# Ratio Analysis 101 from Investopedia.com

Asset/Liability Ratio (Photo credit: Wikipedia)

Stock market of Brussels (Photo credit: Wikipedia)

Asset/Liability Ratio (Photo credit: Wikipedia)

Understanding Financial Leverage (Photo credit: Wikipedia)

English: Diagram of DuPont analysis of return on equity. ‪Norsk (bokmål)â¬: Diagram over DuPont-analyse av kapitalrentabilitet. (Photo credit: Wikipedia)

ROI Treiberbaum Du Pont (Photo credit: Wikipedia)

Understanding Financial Leverage (Photo credit: Wikipedia)

Click on this pin from Investopedia:

http://www.pinterest.com/pin/237213105347333013/

This pin will lead you to my “Financial Ratio” Pinterest Board

Where you will find this tutorial:

http://www.pinterest.com/pin/237213105347333010/

It explains every ratio that we have discussed in this class.

“A financial ratio (or accounting ratio) is a relative magnitude of two selected numerical values taken from an enterprise’s financial statements. Often used in accounting, there are many ratios that are used to evaluate the overall financial condition of a corporation or other organization.”

Many stakeholders are interested in financial ratios: managers, shareholders (owners)  and a firm’s creditors.

Watch this video for review:

http://www.investopedia.com/video/play/understanding-fundamental-analysis/

Here is the Financial Report that Investopedia is using for the calculations in the Tutorial:

http://www.sec.gov/Archives/edgar/data/1136869/000095013706002478/c02799e10vkwxpdfy.pdf

Fundamental analysis has a very broad scope. One aspect looks at the general (qualitative) factors of a company. The other side considers tangible and measurable factors (quantitative). This means crunching and analyzing numbers from the financial statements. If used in conjunction with other methods, quantitative analysis can produce excellent results.

Ratio analysis isn’t just comparing different numbers from the balance sheet, income statement and cash flow statement. It’s comparing the number against previous years, other companies, the industry or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and how it might perform in the future.

For example, current assets alone don’t tell us a whole lot, but when we divide them by current liabilities we are able to determine whether the company has enough money to cover short-term debts.
Comparing these ratios against numbers from previous years, other companies, industry averages and the economy in general can tell you a lot about where a company might be headed. Valuing a company is no easy task. This tutorial will shed some light on how it can be done and, ultimately, help you to make more informed choices as an investor.

There is a lot to be said for valuing a company, it is no easy task. If you have yet to discover this goldmine, the satisfaction one gets from tearing apart a companies financial statements and analyzing it on a whole different level is great – especially if you make or save yourself money for your efforts.
Here is a list of 19 basic fundamental analysis ratios to help you get started. You have these formulas in your textbook.

The basic ratio categories include:

http://www.pinterest.com/pin/237213105347333006/

The Ratios:

 Performance Activity Book Value Per Common Share Asset Turnover Cash Return On Assets Average Collection Period Vertical Analysis Inventory Turnover Dividend Payout Ratio Financing Earnings Per Share Debt Ratio Gross Profit Margin Debt / Equity Ratio Price/Earnings Ratio Liquidity Warnings Profit Margin Acid-Test Ratio Return on Assets Interest Coverage Return on Equity Working Capital

Taken directly from the www.Investopedia.com website

Profitability Ratios

1. Gross profit margin

Sales – Cost of goods sold/Sales

Shows the percentage 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)

Sales – Operating expenses/Sales

or

Operating income/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)

Profits after taxes/Sales

Shows after-tax profi ts per dollar of sales. Higher is

better and the trend should be upward.

4. Total return on assets

Profits after taxes + Interest/Total assets

A measure of the return on total monetary investment

in the enterprise. Interest is added to after-tax 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. Net return on total assets (ROA)

Profits after taxes/Total assets

A measure of the return earned by stockholders on the

fi rm’s total assets. Higher is better, and the trend should

be upward.

6. Return on stockholder’s equity (ROE)

Profits after taxes/Total stockholders’ equity

Shows the return stockholders are earning on their

capital investment in the enterprise. A return in the

12–15% range is “average,” and the trend should be

upward.

7. Return on invested capital (ROIC)—

sometimes referred to as return on capital employed (ROCE)

Profits after taxes/Long-term debt plus total stockholders’ equity

A measure of the return shareholders are earning

on the long-term monetary capital invested in the

enterprise. A higher return refl ects greater bottom-line

effectiveness in the use of long-term capital, and the

trend should be upward.

8. Earnings per share (EPS)

Profits after taxes/Number of shares of common stock outstanding

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

Current assets/Current liabilities

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. Working capital

Current assets minus Current Liabilities

Bigger amounts are better because the company hasmore 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. Total debt-to-assets ratio

Total debt/Total assets

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. Long-term debt-to-capital Ratio

Long-term debt/Long-term debt plus Total stockholders’ equity

An important measure of creditworthiness and balance

sheet strength. Indicates the percentage of capital

investment which has been fi nanced by creditors and

bondholders. Fractions or ratios below .25 or 25% are

usually quite satisfactory since monies invested by stockholders

account for 75% or more of the company’s total capital.

The lower the ratio, the greater the capacity to borrow additional funds.

Debt-to-capital ratios above 50% and certainly above 75% indicate a heavy and

perhaps excessive reliance on debt, lower creditworthiness, and weak balance sheet

strength.

3. Debt-to-equity ratio

Total debt/Total stockholders’ equity

Should usually be less than 1.0. High ratios

(especially above 1.0) signal excessive debt, lower

creditworthiness, and weaker balance sheet strength.

4. Long-term debt-to-equity

ratio

Long-term debt/Total stockholders’ equity

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

Operating income/Interest expenses

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

Inventory/Cost of goods sold divided by 365

Measures inventory management efficiency. Fewer days

of inventory are usually better.

2. Inventory turnover

Cost of goods sold/Inventory

Measures the number of inventory turns per year.

Higher is better.

3. Average Collection Period

Accounts receivable/Total sales revenues ÷ 365

or

Accounts receivable/Average daily sales

Indicates the average length of time the fi rm 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

Annual dividends per share/Current market price per share

A measure of the return that shareholders receive in

the form of dividends. A “typical” dividend yield is 2–3%.

The dividend yield for fast-growth companies is often

below 1% (maybe even 0); the dividend yield for slowgrowth

companies can run 4–5%.

2. Price-earnings ratio

Current market price per share/Earnings per share

P-E ratios above 20 indicate strong investor confi dence

in a fi rm’s outlook and earnings growth; fi rms whose

future earnings are at risk or likely to grow slowly

typically have ratios below 12.

3. Dividend payout ratio

Annual dividends per share/Earnings per share

Indicates the percentage of after-tax profits paid cut as

dividends.

4. Internal cash flow

After tax profits plus depreciation

A quick and rough estimate of the cash the business is generating after payment of operating expenses, interest, and taxes.

Such amounts can be used for dividend payments or funding capital expenditures.

5. Free cash flow

After tax profits plus depreciation minus capital expenditures minus dividends

A quick and rough estimate of the cash a company’s

business is generating after payment of operating

expenses, interest, taxes, dividends, and desirable

reinvestments in the business. The larger a company’s

free cash fl ow, the greater is its ability to internally

fund new strategic initiatives, repay debt, make new

acquisitions, repurchase shares of stock, or increase

dividend payments.