Ratios and Formulas in Financial Analysis
Financial statement
analysis is a judgmental process. One of the primary objectives is
identification of major changes in trends, and relationships and the
investigation of the reasons underlying those changes. The judgment process can
be improved by experience and the use of analytical tools. Probably the most
widely used financial analysis technique is ratio analysis, the analysis of
relationships between two or more line items on the financial statement.
Financial ratios are usually expressed in percentage or times. Generally,
financial ratios are calculated for the purpose of evaluating aspects of a
company's operations and fall into the following categories:
- Liquidity
ratios measure a firm's ability to
meet its current obligations.
- Profitability
ratios measure management's
ability to control expenses and to earn a return on the resources
committed to the business.
- Leverage
ratios measure the degree of
protection of suppliers of long-term funds and can also aid in judging a
firm's ability to raise additional debt and its capacity to pay its
liabilities on time.
- Efficiency,
Activity or Turnover ratios provide
information about management's ability to control expenses and to earn a
return on the resources committed to the business.
A ratio can be computed
from any pair of numbers. Given the large quantity of variables included in
financial statements, a very long list of meaningful ratios can be derived. A
standard list of ratios or standard computation of them does not exist. The
following ratio presentation includes ratios that are most often used when
evaluating the credit worthiness of a customer. Ratio analysis becomes a very
personal or company driven procedure. Analysts are drawn to and use the ones they
are comfortable with and understand.
Ø Working Capital
Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.
Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.
· Formula
Current
Assets - Current Liabilities = Working Capital
Ø Acid Test or Quick Ratio
A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower than its current ratio. It is a stringent test of liquidity.
A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does not include inventory and prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower than its current ratio. It is a stringent test of liquidity.
· Formula
Cash
+ Marketable Securities + Accounts Receivable
Current Liabilities
Current Liabilities
Ø Current Ratio
Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business's current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.
Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business's current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.
· Formula
Current
Assets
Current Liabilities
Current Liabilities
Ø Cash Ratio
Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.
Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.
· Formula
Cash
Equivalents + Marketable Securities
Current Liabilities
Current Liabilities
Ø Net Profit Margin (Return on Sales)
A measure of net income dollars generated by each dollar of sales.
A measure of net income dollars generated by each dollar of sales.
· Formula
Net
Income *
Net Sales
Net Sales
* Refinements to the net income
figure can make it more accurate than this ratio computation. They could
include removal of equity earnings from investments, "other income"
and "other expense" items as well as minority share of earnings and
nonrecuring items.
Ø Return on Assets
Measures the company's ability to utilize its assets to create profits.
Measures the company's ability to utilize its assets to create profits.
· Formula
Net
Income *
(Beginning + Ending Total Assets) / 2
(Beginning + Ending Total Assets) / 2
Ø Operating Income Margin
A measure of the operating income generated by each dollar of sales.
A measure of the operating income generated by each dollar of sales.
· Formula
Operating
Income
Net Sales
Net Sales
Ø Return on Investment
Measures the income earned on the invested capital.
Measures the income earned on the invested capital.
· Formula
Net
Income *
Long-term Liabilities + Equity
Long-term Liabilities + Equity
Ø Return on Equity
Measures the income earned on the shareholder's investment in the business.
Measures the income earned on the shareholder's investment in the business.
· Formula
Net
Income *
Equity
Equity
Ø Du Pont Return on Assets
A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company generates its return.
A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company generates its return.
· Formula
|
Net
Income *
Sales |
x
|
Sales
Assets |
x
|
Assets
Equity |
Ø
Gross
Profit Margin
Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should be compared with industry data as it may indicate insufficient volume and excessive purchasing or labor costs.
Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should be compared with industry data as it may indicate insufficient volume and excessive purchasing or labor costs.
· Formula
Gross
Profit
Net Sales
Net Sales
Ø
Total
Debts to Assets
Provides information about the company's ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors.
Provides information about the company's ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors.
· Formula
Total
Liabilities
Total Assets
Total Assets
Ø
Capitalization
Ratio
Indicates long-term debt usage.
Indicates long-term debt usage.
· Formula
Long-Term
Debt
Long-Term Debt + Owners' Equity
Long-Term Debt + Owners' Equity
Ø
Debt to
Equity
Indicates how well creditors are protected in case of the company's insolvency.
Indicates how well creditors are protected in case of the company's insolvency.
· Formula
Total
Debt
Total Equity
Total Equity
Ø Interest Coverage Ratio (Times Interest Earned)
Indicates a company's capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes)
Indicates a company's capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes)
· Formula
EBIT
Interest Expense
Interest Expense
Ø Long-term Debt to Net Working Capital
Provides insight into the ability to pay long term debt from current assets after paying current liabilities.
Provides insight into the ability to pay long term debt from current assets after paying current liabilities.
· Formula
Long-term
Debt
Current Assets - Current Liabilities
Current Assets - Current Liabilities
Ø Cash Turnover
Measures how effective a company is utilizing its cash.
Measures how effective a company is utilizing its cash.
· Formula
Net
Sales
Cash
Cash
Ø Sales to Working Capital (Net Working Capital Turnover)
Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that the company's working capital is working too hard.
Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that the company's working capital is working too hard.
· Formula
Net
Sales
Average Working Capital
Average Working Capital
Ø Total Asset Turnover
Measures the activity of the assets and the ability of the business to generate sales through the use of the assets.
Measures the activity of the assets and the ability of the business to generate sales through the use of the assets.
· Formula
Net
Sales
Average Total Assets
Average Total Assets
Ø Fixed Asset Turnover
Measures the capacity utilization and the quality of fixed assets.
Measures the capacity utilization and the quality of fixed assets.
· Formula
Net
Sales
Net Fixed Assets
Net Fixed Assets
Ø Days' Sales in Receivables
Indicates the average time in days, that receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days' sales in receivables with the company's credit terms as an indication of how efficiently the company manages its receivables.
Indicates the average time in days, that receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days' sales in receivables with the company's credit terms as an indication of how efficiently the company manages its receivables.
· Formula
Gross
Receivables
Annual Net Sales / 365
Annual Net Sales / 365
Ø Accounts Receivable Turnover
Indicates the liquidity of the company's receivables.
Indicates the liquidity of the company's receivables.
· Formula
Net
Sales
Average Gross Receivables
Average Gross Receivables
Ø Accounts Receivable Turnover in Days
Indicates the liquidity of the company's receivables in days.
Indicates the liquidity of the company's receivables in days.
· Formula
Average
Gross Receivables
Annual Net Sales / 365
Annual Net Sales / 365
Ø Days' Sales in Inventory
Indicates the length of time that it will take to use up the inventory through sales.
Indicates the length of time that it will take to use up the inventory through sales.
· Formula
Ending
Inventory
Cost of Goods Sold / 365
Cost of Goods Sold / 365
Ø Inventory Turnover
Indicates the liquidity of the inventory.
Indicates the liquidity of the inventory.
· Formula
Cost
of Goods Sold
Average Inventory
Average Inventory
Ø Inventory Turnover in Days
Indicates the liquidity of the inventory in days.
Indicates the liquidity of the inventory in days.
· Formula
Average
Inventory
Cost of Goods Sold / 365
Cost of Goods Sold / 365
Ø Operating Cycle
Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most companies the operating cycle is less than one year, but in some industries it is longer.
Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most companies the operating cycle is less than one year, but in some industries it is longer.
· Formula
Accounts
Receivable Turnover in Days
+ Inventory Turnover in Day
+ Inventory Turnover in Day
Ø Days' Payables Outstanding
Indicates how the firm handles obligations of its suppliers.
Indicates how the firm handles obligations of its suppliers.
· Formula
Ending
Accounts Payable
Purchases / 365
Purchases / 365
Ø Payables Turnover
Indicates the liquidity of the firm's payables.
Indicates the liquidity of the firm's payables.
· Formula
Purchases
Average Accounts Payable
Average Accounts Payable
Ø Payables Turnover in Days
Indicates the liquidity of the firm's payables in days.
Indicates the liquidity of the firm's payables in days.
· Formula
Average
Accounts Payable
Purchases / 365
Purchases / 365
Ø Altman Z-Score
The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis.
The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis.
The
Z-score is known to be about 90% accurate in forecasting business failure one
year into the future and about 80% accurate in forecasting it two years into
the future.
· Formula
|
Z =
|
1.2
+1.4 +0.6 +0.999 +3.3 |
x
x x x x |
(Working Capital / Total Assets)
(Retained Earnings / Total Assets) (Market Value of Equity / Book Value of Debt) (Sales / Total Assets) (EBIT / Total Assets) |
|
Z-score
|
Probability
of Failure
|
|
less than 1.8
greater than 1.81 but less than 2.99 greater than 3.0 |
Very
High
Not Sure Unlikely |
Ø Bad-Debt to Accounts Receivable Ratio
Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.
Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.
· Formula
Bad
Debts
Accounts Receivable
Accounts Receivable
Ø Bad-Debt to Sales Ratio
Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.
Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.
· Formula
Bad
Debts
Sales
Sales
Ø Book Value per Common Share
Book value per common share is the net assets available to common stockholders divided by the shares outstanding, where net assets represent stockholders' equity less preferred stock. Book value per share tells what each share is worth per the books based on historical cost.
Book value per common share is the net assets available to common stockholders divided by the shares outstanding, where net assets represent stockholders' equity less preferred stock. Book value per share tells what each share is worth per the books based on historical cost.
· Formula
(Total
Stockholders' Equity - Liquidation Value of Preferred Stocks - Preferred
Dividends in Arrears)
Common Shares Outstanding
Common Shares Outstanding
Ø Common Size Analysis
In vertical analysis of financial statements, an item is used as a base value and all other accounts in the financial statement are compared to this base value.
In vertical analysis of financial statements, an item is used as a base value and all other accounts in the financial statement are compared to this base value.
On the
balance sheet, total assets equal 100% and each asset is stated as a percentage
of total assets. Similarly, total liabilities and stockholder's equity are
assigned 100%, with a given liability or equity account stated as a percentage
of total liabilities and stockholder's equity.
On the
income statement, 100% is assigned to net sales, with all revenue and expense
accounts then related to it.
Ø Cost of Credit
The cost of credit is the cost of not taking credit terms extended for a business transaction. Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial.
The cost of credit is the cost of not taking credit terms extended for a business transaction. Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial.
· Formula
|
%
Discount
100 - % Discount |
x
|
360
Credit Period - Discount Period |
Example
On a Rs10,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the 10 days discount period or wait for the full 30 days and pay the full amount. By waiting the full 30 days, the customer effectively borrows the discounted amount for 20 days.
On a Rs10,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the 10 days discount period or wait for the full 30 days and pay the full amount. By waiting the full 30 days, the customer effectively borrows the discounted amount for 20 days.
Rs.10,000 x (1 - .02) = Rs.9,800
This gives the amount paid in
interest as:
Rs.10,000 – 9,800 = Rs. 20
This information can be used to
compute the credit cost of borrowing this money.
|
%
Discount
100 - % Discount |
x
|
|
360
Credit Period - Discount Period |
|
=
2
98 |
x
|
360
20 |
= .3673
|
As this example illustrates, the
annual percentage cost of offering a 2/10, net/30 trade discount is almost 37%.
Ø Current-Liability Ratios
Current-liability ratios indicate the degree to which current debt payments will be required within the year. Understanding a company's liability is critical, since if it is unable to meet current debt, a liquidity crisis looms. The following ratios are compared to industry norms.
Current-liability ratios indicate the degree to which current debt payments will be required within the year. Understanding a company's liability is critical, since if it is unable to meet current debt, a liquidity crisis looms. The following ratios are compared to industry norms.
· Formulas
|
Current
to Non-current
|
=
|
Current
Liabilities
Non-current Liabilities |
|
Current
to Total
|
=
|
Current
Liabilities
Total Liabilities |
Ø Rule of 72
A rule of thumb method used to calculate the number of years it takes to double an investment.
A rule of thumb method used to calculate the number of years it takes to double an investment.
· Formula
72
Rate of Return
Rate of Return
Example
Paul bought securities yielding an annual return of 9.25%. This investment will double in less than eight years because,
Paul bought securities yielding an annual return of 9.25%. This investment will double in less than eight years because,
|
72
9.25 |
=
7.78 years
|
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