounts from the EBIT example above, and the interest earned from income statement for 2008, would look like:  TIE = $2,289,000 ÷ $93,000  (which is 25 times).

 

 

 

PROFITABILITY RATIOS

 

Profitability Ratios are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.  For most of these ratios, having a higher value relative to a competitor's ratio, or the same ratio from a previous period, is indicative that the company is doing well.

 

Gross Margin = Gross Income ÷ Net Sales (Revenue):  Also known as Gross profit.  Gross margin is the gross income as a percentage of sales.  This measures the margin on sales the company is achieving.  It can be an indication of manufacturing efficiency or marketing effectiveness.  You get the gross income by subtracting the COGS from the Sales on the income statement.  Using the example income statement above for the year 2008 to get the gross margin, it would look like:  $5,600,000 (gross income) ÷ $15,500,000 (revenue or sales) = 36% (which translates to 64% of its sales spent on COGS).  The higher the gross margin the better.  It depends on the value of the product.  It could be charging more money for a high quality product while maintaining relatively steady COGS, or by offering something a customer values that can be made cheaply.

 

Operating Margin = Operating Income (aka EBIT) ÷ Net Sales (Revenue):  Operating margin measures the operating income as a percentage of sales.  If there is a good gross margin, but poor operating margin, most likely there is mismanagement that accounts for SG&A expense.  Using the EBIT example and revenue from income statement above for the year 2008, to get the operating margin it would look like:  $2,289,000 (EBIT or operating income) ÷ $15,500,000 (revenue or sales) = 15% operating margin.  Again, the higher the profit margins the better.

 

Net Margin = Net Income ÷ Net Sales (Revenue):  Also known as Net profitability.  This measures the overall profitability of the company, or the bottom line, as a percentage of sales.  A net margin range of around 5% is common, however, somewhere around 10% would be excellent.  In general terms, net margin or profitability shows the effectiveness of management.  Though the optimal level depends on the type of business, the ratios can be compared for firms in the same industry.  The net income would be on the bottom of the income statement (this figure is the revenue minus all the production, operating, interest, taxes and other expenses).  Using the income statement above for the year 2008, to get the net margin it would look like:  $299,000 (net income) ÷ $15,500,000 (revenue or sales) = 2% net margin. 

 

Asset Turnover = Net Sales (Revenue) ÷ Total Assets:  Also known as Investment turnover.  This measures a company's ability to use assets to generate sales.  Although the ideal level for this ratio varies greatly, a very low figure may mean that the company maintains too many assets or has not deployed its assets well, whereas a high figure means that the assets have been used to produce good sales numbers.  A ratio of 1.0 is the average, but it all really depends on the type of business.  The lower the turnover usually means the higher the profit margin on the product, however the higher the turnover is to be expected on highly competitive retail stores.  Using the balance sheet above for the year 2008, to get the asset turnover it would look like:  $15,500,000 (revenue or sales) ÷ $685,500 (total assets) = 23 times. 

 

Return on assets (ROA) = Net Income ÷ Total Assets:  This indicates how effectively the company is deploying its assets.  A very low ROA usually indicates inefficient management, whereas a high ROA means efficient management. However, depreciation or any unusual expenses can distort this ratio.  It's a useful number for comparing competing companies in the same industry.  Using the income sheet for net income, and the balance sheet for total assets for the year 2008, to get the ROA it would look like:  $299,000 (net income) ÷ $685,500 (total assets) = 44% ROA. 

 

Return on investment (ROI) = Net Income ÷ Owners' Equity:  Also called Return on equity or ROE.  This is a key measure of return for both shareholders and management.  It indicates how well the company is utilizing its equity investment. Due to leverage, this measure will generally be higher than return on assets.  ROI is considered to be one of the best indicators of profitability.  It is also a good figure to compare against competitors or an industry average.  Generally, companies usually need at least 10-14 percent ROI in order to fund future growth.  If this ratio is too low, shareholders will sell their shares to invest in a company with a better return, and the Board of Directors (BOD) might have to replace management.  On the other hand, a high ROI can mean that management is doing a good job, or that the firm is undercapitalized.  Using the income sheet for net income, and the balance sheet for owners’ equity for the year 2008, to get the ROI it would look like:  $299,000 (net income) ÷ $338,500 (owners’ or shareholders equity) = 88% ROI. 

 

 

By calculating ratios, you can find patterns like is the company generating cash?  Is the liquidity strong?  Does the company have too much debt or too many assets?  Is it growing the assets faster than sales?  Are the margins weak or strong?  How do the ratios compare to the last couple of years, etc?   You can compare ratios using industry norms published in Standard & Poor’s or Dun & Bradstreet. 

 

It is imperative to calculate accurately on all financial statements, as these will tell you the company’s performance and creditworthiness.  All red flags, such as increasing earnings and declining cash flow, should be taken seriously.  Again, the goal is to be EBIT positive and you should always do your part to help get to that point and stay there.

 

Some other ratios that investors look at are:

 

  • Earnings Per Share (EPS) = Net income remaining for stockholders ÷ Common shares outstanding (also considered part of the bottom line).  For example,  $700 (Net income) ÷ 1,000 (1,000 shares of stock) = $ 0.70

 

  • Price Earning Ratio (PE) = Market price ÷ Earnings per share

 

  • Dividend Payout Ratio = Dividends per share ÷ Earnings per share

 

  • Dividend Yield Ratio = Dividends per share ÷ Current market price

 

 

 

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