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## Financial ratios

- Financial ratios are a comparison of two selected numerical values taken from financial statements of a company. These ratios can be used to evaluate the financial position of a company.
- Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:
- Liquidity ratios
- Asset turnover ratios
- Financial leverage ratios
- Profitability ratios
- Dividend policy ratios
- Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.
- The current ratio is the ratio of current assets to current liabilities:
- The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:
- The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:
- The collection period also can be written as:
- Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:
- The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:
- The inventory period also can be written as:
- Other asset turnover ratios include fixed asset turnover and total asset turnover.
- Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.
- The debt ratio is defined as total debt divided by total assets:
- The debt-to-equity ratio is total debt divided by total equity:
- Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity.
- The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:
- Profitability ratios offer several different measures of the success of the firm at generating profits. The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:
- Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as:
- Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows:
- Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.
- The dividend yield is defined as follows:
- A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard, and is defined as follows:
Current Assets Current Ratio = ------------------------Current Liabilities Current Assets - Inventory Quick Ratio = ----------------------------------Current Liabilities Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows: Annual Credit Sales Receivables Turnover = -------------------------Accounts Receivable Accounts Receivable Average Collection Period = --------------------------------Annual Credit Sales / 365 365 Average Collection Period = -----------------------------Receivables Turnover Cost of Goods Sold Inventory Turnover = -----------------------Average Inventory Average Inventory Inventory Period = -------------------------------------Annual Cost of Goods Sold / 365 365 Inventory Period = ---------------------------Inventory Turnover Total Debt Debt Ratio = ----------------------Total Assets Total Debt Debt-to-Equity Ratio = --------------------------Total Equity EBIT Interest Coverage = --------------------Interest Charges Where, 4. Profitability RatiosEBIT = Earnings Before Interest and Taxes Sales - Cost of Goods Sold Gross Profit Margin = -----------------------------Sales Net Income Return on Assets = ------------------------Total Assets Net Income Return on Equity = ----------------------------Shareholder Equity Dividends Per Share Dividend Yield = ------------------------Share Price Dividends Per Share Payout Ratio = -----------------------------Earnings Per Share |

Last modified: Saturday, 23 June 2012, 7:06 AM