Financial Ratios

Financial Ratios

Financial Ratios
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RATIO HOW CALCULATED WHAT IT SHOWS
Leverage Ratios
1. Gross profit margin Shows the percent of revenues available to cover operating expenses and yield a profit. Higher is better and the trend should be upward.
2. Operating profit margin (or return on sales) Shows the profitability of current operations without regard to interest charges and income taxes. Higher is better and the trend should be upward.
3. Net profit margin (or net return on sales) Shows after-tax profits per dollar of sales. Higher is better and the trend should be upward.
4. Return on total assets A measure of the return on total investment in the enterprise. Interest is added to aftertax profits to form the numerator since total assets are financed by creditors as well as by stockholders. Higher is better and the trend should be upward.
5. Return on stockholders' equity Shows the return stockholders are earning on their investment in the enterprise. A return in the 12–15% range is "average" and the trend should be upward.
6. Earnings per share Shows the earnings for each share of common stock outstanding. The trend should be upward, and the bigger the annual percentage gains, the better.

Liquidity Ratios
1. Current ratio Shows a firm's ability to pay current liabilities using assets that can be converted to cash in the near term. Ratio should definitely be higher than 1.0; ratios of 2 or higher are better still.
2. Quick ratio (or acid-test ratio) Shows a firm's ability to pay current liabilities without relying on the sale of its inventories.
3. Working capital Bigger amounts are better because the company has more internal funds available to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital.

Leverage Ratios
1. Debt-to-assets ratio Measures the extent to which borrowed funds have been used to finance the firm's operations. Low fractions or ratios are better—high fractions indicate overuse of debt and greater risk of bankruptcy.
2. Debt-to-equity ratio Should usually be less than 1.0. High ratios (especially above 1.0) signal excessive debt, lower creditworthiness, and weaker balance sheet strength.
3. Long-term debt-to-equity ratio Shows the balance between debt and equity in the firm's long-term capital structure. Low ratios indicate greater capacity to borrow additional funds if needed.
4. Times-interest-earned (or coverage) ratio Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios above 3.0 signal better creditworthiness.

Activity Ratios
1. Days of inventory Measures inventory management efficiency. Fewer days of inventory are usually better.
2. Inventory turnover Measures the number of inventory turns per year. Higher is better.
3. Average collection period Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better.

Other Important Measures of Financial Performance
1. Dividend yield on common stock A measure of the return to owners received in the form of dividends.
2. Price/Earnings ratio P/E ratios above 20 indicate strong investor confidence in a firm's outlook and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12.
3. Dividend payout ratio Indicates the percentage of after-tax profits paid out as dividends.
4. Internal cash flow A quick and rough estimate of the cash a company's business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures.

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