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Ratios or Other Mesurements Method of Computation

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Formula for ratio


Ratios or other mesurements Method of computation
1. Current ratio Current assets Current liabilities
2. Quick ratio Quick assets Current liabilities
3. Working capital Current assets Current liabilities
4. Net cash provided by operating
activities
Appears in the statement of cash flow
5. Cash flow from operations to current
liabilities
Cash flow from operating activities
current liabilities
6. Receivable turnover rate Net sales average accounts receivable
7. Days to collect accounts receivable 365 days receivable turnover rate
8. Inventory turnover rate Cost of good sold average inventory
9. Days to sell the average inventory 365 days inventory turnover rate
10. Free cash flow Net cash from operating activities
cash used for investing activities and dividends
11. Debt ratio Total liabilities total assets
12. Interest coverage ratio Income before interest and taxes(profit of
operating)
annual interest expense
13. Operating expense ratio Operating expense net sales(sales of good)
14. Operating income Gross profit
operating expense(profit of operating)
15. Net income as a percentage of net
sales
Net income net sales
16. Earning per share (Net income preferred dividends)
(average number of common shares outstanding)
17. Return on assets Operating income average total assets
18. Return on common stockholders
equity
(Net income preferred dividends)
(average common stockholders equity)
19. Price-earning ratio Current stock price earning per share
20. Dividend yield Annual dividend current stock price
21. Book value per share Common stockholders equity
shares of common stock outstanding

Financial Ratio Analysis
It is difficult to infer organizational performance from one or two simple
numbers. Nevertheless, in practice a number of different ratios are often calculated
in strategic planning endeavors and, taken as a whole and with some caution, these
ratios do provide some information about the relative performance of an
organization. In particular, a careful analysis of a combination of these ratios may
help you to distinguish between firms that will eventually fail and those that will
continue to survive. Evidence suggests that, as early as five years before a firm
fails, one may be able to detect trouble from the value of these financial ratios.
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In this note, the basic financial ratios are reviewed, and some of the caveats
associated with using them are highlighted. The ratios tend to be most meaningful
when they are used to compare organizations within the same broad industry, or
when they are used to make inferences about changes in a particular organization's
structure over time.
LIQUIDITY RATIOS
In order to survive, firms must be able to meet their short-term obligationspay
their creditors and repay their short-term debts. Thus, the liquidity of the firm is
one measure of a firm's financial health. Two measures of liquidity are in common:
Current ratio = current assets / current liabilities
Quick ratio = (cash + marketable securities + net receivables) / current liabilities
The main difference between the current ratio and the quick ratio is that the
latter does not include inventories, while the former does.
Which ratio is a better measure of a firm's short-term position? In some
ways, the quick ratio is a more conservative standard. If the quick ratio is greater
than one, there would seem to be no danger that the firm would not be able to meet
its current obligations. If the quick ratio is less than one, but the current ratio is
considerably above one, the status of the firm is more complex. In this case, the
valuation of inventories and the inventory turnover are obviously critical.
A number of problems with inventory valuation can contaminate the
current ratio. An obvious accounting problem occurs because organizations value
inventories using either of two methods, last in, first out (LIFO) or first in, first out
(FIFO). Under the LIFO method, inventories are valued at their old costs. If the
organization has a substantial quantity of inventory, some of it may be carried at
relatively low cost, assuming some inflation in overall prices. On the other hand, if
there has been technical progress in a market and prices have been falling, the
LIFO method will lead to an overvalued inventory. Under the FIFO method of
inventory valuation, inventories are valued at close to their current replacement
cost. Clearly, if we have firms that differ in their accounting methods, and hold
substantial inventories, comparisons of current ratios will not be very helpful in
measuring their relative strength, unless accounting differences are adjusted for in
the computations.
A second problem with including inventories in the current ratio derives
from the difference between the inventory's accounting value, however calculated,
and its economic value. A simple example is a firm subject to business-cycle
fluctuations. For a firm of this sort, inventories will typically build during a
downturn. The posted market price for the inventoried product will often not fall
very much during this period; nevertheless, the firm finds it cannot sell very much
of its inventoried product at the so-called market price. The growing inventory is
carried at the posted price, but there really is no way that the firm could liquidate
that inventory in order to meet current obligations. Thus, including inventories in
current assets will tend to understate the precarious financial position of firms
suffering inventory buildup during downturns.
Might we then conclude that the quick ratio is always to be
preferred? Probably not. If we ignore inventories, firms with readily marketable
inventories, appropriately valued, will be undeservedly penalized. Clearly, some
judicious further investigation of the marketability of the inventories would be
helpful.
Low values for the current or quick ratios suggest that a firm may have
difficulty meeting current obligations. Low values, however, are not always
fatal. If an organization has good long-term prospects, it may be able to enter the
capital market and borrow against those prospects to meet current obligations. The
nature of the business itself might also allow it to operate with a current ratio less
than one. For example, in an operation like McDonald's, inventory turns over
much more rapidly than the accounts payable become due. This timing difference
can also allow a firm to operate with a low current ratio. Finally, to the extent that
the current and quick ratios are helpful indexes of a firm's financial health, they act
strictly as signals of trouble at extreme rates. Some liquidity is useful for an
organization, but a very high current ratio might suggest that the firm is sitting
around with a lot of cash because it lacks the managerial acumen to put those
resources to work. Very low liquidity, on the other hand, is also problematic.
LEVERAGE
Firms are financed by some combination o debt and equity. The right capital
structure will depend on tax policyhigh corporate rates favor debt, high personal
tax rates favor equityon bankruptcy costs, and on overall corporate risk. In
particular, if we are concerned about bankruptcy possibilities, the long-run
solvency or leverage of the firm may be important. There are two commonly used
measures of leverage, the debt-to-assets ratio and the debt-equity ratio;
Debt-to-asset ratio = total liabilities / total assets
Debt-equity ratio = long-term debt / shareholder's equity
As with liquidity measures, problems in measurement and interpretation
also occur in leverage measures. The central problem is that assets and equity are
typically measured in terms of the carrying (book) value in the firm's financial
statements. This figure, however, often has very little to do with the market value
of the firm, or the value that creditors could receive were the firm liquidated.
Debt-to-equity ratios vary considerably across industries, in large measure
due to other characteristics of the industry and its environment. A utility, for
example, which is a stable business, can comfortably operate with a relatively high
debt-equity ratio. A more cyclical business, like manufacturing of recreational
vehicles, typically needs a lower D/Ea reminder that cross-industry comparisons
of these ratios is typically not very helpful.
Often, analysts look at the debt-equity ratio to determine the ability of an
organization to generate new funds from the capital market. An organization with
considerable debt is often thought to have little new-financing capacity. Of course,
the overall financing capacity of an organization probably has as much to do with
the quality of the new product the organization wishes to pursue as with its
financial structure. Nevertheless, given the threat of bankruptcy and the attendant
costs, a very high debt-equity ratio may make future financing difficult. It has
been argued, for example, that railroads in the 1970s found it hard to find funds for
new investments in piggybacking, a large technical improvement in railroading,
because the threat of bankruptcy from prior poor investments was so high.
RATES OF RETURN
There are two measures of profitability common in the financial com-
munity, return on assets (ROA) and return on equity (ROE).
ROA = net income / total average assets
ROE = net income / total stockholders equity
Assets and equity, as used in these two common indexes, are both mea-
sured in terms of book value. Thus, if assets were acquired some time ago at a low
price, the current performance of the organization may be overstated by the use of
historically valued denominators. As a result, the accounting returns for any
investment generally do not correlate well with the true economic internal rate of
return for that investment.
Difficulties with using either ROA and ROE as a performance measure can
be seen in merger transactions. Suppose we have an organization that has been
earning a net income of $500 on assets with a book value of $1000, for a hefty
ROA of 50 percent. That organization is now acquired by a second firm, which
then moves the new assets onto its books at the acquisition price, assuming the
acquisition is treated using the purchase method of accounting. Of course, the
acquisition price will be considerably above the $1,000 book value of assets, for
the potential acquirer will have to pay handsomely for the privilege of earning
$500 on a regular basis. Suppose the acquirer pays $2,000 for the assets. After the
acquisition, it will appear that the returns of the acquired firm have fallen. The
firm continues to earn $500, but the asset base is now $2,000, so the ROA is
reduced to 25 percent. Indeed, the ROA may be less as a result of other factors,
such as increased depreciation of the newly acquired assets. Yet in fact nothing has
happened to the earnings of the firm. All that has changed is its accounting, not its
performance.
Another fundamental problem with ROA and ROE measures comes from
the tendency of analysts to focus on performance in single years, years that may be
idiosyncratic. At a minimum, one should examine these ratios averaging over a
number of years to isolate idiosyncratic returns and try to find patterns in the data.


STOCK MARKET RATIOS
Several ratios are calculated not from the income statements and balance sheets of
organizations, but from data associated with their stock market performance. The
three most common ratios are earnings per share(EPS), the price-earnings
ratio (P/E), and the dividend-yield ratio:
EPS = (net income - preferred dividends) /
common shares outstanding
P/E = market price per share / earnings per share
Dividend yield = annual dividends / price per share
EPS is one of the most widely used statistics. Indeed, it is required to be
given in the income statements of publicly traded firms. As we can see, the ratio
tells us how much the firm has earned per share of stock outstanding. As it turns
out, this is not generally a very helpful statistic. It says nothing about how many
assets a firm used to generate those earnings, and hence nothing about
profitability. Nor does it tell us how much the individual stockholder has paid per
share for the rights over that annual earning. Further, accounting practices in the
calculation of earnings may distort these ratios. And finally, the treatment of
inventories is again problematic.
The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily
newspapers. A high P/E tends to indicate that investors believe the future
prospects of the firm are better than its current performance. They are in some
sense paying more per share than the firm's current earnings warrant. Again,
earnings are treated differently in different accounting practices.
Finally, from the perspective of some stockholders at least, dividend policy
may be important. The dividend-yield ratio tells us how much of its earnings the
firm pays out in dividends versus reinvestment. Rapidly growing firms in new
areas tend to have low dividend-yield ratios; more mature firms tend to have higher
ratios.

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