Liquidity measures
1) Current ratio- indicates a company’s ability to satisfy its current liabilities with its
current assets; a healthy current ratio is greater than 2
a. it is a measure of short-term liquidity
b. the unit of measurement is either dollars or times
c. the higher the current ratio, the better to a creditor such as a supplier
d. to the firm, a high current ratio indicates liquidity but it also may indicate an
inefficient use of cash and other short-term assets
e. Interpretation: if current ratio = 1.31 times, we can say that:
i. for every $1 in current liabilities, the company has $1.31 in current
assets
ii. the company has $1.31 in current assets for every $1 in current
liabilities
iii. the company can pay its current liabilities from its current assets
1.31 times over
f. a current ratio of less than 1 would mean that net working capital (current
assets minus current liabilities) is negative
Current ratio =
Current assets
Current liabilities
g. improve by increasing current assets or reducing current liabilities
2) Quick ratio (or acid-test ratio)- indicates a company’s ability to satisfy current
liabilities with its most liquid assets
a. it is a measure of short-term liquidity
b. the unit of measurement is either dollars or times
c. Interpretation: if quick ratio = 0.59 times, we can say that:
i. for every $1 in current liabilities, the company has $0.59 in quick
assets
ii. the company has $0.59 in quick assets for every $1 in current
liabilities
iii. the company can pay its current liabilities from its quick assets 0.59
times over
Quick ratio = Current assets – Inventory
Current liabilities
3) Cash ratio- indicates a company’s ability to repay its current liabilities by only using
cash
a. it is a measure of short-term liquidity
b. the unit of measurement is either dollars or times
c. Interpretation: if cash ratio = 0.18 times, we can say that:
i. for every $1 in current liabilities, the company has $0.18 in cash
ii. the company has $0.18 in cash for every $1 in current liabilities
iii. the company can pay its current liabilities from its cash 0.18 times
over
Cash ratio =
Cash
Current liabilities
d. A cash ratio of 1.00 and above means that the business will be able to pay all
its current liabilities in immediate short term
e. Creditors usually prefer a high cash ratio, but, businesses usually do not plan
to keep their cash at level with their current liabilities because they can use
a portion of idle cash to generate profits. Therefore, a normal value of cash
ratio is somewhere below 1.00.
4) Net working capital to total assets – indicates a company’s ability to pay its short
term financial obligations
a. it is a measure of short-term liquidity
b. it is expressed as a percentage
c. Interpretation: a relatively low value might indicate relatively low levels of
liquidity (i.e., 4.7%)
d. an increasing net working capital to total assets ratio is usually a positive
sign, showing the company's liquidity is improving over time
e. a low or decreasing ratio indicates the company may have too many total
current liabilities, reducing the amount of working capital available
Net working capital to total assets =
Net working capital
Total assets
(Note: Net Working Capital = Current Assets – Current Liabilities)
5) Interval measure – used to determine the length of time a firm can continue
everyday business with using current assets in the event of a halt of cash inflow (i.e.,
company facing strike)
Interval measure =
Current assets
Average daily operating costs
=
Current assets
(COGS / 365)
Long-term solvency measures
1) Total Debt Ratio – indicates what proportion of debt a company has relative to its
assets
a. A low percentage means that the company is less dependent on leverage
(i.e., money borrowed from others)
b. The lower the percentage, the less leverage a company is using and the
stronger its equity position
c. Interpretation: if total debt ratio = .28 times, we can say that:
i. the company uses 28% debt and therefore, 72% equity
ii. there's $.72 in equity ($1-.28) for every $.28 in debt
iii. for every $1 in total assets, the company has $0.28 in debt
iv. the company has $0.28 in debt for every $1 in total assets
Total debt ratio =
Total assets – Total equity
Total assets
 Two useful variations on the total debt ratio:
o Debt-to-equity ratio = Total debt/Total equity
 indicates what proportion of equity and debt the company
is using to finance its assets
 A high debt-to-equity ratio generally means that a company
has been aggressive in financing its growth with debt
o
Equity multiplier= Total assets/Total equity
 a way of examining how a company uses debt to finance its
assets
 shows a company's total assets per dollar of stockholders'
equity
 a higher equity multiplier indicates higher financial leverage,
which means the company is relying more on debt to
finance its assets
2) Long-term debt ratio – shows the extent to which long-term debt are used for the
company' s permanent financing
a. determines how much a company's total capitalization is coming from its
long term debt
b. As the ratio gets higher, this means that a higher proportion of debt is used
for the permanent financing for the company as opposed to investor funds
(equity)
c. Interpretation: if long-term debt ratio = .15 times, we can say that:
i. for every $1 of the firm's total capitalization (long-term debt + total
equity), there is $.15 in long-term debt
Long-term debt ratio =
Long-term debt
Long-term debt + Total equity
3) Times interest earned ratio – measures how well a company has its interest
obligations covered
a. often called the interest coverage ratio
b. a higher value of times interest earned ratio is favorable meaning that the
company has a greater ability to repay its interest
c. In general, a times interest earned ratio of 1.5 or below is unsafe
d. A ratio of 1.00 means that earnings before interest and taxes (EBIT) of the
company is just enough to pay off its interest expense
e. Interpretation: if times interest earned ratio = 4.9 times, we can say that:
i. the interest bill is covered 4.9 times over
Times interest earned ratio =
EBIT
Interest
4) Cash coverage ratio – useful for determining the amount of cash available to pay for
interest
a. a problem with times interest earned ratio is that it is based on EBIT, which
is not really a measure of cash available to pay interest (because
depreciation, a noncash expense, has been deducted out)
b. Interpretation: if cash coverage ratio = 6.9 times, we can say that:
i. the interest bill is covered by cash 6.9 times over
Cash coverage ratio = EBIT + Depreciation
Interest
Asset management, or turnover, measures
1) Inventory turnover – indicates how many times inventory is created and sold during
the period
a. tells us how fast the company can sell its product
b. a low turnover implies poor sales and, therefore, excess inventory
c. as long as the company is not running out of stock, the higher this ratio, the
more efficiently inventory is being managed
d. Interpretation: if inventory turnover = 3.2 times, we can say that:
i. the firm sold off (or turned over) the entire inventory 3.2 times
Inventory turnover =
COGS
Inventory
 Days' sales in inventory – indicates how long it takes a company to
turn its inventory into sales
o generally, the lower (shorter) the DSI the better
o it is important to note that the average DSI varies from one industry
to another
o Interpretation: if days' sales in inventory = 114 days, we can say
that:
 inventory sits 114 days on average before it is sold
Days' sales in inventory =
365 days
Inventory turnover
2) Receivables turnover – indicates how fast the company collects on its sales
a. a high ratio implies either that a company operates on a cash basis or that
its extension of credit and collection of accounts receivable is efficient
b. a low ratio implies the company should re-assess its credit policies in order
to ensure the timely collection of imparted credit that is not earning interest
for the firm
c. Interpretation: if receivables turnover = 12.3 times, we can say that:
i. the company collects its outstanding credit accounts and reloans the
money 12.3 times during the year
Receivables turnover =
Sales
Accounts receivable
 Days' sales in receivables – the number of days of net sales that are tied up
in credit sales (accounts receivable) that haven’t been collected yet
o also known as the average collection period
o Interpretation: if days' sales in receivables = 30 days, we can say
that:
 on average, the company collects on its credit sales in 30
days
Days' sales in receivables =
365 days
Receivables turnover
3) NWC turnover – measures how much "work" the company gets out of its working
capital
a. provides some useful information as to how effectively a company is
using its working capital to generate sales
b. used to analyze the relationship between the money used to fund
operations and the sales generated from these operations
c. the higher the NWC turnover, the better because it means that the company
is generating a lot of sales compared to the money it uses to fund the sales
d. Interpretation: if NWC turnover = 13.8 times, we can say that:
i. for every $1 in net working capital, the company generates $13.8 in
sales
NWC turnover =
Sales
NWC
4) Fixed asset turnover – measures the company's efficiency at using its fixed assets to
generate sales
a. the higher the number the better
b. a higher fixed asset turnover ratio shows that the company has been more
effective in using the investment in fixed assets to generate revenues
c. Interpretation: if fixed asset turnover = 0.80 times, we can say that:
i. for every $1 in fixed assets, the company generates $.80 in sales
Fixed asset turnover =
Sales
Net fixed assets
5) Total asset turnover – measures the company's efficiency at using its total assets to
generate sales
a. the higher the number the better
b. a higher total asset turnover ratio shows that the company has been more
effective in using the investment in total assets to generate revenues
c. Interpretation: if total asset turnover = 0.64 times, we can say that:
i. for every $1 in total assets, the company generates $.64 in sales
Total asset turnover =
Sales
Total assets
Profitability measures
1) Profit margin – measures how much out of every dollar of sales a company actually
keeps in earnings
a. expressed as a percentage
b. a higher profit margin is better because it indicates a more profitable
company that has better control over its costs compared to its competitors
c. Interpretation: if profit margin = 15.7%, we can say that:
i. for every $1 in sales, the company generates $.157 in profit
Profit margin =
Net income
Sales
2) Return on Assets (ROA) – measures how efficient the company is at using its assets
to generate earnings
a. expressed as a percentage
b. the higher the ratio, the better, because the company is earning more
money on less investment
c. Interpretation: if ROA = 10.12%, we can say that:
i. for every $1 in total assets, the company generates $.1012 in profit
ROA =
Net income
Total assets
3) Return on Equity (ROE) – measures how efficient the company is at using its equity
to generate earnings
a. measures a company's profitability by revealing how much profit a company
generates with the money shareholders have invested
b. expressed as a percentage
c. the higher the ratio, the better, because the company is more efficient in
utilizing its equity base and the better return is to investors
d. Interpretation: if ROE = 14%, we can say that:
i. for every $1 in total equity, the company generates $.14 in profit
ROE =
Net income
Total equity
4) Du Pont Identity –
ROE = Profit margin x Total asset turnover x Equity multiplier
ROE = Net income x Sales x Assets
Sales
Assets Equity
Market Value Measures
1) Price-earnings (PE) ratio – a valuation ratio of a company's current share price
compared to its earnings per share
a. in general, a high PE ratio suggests that investors are expecting higher
earnings growth in the future compared to companies with a lower PE ratio
b. Interpretation: if PE ratio = 8 times, we can say that:
i. the company shares sell for 8 times earnings
ii. the company shares have or "carry" a PE multiple of 8
iii. investors are willing to pay $8 for every $1 of current earnings
PE ratio =
Price per share
Earnings per share
(Note: price per share is the same as market value per share)
EPS =
Net income
Shares outstanding
2) Price-sales ratio – A ratio for valuing a stock relative to its own past performance,
other companies or the market itself
a. as with PE ratios, whether a particular price-sales ratio is high or low
depends on the industry involved
b. Interpretation: if price-sales ratio = 1.26 times, we can say that:
i. the company shares sell for 1.26 times sales
ii. investors are willing to pay $1.26 for every $1 of sales
Price-sales ratio =
Price per share
Sales per share
3) Market-to-book ratio – compares the market value of the firm's investments to
their cost
a. Interpretation: a value of less than 1 could mean that the firm has not been
successful overall in creating value for its stockholders
Market-to-book ratio =
Market value per share
Book value per share
(Note: Book value per share = total equity/number of shares outstanding)