Financial Ratio Review
‘Top 8’
Plus
Capstone
Financial Ratios
Kenneth EA Wendeln
©2012 KEAW v5
‘Top 8’ Key Financial Ratios
Profitability
Liquidity
Return on Owners’ Equity
Current Ratio
%
# n.nn
EPS – Earnings per Share
Acid Test or Quick Ratio
$ DD.00
Return on Sales
%
Financial Leverage
Total Liabilities to Equity
%
# n.nn
Asset Turnover
Accounts Receivable
Turnover
X (times/year) or # days
Inventory Turnover
X (times/year) or # days
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Summary of Financial Ratios
Profitability
Return to
Investors
Return
to
Investors
Leverage /Debt
Management
Amount
of
Debt
Liquidity
Asset
Management
Coverage
of
Debt
Short
Run
Solvency
Current
Assets
Operating
Efficiency
Margins
Returns
*Net
Profit
Margin
(ROS)
*Return
on
Equity
*Return
on
Equity
*Total
Liabilities/
Equity
Times
Interest
Earned
*Current
Ratio
*A/R
Average
Collection
Period
*A/R
Turnover
Operating
Profit
Margin
Return
on Total
Assets
(ROA)
Return
on Total
Assets
(ROA)
Debt/
Equity
Fixed
Charge
Coverage
*Quick
or
Acid Test
Ratio
*Days
Inventory
Held
*Inventory
Turnover
Gross
Profit
Margin
Cash
Return
on
Assets
*Earnings
Per
Share
LEVERAGE
Cash
Assets/
Flow
Equity
Adequacy
Cash
Flow
Liquidity
Ratio
Days
Payables
Outstanding
Fixed
Asset
Turnover
Days
of
Working
Capital
Total
Asset
Turnover
Product
Contribution
Margin
Price
to
Earnings
Ratio
Debt/
Assets
Cash
Flow
Margin
Dividend
Yield
LT Debt/
Total
Capitalization
Cash
Interest
Coverage
*‘Top 8’ &
CAPSTONE
Financial
Ratios
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Other
Common
Ratios
Return
on Total
Assets
(ROA)
Derived from: Fraser/Ormiston,
Understanding the Corporate Annual Report;
Understanding Financial Statements 6e
3
Key Financial Statements
● PPE
● Fixed Assets
TOTAL ASSETS
Current
(12mo)
Long-Term
● A/P
● ST Debt
● LT Debt
TOTAL LIABILITIES
Contributed
Capital
Retained
Earnings
● Stock @ par
● Paid-in
Capital
● Accumulated
Net Income
● less Dividends
TOTAL OWNERS’/
SHAREHOLDERS’ EQUITY
Net Sales
for Period
● Units Sold
● @ Price
● less Returns
& Allowances
TOTAL REVENUES
Cost of
Goods Sold
●
●
●
●
Units Sold
@ Material
@ Labor
@ Overhead
Expenses
for Period
●
●
●
●
●
R&D
Marketing
Distribution
Sales
Admin
TOTAL OP EXPENSES
Operating Profit
Other
Expenses
● Interest
● Taxes
● One-time
TOTAL NET INCOME
or (LOSS)
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Cash Flow Statement
Change in cash - Sources & (Uses) between Periods
Income Statement
Net Income ●
● Accrual Based
Adjustments
for Non-cash
Items
●
●
●
●
Depreciation
A/R & A/P
Inventory
Other Accruals
CASH provided (used) by
OPERATING Activities
● (Additions) Sale
PPE
● (Additions) Sale
Other
Investments
CASH provided (used) by
INVESTING Activities
Stock
Dividends
● Sale (Purchase)
● (Paid)
● Increase
Debt/
(Decrease)
Borrowing
CASH provided (used) by
FINANCING Activities
4
Cash
Long-Term
● Cash
● A/R
● Inventories
Income Statement
Revenues – Expenses = Net Income
(12mo)
Assets = Liabilities + Owners’ Equity
Current
Period Ending
∆ = Operating + Investing + Financing
Balance Sheet
Profitability and
Return to Investors
ROE
*Return on Owners’ Equity
%
ROA
Return on Total Assets
%
ROS
*Return on Sales
%
EPS
*Earnings per Share
$ DD.00
Net Income (after taxes)
Owners’ Equity
Net Income (after taxes)
Total Assets
Net Income (after taxes)
Net Sales Revenue
Net Income or Loss (after taxes)
Average # of Common Stock
Shares Outstanding
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Return on Owners’ Equity
Profitability ratio that provides an overall
measure of a business’s performance.
Net income earned (after tax) per dollar of
owners’ investment accumulated in the
business.
Net Income (after taxes)
Owners’ Equity
Typically between 15% and 25% for
profitable companies
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Return on Sales
or Net Profit Margin
This profitability ratio measures how well the
company generated net profit (after tax) per
dollar of net sales revenue.
Net Income (after taxes)
Net Sales Revenue
This ratio is best evaluated by analyzing a
firm’s year to year trends and by comparing
to businesses within appropriate industries.
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EPS
Earnings per Share
This profitability ratio tells the owner of a
share of stock how much of the net earnings
for the year belongs to him or her.
Net Income or Loss (after taxes)
Average # Shares of Common
Stock Outstanding
These earnings may be paid to the
stockholders as dividends . . . or reinvested
(as retained earnings) back into the business
to fund its growth.
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Liquidity and Asset
Management
*Current Ratio
Current Assets
Current Liabilities
*Acid Test or Quick Ratio
Current Assets - Inventory
Current Liabilities
#.#
#.#
*Accounts Receivable
Turnover
X (times/year) or # days
*Inventory
Turnover
Net Sales
.
Average Accounts Receivable
# days = 365 days/AR turnover
Cost of Goods Sold
Average Inventory
X (times/year) or # days
# days = 365 days/Inventory turns
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Current Ratio
Measures liquidity - the capacity of a firm to meet
its current obligations using liquid assets that are
in cash or other resources that can be quickly
converted to cash.
Current Assets
Current Liabilities
Capstone requires a current ratio >2.0,
to indicate that the firm can pay its current
liabilities using its current assets.
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Acid-Test or Quick Ratio
Measures liquidity - the ability of a firm to pay
current liabilities ‘quickly’ – without selling
inventory.
Current Assets - Inventory
Current Liabilities
For all businesses the desired
acid-test ratio is ~1.0
indicating firm can pay its current liabilities
from its non-inventory current assets.
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Accounts Receivable
Turnover - Activity Ratio
Determines the number of times during the year a
company is ‘turning over’ or collecting its accounts
receivable. Measured in X times per year. Can be
converted to ‘days outstanding’ by dividing
turnover ratio into 365 days.
Net Sales
Average Accounts Receivable
Customers will give a preference to companies that
extend payment terms and, in effect, provide a loan.
6X turnover is equivalent to 60 days of outstanding
receivables, 9X is 45 days, 12X is 30 days.
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Inventory Turnover
Activity Ratio
Determines the number of times during the year a
company is ‘turning over’ its inventory. Measured
in X times per year. Can also be converted to ‘days
of inventory’ by dividing ratio into 365 days.
Cost of Goods Sold
Average Inventory
The average inventory turnover for all firms is about 9
times per year, or about once every 45 days. It varies
considerable by industry. Capstone penalizes firms
with excessive inventory carrying costs
(>120 days of current sales).
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Working Capital
Asset Management
Working Capital = Current Assets – Current Liabilities
Working Capital ~ Accts Receivable + Inventory
- Accts Payable
Example
A/R =
35 days
Inventory =
70 days
less A/P =
-15 days
Capstone
Ideal Range
Working
Capital
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=
90 days
14
Better Returns
via Asset Management
How good are we at producing wealth with our assets?
Asset
Turnover
Sales
Assets
X
ROS
Return on
Sales
=
ROA
Return on
Assets
X
Profits
Sales
=
Profits
Assets
1.2
Aircraft - Boeing
3.6%
4.3%
3.1
Grocery - Kroger
1.7%
5.3%
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Capital Structure - Leverage
Using Equity + Debt for Financing
Using DEBT provides ‘LEVERAGE’
for the shareholders & increases
their “Return on Owners’ Equity”
BUT………using more debt
(which must be repaid)
increases the RISK to the
lenders & shareholders
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Leverage and
Debt Management
*Total Liabilities to Equity
%
Total Liabilities
Owners’ Equity
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Total Liabilities
to Owners’ Equity Ratio
This financial leverage ratio indicates the degree
to which a firm’s operations are financed through
debt, borrowings & other liabilities - determines a
firm’s financial risk and ability to borrow money.
Total Liabilities
Owners’ Equity
The liabilities-to-owners’ equity ratio
typically ranges between 33 and 50%.
The higher this ratio, the riskier the situation
for lenders and shareholders.
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Leverage and
Debt Management
*Total Liabilities to Equity
%
Total Liabilities
Owners’ Equity
Financial Leverage
#.#
Total Assets
Owners’ Equity
or
Capstone
Ideal Range
Total
Owners’
Liabilities + Equity
Owners’ Equity
Examples
2.0 = 50% Liabilities
50% Equity
2.5 =
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60% Liabilities
40% Equity
19
Leverage & Risk
Impact on Firm’s Cost of Capital
Weighted Cost of Capital (Debt & Equity WCC)
11.0%
10.9%
10.8%
10.7%
Equity investors
require a return at
least as great as the
‘best alternative
opportunity forgone’.
10.6%
‘Optimum’
Leverage
& WCC
10.5%
10.4%
As ‘Leverage’ increases
with more debt, the risk
increases to the lenders
& the shareholders,
increasing the cost of
both debt & equity.
10.3%
10.2%
10.1%
10.0%
Debt financing is lower
risk & cost than equity,
lowering the WCC.
0%
Low
20%
40%
60%
Financial Leverage
80%
100%
High
Source: adapted from The Real Cost of Capital
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