Ratios

Financial leverage

(Average Assets)/(Average Shareholders' Equity) The bigger the ratio, the higher percentage of liabilities used to finance assets. Leverage measures the assets purchased for the amount of equity available. The more assets purchased per dollar of equity, then the more debt required for financing those assets. To interpret the ratio, rewrite it as = (Average Liabilities and Shareholders' Equity)/(Average Shareholders' Equity) For example, a ratio of 1.3 suggests that for every dollar of equity, 30 cents of debt has been used to fund assets. A ratio of 1.4 suggests 40 cents of debt has been used. Leverage increases ROE, but it also increases the risk of the firm.

Cash flow from operations to total liabilities ratio

(Cash Flow From Operations)/(Average Total Liabilities) The higher the ratio, the lower the risk and the greater the long-term liquidity. Measures cash generation of the firm to cover total obligations. 20% is considered a reasonable benchmark. So a ratio above 20% suggests sufficient liquidity.

Cash flow from operations to average current liabilities ratio

(Cash Flow from Operations)/(Average Current Liabilities) The higher the ratio, the greater the short-term liquidity. This ratio has an advantage over current ratio and quick ratio because the cash flow numerator is measured over a period of time rather than the end of the period. A higher inventory turn and accounts receivable turn are positively associated with cash flows in the numerator of this ratio. A lower accounts payable turn is positively associated with cash flows in the numerator. 40% is considered a reasonable benchmark. If the ratio is above 40% it has adequate liquidity.

Current Ratio

(Current Assets)/(Current Liabilities) The higher the ratio, the greater the short-term liquidity. This ratio should be greater than 1, but firms with a steady inflow of cash and a lot of liquid assets may be content to keep a lower current ratio. It is a limited measure of liquidity because a firm could have a high current ratio because accounts receivable and inventory are high, which could indicate they are having difficulty selling inventory and collecting the cash. Likewise, higher Inventory turnover, which is related to lower inventory and receivable balances, will decrease the current ratio. Thus, the current ratio can be lower for a good reason; the firm is managing their inventory well. The quick ratio fixes this problem.

Interest coverage

(Income Before Interest and Taxes)/(Interest Expense) The higher the ratio, the less the risk because the firm has more profitability to cover interest costs. However, it does not capture the cash that is actually available to pay off debt.

Long-term debt ratio

(Long-term Debt )/Assets The higher the ratio, the greater the risk of not being able to pay back interest-bearing long-term debt.

Debt-Equity ratio

(Long-term Debt)/(Shareholders' Equity) The higher the ratio, the greater the risk given the greater reliance on debt rather than equity financing.

Return on assets

(Net Income)/(Average Assets) o ROA measures the effectiveness of assets in generating profits. o The bigger the ratio, the greater the profitability relative to the resources of the firm. o Return on assets is explained by the change in profit margin and asset turnover.

Return on equity

(Net Income)/(Average Equity) ROE is a function of ROA and Financial Leverage. o ROE is an overall measure of performance. o The bigger the ratio, the greater the efficiency in managing shareholders' investment to generate income. o Return on equity is explained by change in Return on Assets and Financial Leverage.

Profit Margin

(Net Income)/Sales Profit margin measures the percentage of profit the firm produces relative to the amount sold. The larger the ratio, the greater the ability to sell profitable products and services and control costs through efficiency. It captures the bottom line net income on the income statement relative to the top line revenue on the income statement. Profit margin is explained by the common size income statement.

Accounts payable turnover

(Purchases)/(Average Accounts Payable) Remember the equation: Beg. Inv + Purch. - End Inv. = Cost of Goods Sold. Rearrange the equation: Purchases = Cost Goods Sold + End Inv - Beg Inv. = Cost Goods Sold + Change Inv. Get the inventory amounts from the balance sheet. Get Cost of Goods Sold amounts from the income statement. A higher ratio indicates that the firm pays their suppliers more quickly. It measures the number of times average payables are paid off during the year. Interpret accounts payable turnover carefully. 1. High turnover can mean either the ability to pay off suppliers quickly to take advantage of discounts offered by suppliers for prompt payment (which is good) OR that the suppliers demand to be paid quickly because of the firm's lack of negotiating power (which is bad). 2. Low turnover can mean either trouble paying suppliers if there is evidence of liquidity problems elsewhere on the statements (which is bad) OR effective use of a low cost source of financing if there is no evidence of liquidity problems elsewhere on the statements (which is good).

Asset turnover

(Sales Revenue)/(Average Assets) The larger the ratio, the more effective the firm is in using assets to generate sales. What ratios help explain asset turnover? Receivables turnover, inventory turnover and fixed assets turnover all investigate the performance of assets because all three ratios include an asset account in the denominator.

Receivables turnover

(Sales Revenue)/(Average Net Accounts Receivable) This ratio reflects the number of times the average balance of trade receivables are recorded and collected in a period. It captures the speed of cash collection. High turnover indicates effectiveness of credit-granting and collection activities. Low turnover indicates potential late payments, bad debts and ineffective collection. 365/Receivables Turnover = Average number of days AR is held This ratio is less relevant for retail firms that allow customers to purchase with cash or a bank credit card (e.g., Visa), which is basically the same as cash. However, if customers use a firm-sponsored credit card (JC Penney's Card), then the ratio is very relevant because credit card receivables will be on the balance sheet. Higher receivable turnover is (1) positively related to cash flow from operations and (2) negatively related to the current ratio. Why?

Fixed asset turnover

(Sales Revenue)/(Average Net PPE) Net PPE = PPE-Accumulated Depreciation A higher ratio indicates greater effectiveness in using fixed assets to generate revenues. Sales revenue in the numerator does not include the sale of fixed assets. Fixed assets are used to generate the sales of goods and services; it is inappropriate to say that sales revenue increased because a firm sold more fixed assets during the period." High number indicates lower level of fixed asset is necessary to generate annual sales volume. This ratio is extremely important for capital-intensive firms like manufacturing firms, utilities, or airlines. There is often a lag between investments in PPE and sales. A growth firm may experience a decline in fixed asset turnover as they invest in new PPE. Firms can pull back on capital expenditures of PPE if they are expecting a decrease in sales to stabilize the PPE turnover.

Inventory turnover

CGS/(Average Inventory) 365/Inventory Turnover = Average number of days inventory is held This ratio will vary greatly depending on the nature of the inventory. Meat packers will have high inventory turnover while jewelry stores will have low turnover. High inventory turnover indicates a firm is selling goods quickly. This will lower storage costs, reduce markdowns, and decrease CGS/Sales. High inventory turnover is (1) positively related to cash flow from operations and (2) negatively related to the current ratio

Reminder

Describe changes in ROE in terms of ROA + Leverage

Reminder 3

IF A RATIO DECREASES LIQUIDITY, IT INCREASES RISK AND IF IT INCREASES LIQUIDITY, IT DECREASES RISK. THERE IS AN INVERSE RELATIONSHIP BETWEEN LIQUIDITY AND RISK.

Reminder 2

If fixed asset, inventory and receivable turnover ratios move in an opposite direction compared to total asset turnover, then these ratios are not helping explain the charge in asset turnover.

Liabilities to Assets ratio

Liabilities/Assets The higher the ratio, the greater the risk because a larger percentage of assets are financed with liabilities.

Asset turnover

The bigger the ratio, the more effective the firm is in using assets to generate sales. A firm strives to maximize the amount of sales generated from a fixed investment in assets. Effectiveness in using existing assets minimizes the need to spend cash or borrow money to buy more assets. There often is a tradeoff between profit margin and asset turnover in determining ROA. For example, Neiman's may have a higher profit margin but lower asset turnover and still have a similar ROA as Amazon that has a lower profit margin and higher asset turnover.

Quick Ratio

The higher the ratio, the greater the short-term liquidity. The assets in the numerator are everything on the balance sheet that are more liquid than inventory. It excludes inventory and other current assets that take longer to turn into cash.