Click on this pin from Investopedia:
This pin will lead you to my “Financial Ratio” Pinterest Board
Where you will find this tutorial:
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.”
Watch this video for review:
Here is the Financial Report that Investopedia is using for the calculations in the Tutorial:
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:
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
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
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
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.
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.
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
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
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.
(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.
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
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
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
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