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2.4.1 Liquidity Ratios
1. Current Ratio I Higher ratio = sufficient assets to cover its current obligations 7
Current Assets
Current Liabilities
245
The current ratio in 2008
4.1 times
60
The higher the ratio, the more protection the firm has against liquidity problems.
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However, the ratio may be distorted by seasonal influences, slow-moving
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inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.
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2. Quick Ratio (Acid-Test Ratio)
Current Assets - Inventory
Current Liabilities
245 130
The quick ratio in 2008
1.9 times
60
immediately extinguish its current liabilities.
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3. Cash Ratio
Cash
Current Liabilities
20
0.3 times
60
Very short-term creditor might be interested in this ratio.
The cash ratio in 2008
A company's ability to repay its short-term debt with cash or near-cash resources
-
2.4.2 Solvency Ratios
Solvency ratios generate insight into a
-term debt payment.
1. Total Debt Ratio
Total Liabilities
Total Assets
The total debt ratio in 2008
110
385
0.29
to
and long-term credit sources.
The lower the debt to asset ratio, the less risky the company.
. . .
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Another variation of this ratio is to measure the relative mix of funds provided by the owners
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and the creditors.
2. Debt-equity Ratio
Total Liabilities
Shareholders' Equity
The debt-equity ratio in 2008
110
275
0.4
3. Times Interest Earned Ratio
EBIT
Interest
extent
Inn )
SEIKI"{UTE
102
20.4 times
5
This ratio indicates the extent to which operating profits can decline without
-term debt.
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Times interest earned in 2008
4. Cash Coverage Ratio
EBIT Depreciation
Interest
102 10
22.4 times
5
at
This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.
Cash coverage in 2008
A calculation that determines a business's ability to pay off its liabilities with its existing cash.
2.4.3 Asset Management Ratios
Asset management ratios measure how a firm manages its investment and fixed assets. The
focus of these ratios is on the efficiency of the uses of the assets. That is, how good a firm
utilizes its assets.
1. Inventory Turnover
Cost of Goods Sold
Inventory
1, 004
7.7 times
130
The inventory turnover ratio indicates how fast inventory items move through a
business.
The inventory turnover in 2008
28
2.
365 days
Inventory Turnover
365
47 days
7.7
This ratio estimates the average length of time items spent in inventory.
3. Receivables Turnover
Sales
Net credit
Accounts Receivable
Average
The receivable turnover in 2008
1,506
15.9 times
95
Only credit sales should be used.
the credit sales.
4. Average Collection Period
365 days
Receivables Turnover
The average collection period in 2008
Average
365
15.9
23 days
5. Asset Turnover
Sales
Total Assets
1,506
3.9 times
385
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This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
High turnover rates suggest efficient asset management.
The asset turnover in 2008
,
29
2.4.4 Profitability Ratios
We look at profits in two ways. First, as a percentage of net sales; second, as a return on the
funds invested in the business.
1. Profit Margin
Net Income
Net Sales
I
1
The profit margin in 2008
50
1,506
3.3%
It measures the total operating and financial ability of management.
2. Return on Assets (ROA)
Net Income
Total Assets
50
13%
385
This ratio measures the return on total assets after recognition of taxes and
financing costs.
The ROA in 2008
3. Return on Equity (ROE)
Net Income
Total Equity
The ROE in 2008
50
18%
275
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financial leverage.
Value
2.4.5 Market Value Ratios
VS
Book value
The market value ratios are based on information on the market price of the stocks. These
measures can be calculated directly for publicly traded companies.
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1. Earnings Per Share (EPS)
Net Income
Shares Outstanding ← 4¥47 shares
The EPS in 2008
50
10
$5 per share
?
30
2. Price-Earnings Ratio (PE)
Price Per Share
Earnings Per Share
Assume the price for the stock of City Corporation is $40, the PE ratio
40
8 times
5
PE ratio measures how much investors are willing to pay per dollar of current
earnings.
Higher PEs are often taken to mean that the firm has significant prospects for
future growth.
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3. Price-Sales Ratio
a formula used to measure the total value that investors place
Price Per Share
on the company in comparison to the total revenue generated
by the business
Sales Per Share
Assume the price for the stock of City Corporation is $40, the price-sales ratio
40
0.27 times
150.6
Price-Sales ratio can be used when the firm reported negative earnings for the
low price to sales ratios are more appealing because they suggest that a
period.
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4. Market-to-Book Ratio (MB)
Market Value Per Share
Book Value Per Share
40
1.45 times
27.5
Note that book value per share is total equity divided by the number of shares
outstanding.
A value less than 1 could mean that the firm has not been successful overall in
creating value for its shareholders.
The MB ratio in 2008
31
2.4.6 Linking Ratios
financial ratios.
1. ROA
Profit Margin Asset Turnover = ROA
Net Income
Sales
Net Income
Sales
Total Assets Total Assets
3.3% 3.9 13%
This formula indicates that the return on assets is closely related to the
profitability and turnover.
2. ROE (Du Pont Identity)
Profit Margin Asset Turnover Equity Multiplier = ROE
Net Income
Sales
Total Assets Net Income
Sales
Total Assets Total Equity Total Equity
3.3% 3.9 1.4 18%
Du Pont identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.
2.4.7 Managerial Implications
So far, we have looked at the five major types of financial ratios. As a CFO, you would
interpret
A simple way to analyze the overall picture is to group the ratios into a matrix. For example:
Liquidity / Solvency
Liquid / Solvent
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