Appendix A: Financial Ratios
Activity Ratios: Measure how productive a particular asset was in producing sales activity
Ratio Name
Asset
turnover
Interpretation
Measures how efficiently a business
uses all of its assets to produce sales
Decision Criteria
Higher ratio is
better
Accounts
receivable
turnover
Measures the frequency with which
receivables are converted to cash
Inventory
turnover
Indicates how quickly inventory is
sold and thus the relative efficiency
of both the sales and purchasing
functions
Similar to inventory turnover, but
easier to understand
Higher turnover
provides faster
access to cash
that can be used
in the business
Higher turnover
is preferred
Average
holding
period
Days
payable
Collection
ratio (“days
receivable”)
Measures the speed at which the
company is paying bills
Measures the quality of the accounts
receivable; the average number of
days it takes to collect receivables
Formula
Net Sales Revenue
Average total assets
[Beginning assets-Ending
assets]/2
Net Credit Sales
Average Net Accounts
Receivable
Cost of Goods Sold
Average Merchandise
Inventory
Shorter period is
preferred
365 days
Inventory turnover ratio
Ideally, it is best
to wait as long as
possible to pay
bills, without
negatively
affecting product
service or
shipments from
suppliers
Lower ratio is
preferred, but
may vary
seasonally
Accounts Payable
(Cost of Goods Sold/365)
Accounts Receivable
(Revenue/365)
Profitability Ratios: Measures management effectiveness in creating wealth from sales and from
invested funds
Ratio Name
Gross
margin
Net
Operating
Income
Profit
Interpretation
Measures the percentage of sales
revenue available to pay operating
costs and to provide profits after
paying for inventory
Measures income generated from
operations without regard to the
company’s financing and taxes
Measures management’s
Decision Criteria
Higher ratio is
preferred
Lower ratio is
preferred
Higher ratio is
Formula
Gross Margin
Sales Revenue
Sales Expenses [not
including interest]
Sales
Net Income
margin, also
called return
on sales
(ROS)
Return on
equity
effectiveness in managing all costs
relative to sales
preferred
Measures management’s
effectiveness in using investor funds
to provide profits
Higher ratio is
preferred
Return on
assets
Measures management’s
effectiveness in using the assets of
the business to provide profits
Measures management’s
effectiveness in using the invested
capital of the business to provide
profits
Measures profitability per share
investment
Higher ratio is
preferred
Net Income – Preferred
Stock Dividends Declared
Average Common
Stockholders’ Equity
Net Income
Average Total Assets
Higher ratio is
preferred
Net Income
Average Investment
Return on
investments
(ROI)
Earnings per
share
Examined over
time; increasing
trend is preferred
Sales Revenue
Net Income – Preferred
Stock Dividends Declared
Weighted Average Common
Stock Outstanding
Valuation Ratio: Measures returns to investors
Ratio Name
Interpretation
Price/earnings Measures the price
(P/E) ratio
that investors are
willing to pay for a
company’s stock for
each dollar of the
company’s earnings
Decision Criteria
Higher ratio means investors expect higher
earnings growth in the future compared to
other companies with lower P/E. Useful to
compare ratios between companies in the
same industry, to the market in general, or
to the company’s historical P/E.
Formula
Price of Stock
Earnings per share
Cash Flow Ratios: Measures a company’s cash position
Ratio Name
Cash flow
cycle
Cash flow
debt
coverage
ratio
Interpretation
Measures the number of days it takes
to convert inventory and receivables
into cash
Measures whether a company can
meet its debt service requirements
Decision Criteria
Formula
(Receivables + Inventory)
Cost of Goods Sold
A 1.25-to-1 ratio
minimum should
be targeted
EBITDA [Earnings before
interest, taxes, depreciation,
and amortization]
(Interest + principle due on
debt)
Liquidity Ratios: Measures the business’s ability to pay debts and expenses that are due in the current
accounting period
Ratio Name
Current ratio
Acid test or
Quick ratio
Interpretation
Measures how much money can be
made available to pay obligations
within the fiscal year
Measures how much money can be
made available very quickly to pay
obligations within the fiscal year
Decision Criteria
Higher ratio is
preferred
Formula
Current Assets
Current Liabilities
Higher ratio is
preferred
Current Assets – (Inventories
+ Prepaid Assets)
Current Liabilities
Leverage Ratios: Measures that indicate the relative risk that a business setback could cause bankruptcy
Ratio Name
Debt to
assets ratio
Interpretation
Measures the extent to which the
business can meet its obligations for
the long haul
Debt to
equity ratio
Measures the extent to which the
business can meet its obligations for
the long haul
Times
earned
interest
Measures the risk of being forced
into bankruptcy for not meeting
required interest payments
Decision Criteria
Lower ratio
indicates greater
solvency, greater
ratio indicates
increased
business risk
Lower ratio
indicates greater
solvency, greater
ratio indicates
increased
business risk
Higher is
preferred
Formula
Total Liabilities
Total Assets
Total Liabilities
Total Owners’ Equity
Operating Income before
Interest and Income Tax
Interest Expense
Sources (all): Entrepreneurial Finance McGraw-Hill/University of Central Florida
Appendix B: Legal Forms of Business
Definition
Pros and
Cons
Tax
Implications
Sole Proprietorship
An unincorporated business with one owner. Not a separate entity.
Pros:
Cons:
Simple to form, operate, and
Limited Capital
dissolve
Difficult to obtain credit Limited skills of management
Owner keeps all profits
and employees
Freedom of control
Unlimited personal liability for the company’s debts
Secrecy
Business has a limited life, because the business and the
Tax Advantages
owner are one in the same.
Because the business and the owner are the same entity, all profits of the business flow
through into the owner’s personal income. For tax purposes, the income of the business
becomes the income of the owner. This can provide an advantage, as the tax structure
for other types of business is not as favorable as the structure for personal income tax.
Definition
Pros and
Cons
Tax
Implications
Definition
Pros and
Cons
Tax
Implications
General Partnership
Two or more persons carrying on a business for profit. Not a separate entity, but rather
the aggregate of all the partners.
Pros:
Cons:
Simple to form
Limited life
Ability to divide labor and
Unlimited personal liability for the company’s debts
management responsibility
(personal assets are liable to the partnership’s
Collaboration of ideas and
obligations)
plans from all members
Each partner is jointly and severally liable for the actions
Access to the skills of all the
of the other partner(s), and a partner cannot obtain
members
bonding protection against the acts of the other
Greater chance at obtaining partner(s)
capital over a sole
Risk of an impasse forming when partners do not agree
proprietorship
Death of any one partner terminates the partnership
More sources of personal
capital
As in a sole proprietorship, the business income flows through to the owners and
becomes personal income of the owners for tax purposes. This retains the same tax
advantage of a sole proprietorship. Unless the partnership agreement states otherwise,
partners have a right to share equally in all distributions of profits; i.e., 4 partners, each
get 25%.
Corporation (C-Corporation)
A legal business entity that is separate and distinct from its owner(s). A corporation has
many of the rights and responsibilities that an individual would have (i.e., can enter into
contracts, loan and borrow money, sue and be sued, own assets, pay taxes, etc.) The
corporation is created (incorporated) by its shareholders—owners who are represented
by their shares of stock in the company. The shareholders elect a board of directors, who
then appoint and oversee management of the company.
Pros:
Cons:
Can have representative management
Perceived as impersonal
Ease of raising large amounts of capital
Owners have limited interest/control over
Separate and distinct from its owners as
the company’s activities
individuals
High incorporation fees in some states
Can be permanent in existence, as the loss
Double income taxation (see below)
of a shareholder does not affect the life of
Government requirements for procedures
the corporation
and extensive financial reports and
Owners’ personal liability for the company’s statements
debt is limited to the amount of their
The charter limits the corporation’s
investment
powers, limiting the ability to do business
in other states
A C-Corporation is subject to what is called “double taxation”. When the company earns
profits, they are taxed at the corporation level (at high corporate tax rates). The profits
left over may be disbursed to the shareholders in the form of dividends. Then, these
dividends are again taxed at the individual level as the personal income of each
shareholder.
Definition
Pros and Cons
(as compared to
a C-Corporation)
Tax Implications
Subchapter S Corporation (S-Corporation)
A type corporation that has acquired a special status to be taxed under Subchapter S
of the IRS Code. With certain limitations, this type of corporation is able to benefit
from the same limited liability as a C-Corporation, but is taxed more favorably like a
partnership.
Pros:
Cons:
Can maintain corporate structure
Numerous restrictions limit the
Owners’ personal liability for the company’s
number of businesses that can
debt is limited to the amount of their
qualify
investment
Must be a domestic company
Taxed like a partnership—profits flow through
Can only have one class of stock
to the owners as personal income without
(common stock)
being taxed first on the corporation level
A maximum of 100 shareholders is
required, and these shareholders
must be domestic
Shareholders must be individuals,
estates, or in some cases, trusts
Shareholders cannot be other
corporations or partnerships
Unlike a C-Corporation, profits of the business are not taxed at the corporate level
first. Profits “flow through” to the shareholders and appear as personal income of
the individual shareholders. Income is taxed only once at the shareholder level, thus
avoiding the “double taxation” problem of C-Corporations.
Pros and
Cons
Limited Liability Partnership (LLP)
A business (not a separate entity) with two or more partners, in which at least one of the
partners does not have unlimited personal liability—they are limited partners and are
liable only to the extent of their investment. Limited partners do not receive dividends,
but enjoy direct access to the flow of income and expenses. The limited partnership
interests are treated as “securities” like corporate stock when it comes to federal
regulation purposes.
Pros:
Cons:
Owners that are limited partners do not have
Limited partners do not have the right
unlimited personal liability for the business’s
to participate in management
debts
General partners are personally liable
Limited partners can assign, buy, or sell their
for the business’s debts and losses
interest in the company without dissolving the
partnership
Loss of a limited partner will not dissolve the
company
Tax
Implications
As in a general partnership, the business income flows through to the owners and
becomes personal income of the owners for tax purposes. This allows for single taxation
Definition
at the individual partners’ tax rates. A limited partnership does, however, have to file an
informational return with the IRS. Additionally, unless the partnership agreement states
otherwise, both general and limited partners share in the profits of the business based
on the proportion of their capital contribution, unlike a general partnership.
Definition
Pros and
Cons
Dissolution
Tax
Implications
Limited Liability Company (LLC)
A business entity that is a “hybrid” of a C-Corporation and a partnership—similar to an SCorporation.
Pros:
Cons:
Provides all of the benefits of an S-Corporation (limited
Members cannot sell their
liability for owners—called “members”—and only single
interest without the
taxation) but without all of the restrictions placed on Sconsent of all other
Corporations
members
All members may participate in management (“member
managed”), or can choose to centralize management
(“manager managed”)
The rules for dissolution can be perceived as both pros and cons. An LLC will dissolve if:
a. All members consent,
b. Expiration of any stated period of duration,
c. The death, incapacitation, retirement, resignation, or bankruptcy of any
member, UNLESS the remaining members vote to continue,
d. Or, in some states, when only one member remains.
Taxed like an S-Corporation or a Limited Liability Partnership, the business’s profits flow
through to the individual members and become their personal income, avoiding double
taxation. Like the limited liability partnership, unless the agreement states otherwise,
profits and losses of the business are allocated based on the proportion of the members’
capital contributions.