Business Terms

"Asset turnover An Operating Ratio"

"Asset turnover = Sales ÷ Assets Shows how efficiently a company uses it assets. The higher the number, the better. If you can reduce inventory, cut average receivables, and increase sales while holding assets constant, asset turnover rises. Basically, this is a good indicator of how the company is doing."

"Current ratio (or banker's ratio; a type of liquidity ratio) An Operating Ratio"

"Current ratio = Total current assets* ÷ Total current liabilities *Total current assets = cash, receivables, + marketable securities Measures how solvent the company is. The higher the number, the better."

"Days inventory An Operating Ratio"

"Days inventory = (Average inventory on hand ÷ Cost of goods sold) × 365 Shows how long it takes the company to sell the average amount of inventory on hand during a given time period. The higher the number, the more likely inventory won't be sold at full value, and the more cash that gets tied up. The faster goods go out the door, the faster you collect the cash. "

"Days payables An Operating Ratio"

"Days payables = (Accounts payable ÷ Cost of goods sold) × 365 Tells how many days it takes the company to pay its suppliers during a given time period. Fewer days means the company is less likely to default on its obligations. Fewer is always best. Companies must strike a balance between preserving cash and paying suppliers promptly to keep them happy and keep their best vendors."

"Days receivables An Operating Ratio"

"Days receivables = (Net accounts receivable ÷ Net sales for end of given time period) × 365 Tells how long it takes a company to collect what it's owed. The lower the number, the better, because the company needs less working capital. "

"Days sales outstanding ("average collection period" or "receivable days") An Operating Ratio"

"Days sales outstanding = Accounts receivable ÷ Total credit sales × Number of days Measures the average time it takes to collect the cash from sales, or how fast customers pay their bills. Can help surface problems and potential areas for improvement. A long period will beg the question: "Why is it taking so long?" Are customers unhappy because of product defects or poor service? Are salespeople too lax in negotiating payment terms? DSO varies by industry, region, economy, season. DSO is a key ratio for doing due diligence on a potential acquisition."

"Debt to equity A Leverage Ratio"

"Debt to equity = Total debt ÷ Total shareholders' equity (Total debt = long-term, short-term, and current maturities) Indicates the extent to which the company is using borrowed money to enhance return on owner's equity. A high debt-to-equity ratio usually means that a company is aggressive in financing its growth with debt. If a high proportion of debt increases earnings by a greater amount than the cost of debt, shareholders gain (more earnings are spread among the same number of shareholders). But if the cost of debt outweighs the returns generated, bankruptcy could result. What's considered a healthy ratio depends on the industry. "

"Earnings before interest and taxes (EBIT) margin (also known as "operating margin" or "operating profit") A Profitability Ratio"

"EBIT margin = EBIT ÷ Net sales Shows how profitable the company's operating activities are. Taxes and interest aren't included (which nonfinancial managers have no control over). So this is a good indicator of how well managers are performing. A downward trend line means costs and expenses are rising faster than sales."

"Gross profit margin A Profitability Ratio"

"Gross profit margin = Gross profit / Sales (Gross profit = Sales - Cost of goods sold) Measures the percentage of gross profit (profit or income after deducting cost of goods sold) relative to sales revenue. Shows profitability before expenses or overhead are added in. That is, it shows the percentage of every sales dollar a company has left over to cover basic operating costs and profit. A decline in gross margin may signal that a company won't be able to meet its expense obligations."

"Interest coverage A Leverage Ratio"

"Interest coverage = EBIT ÷ Interest expense Measures company's margin of safety—how many times over it can make its interest payments. Provides a quick picture of a company's ability to pay the interest charges on its debt. A ratio of 1.5 or lower means a company is struggling to meet interest expenses. (If it's under 1, the company isn't earning enough revenues to cover interest costs.) "

"Inventory turns An Operating Ratio"

"Inventory turns = 365 ÷ Days in inventory Measures how many times inventory turns over in a year. The higher the number of turns (or the lower the number of inventory days), the tighter your management of inventory and the better your cash position. As long as you have enough inventory on hand to meet customer demand, you want to aim for high inventory turns—that's a sign of efficiency. "

"Return on equity (ROE) A Profitiability Ratio"

"Net income / Owner's equity Shows what percentage of profit you make for every dollar of equity invested in the company. Key ratio investors look at. It's a good indication of whether the company can generate a return that's worth the risk of investing.

"Operating cash flow/sales ratio (expressed as a percentage) An Operating Ratio"

"Operating cash flow ÷ Net sales (or revenue) Compares a company's operating cash flow to its net sales or revenues. Gives investors an idea of the company's ability to turn sales into cash. If sales grow and cash flow doesn't, there's a problem."

"Quick ratio (sometimes called "acid test ratio"; a type of liquidity ratio) An Operating Ratio "

"Quick ratio = (Total current assets - Inventory) ÷ Total current liabilities Measures ratio of the company's assets that can be quickly liquidated and used to pay debts."

"Return on assets (ROA) A Profitability Ratio"

"ROA = Net income / Assets Tells what percentage of every dollar invested was returned as a profit. Quantifies how well a company has invested in its assets."

"Return on sales (ROS) (also known as "operating profit margin") A Profitability Ratio"

"ROS = Net income / Total sales revenue Measures how sales translate into profit—how much profit is being produced per dollar of sales. For example, if a company earns $10 for every $100 in sales, ROS is 10/100, or 10%. An increasing ROS indicates the company is growing more efficient; a decreasing ROS indicates potential financial troubles."