Activity Ratio

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What it is:
An activity ratio is a metric which determines the ability of a company to convert its balance
sheet accounts into revenue.

How it works (Example):

Activity ratios assess how effectively a company is able to generate revenue in the form of cash
and sales based on its asset, liability and capital share accounts. Examples of such ratios include
the inventory turnover ratio and the accounts receivable turnover ratio.

Why it Matters:
Activity ratios are critical in evaluating a company's fundamentals because, in addition to
expressing how well a company generates revenue, activity ratios also indicate how well the
company is being managed.

Asset Turnover Ratio

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What it is:
The asset turnover ratio is a measure of how efficiently a company's assets generate revenue. It
measures the number of dollars of revenue generated by one dollar of the company's assets.

How it works (Example):

The formula for the asset turnover ratio is: Revenue / Average Total Assets

Let's look at an example using the following hypothetical information for Company ABC:
Revenue is found on the income statement, and total assets are found on the balance sheet.

Using the asset turnover ratio formula and the information above, we can calculate that Company
ABC's asset turnover ratio this year was:

$1,500,000 / [($975,000 + $1,140,000)/2] = 1.418

#-ad_banner-#This means that for every dollar of Company ABC's assets, Company ABC
generated $1.42 in revenue.

It is important to understand that the age of a company's assets can lead to different asset
turnover ratios for similar companies. A company with older assets (which have higher
accumulated depreciation and hence lower book values) might have a higher asset turnover ratio
than a company with the same revenues but newer, higher-book value assets.

Why it Matters:
In general, a low asset turnover ratio suggests problems with excess production capacity, poor
inventory management, or lax collection methods. Increases in the asset turnover ratio over time
may indicate a company is "growing into" its capacity (while a decreasing ratio may indicate the
opposite), but remember that asset purchases made in anticipation of coming growth (or the sale
of unnecessary assets in anticipation of declining growth) can suddenly and somewhat artificially
change a company's asset turnover ratio.

Low-margin industries tend to have higher asset turnover ratios than high-margin industries
because low-margin industries must offset lower per-unit profits with higher unit-sales volume.
Additionally, capital-intensive companies will typically have lower asset turnover ratios than
companies using fewer assets. This is why comparison of asset turnover ratios is generally most
meaningful among companies within the same industry, and the definition of a "high" or "low"
ratio should be made within this context.

Current Ratio
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What it is:
The current ratio is the ratio of current assets to current liabilities.

How it works (Example):

The current ratio is a commonly used liquidity ratio that measures a company's ability to pay its
current liabilities with its current assets.

Current Ratio = Current Assets / Current Liabilities

For an example of how to calculate the current ratio, let's look at the balance sheet for Company
XYZ:

Balance Sheet for Company XYZ

Year ending December 31, 2009

Assets
Cash 1,000
Accounts Receivable 500
Inventory 500
Total Current Assets 2,000

Liabilities
Accounts Payable 500
Current Long-Term Debt 500
Total Current Liabilities 1,000

Long Term Debt 500

Total Liabilities 1,500

Owners' Equity 500

We can calculate Company XYZ's current ratio as: 2,000 / 1,000 = 2.0

As of the end of 2009, Company XYZ had $2.00 in current assets for every dollar of current
liabilities. The company appears to be able to easily service its short-term debt obligations.

Why it Matters:
Tracking the current ratio and other liquidity ratios helps an investor assess the health of a
company.
A high current ratio indicates that a company is able to meet its short-term obligations. In the
example above, if all of XYZ's current liabilities came due on January 1, 2010, XYZ would be
able to meet those obligations with cash.

Generally, a low current ratio could suggest problems with inventory management, ineffective or
lax standards for collecting receivables, or an excessive cash burn rate. Increases in the current
ratio over time may indicate a company is "growing into" its capacity (while a decreasing ratio
may indicate the opposite). But remember that big purchases made in preparation for coming
growth (or the sale of unnecessary assets) can suddenly and somewhat artificially change a
company's current ratio.

A common but often misleading rule of thumb is that a 2:1 ratio means a company is "in good
shape." Comparison of current ratios is generally most meaningful among companies within the
same industry, and the definition of a "high" or "low" ratio should be made within this context.

Debt-to-Equity Ratio
What it is:
The debt-to-equity ratio is a measure of the relationship between the capital contributed by
creditors and the capital contributed by shareholders. It also shows the extent to which
shareholders' equity can fulfill a company's obligations to creditors in the event of a liquidation.

Here is the debt-to-equity ratio formula:

Debt-to-Equity Ratio = Total Debt / Total Equity

Let's look at an example. Here is some information about Company XYZ:

Using the debt-to-equity formula and the information above, we can calculate that Company
XYZ's debt-to-equity ratio is:

$15,000,000 / $10,000,000 = 1.5 times, or 150%

This means that for every dollar of Company XYZ owned by the shareholders, Company XYZ
owes $1.50 to creditors.

It is important to note that there are many ways to calculate the debt-to-equity ratio, and
therefore it is important to be clear about what types of debt and equity are being used when
comparing debt-to-equity ratios.

For example, the analyst's definition of debt may or may not include all short-term and long-term
fixed obligations, including subordinated convertible debt, operating liabilities such as accounts
payable and accrued liabilities and leases, contractual obligations or other forms of financing that
may not appear on the balance sheet.

Additionally, some analysts may consider preferred stock as debt rather than equity in this
calculation, and some analysts also argue that deferred taxes should be considered in the debt
portion of the calculation because some forms of deferred taxes may never be paid and are thus
part of a company's capital base.

Why it Matters:
In general, a high debt-to-equity ratio indicates that a company may not be able to generate
enough cash to satisfy its debt obligations. However, low debt-to-equity ratios may also indicate
that a company is not taking advantage of the increased profits that financial leverage may bring.

Capital-intensive industries tend to have higher debt-to-equity ratios than low-capital industries
because capital-intensive industries must purchase more property, plants and equipment to
operate. This is why comparison of debt-to-equity ratios is generally most meaningful among
companies within the same industry, and the definition of a "high" or "low" ratio should be made
within this context.

Lenders and investors usually prefer low debt-to-equity ratios because their interests are better
protected in the event of a business decline. Thus, firms with high debt-to-equity ratios may not
be able to attract additional capital.

Dividend Payout Ratio

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What it is:
The dividend payout ratio measures the percentage of a company's net income that is given to
shareholders in the form of dividends.

How it works (Example):

The dividend payout ratio is a relatively simple calculation:

Total Annual Dividends Per Share / Diluted Earnings Per Share

For example, let's assume that Company XYZ distributed four regular quarterly dividend
payments of $0.25 each, for a total annual dividend payment of $1.00 per share. Over the same
period, XYZ reported net earnings of $10 per share. Using the formula above, Company XYZ's
dividend payout ratio is:

$1 / $10 = 10%

In other words, Company XYZ distributed 10% of its net income as dividends last year and
retained the remaining 90% for other operating needs.

Why it Matters:
While some investors prefer that a company reinvest its earnings back into the business to fuel
future growth, many appreciate a generous cash dividend payment -- particularly since tax
legislation enacted in 2003 has given dividends a tax-advantaged status. However, this
legislation is set to expire in 2011, and dividend taxation rates will return to their pre-2001
levels.

For income-oriented investors, the dividend payout ratio is a closely-watched financial measure.
Dividend payout ratios provide valuable insight into a company's dividend policy and can also
reveal whether those payments appear "safe" or are in jeopardy of possibly being reduced. In the
example of XYZ above, a ratio of 10% means that shareholders are only receiving a dime for
every dollar the company is earning. In this case, the company is generating ample profits to
support this relatively modest payment. In fact, if management considered it in the best interests
of the company, it could probably afford to raise its dividend payment significantly.

On the other hand, an excessively high payout ratio suggests that the company might be paying
out more than it can comfortably afford. Not only does this leave just a small percentage of
profits to plow back into the business, but it also leaves the firm highly susceptible to a decline in
future dividend payments. In some cases, a company will even pay out more than it earns, thus
yielding a dividend payout ratio in excess of 100%. Such extremely high payouts are rarely
sustainable and should warn investors that a dividend cut may be on the horizon. Because the act
of reducing dividends is usually interpreted as a sign of weakness, when a dividend cut
announcement is made, it also usually triggers a decline in the share price. Even if management
finds a way to maintain an extremely high dividend payout ratio for an extended period of time,
this strategy usually results in either a dwindling cash position or a rising debt load.

It should be noted, also, that dividend payout ratios can be impacted by a number of factors. For
example, different accounting methods yield different earnings per share figures, which in turn
influence the ratio. Furthermore, businesses in different growth stages can be expected to have
different dividend policies. Young, fast-growing companies are typically focused on reinvesting
earnings in order to grow the business. As such, they generally sport low (or even zero) dividend
payout ratios. At the same time, larger, more-established companies can usually afford to return
a larger percentage of earnings to stockholders.

When comparing dividend payout ratios, you should also remember that they will vary widely
according to industry. For example, where many high-tech sectors often distribute small or non-
existent dividends, banks and utilities typically pay out a healthy chunk of their gains each year.
Also, companies operating in some industries -- such as real estate investment trusts (REITs) --
are required by law to distribute a certain percentage of earnings (this figure now sits at 90% for
REITs). For this reason, it can be misleading to compare the ratios of companies operating in
different industries. When applied correctly, though, dividend payout ratios can be a powerful
analytical tool.

DuPont Analysis

What it is:
DuPont analysis examines the return on equity (ROE) analyzing profit margin, total asset
turnover, and financial leverage. It was created by the DuPont Corporation in the 1920s.
How it works (Example):
The DuPont analysis is also referred to as the DuPont identity.

In a DuPont analysis, the formula for ROE is:

ROE = Profit Margin x Total Asset Turnover x Leverage Factor

The formula breaks down further to:

ROE = (Net Income/Revenues) x (Revenues/Total Assets) x (Total Assets/ Shareholders'

Equity)

For example, let's consider the following information for Company XYZ:

Using the formula above, we can calculate that Company XYZ's ROE is:

ROE = ($2,000/$10,000) x ($10,000/$25,000) x ($25,000/$5,000) = 0.20 x 0.40 x 5 = 0.40 or

40%

The DuPont analysis analyzes the numbers shown in profit margin ($2,000/$10,000), total asset
turnover ($10,000/$25,000) and leverage factor ($25,000/$5,000) to find Company XYZ's ROE.

Why it Matters:
The DuPont Analysis is important determines what is driving a company's ROE; Profit margin
shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor
shows how much leverage is being used.

The method goes beyond profit margin to understand how efficiently a company's assets
generate sales or cash and how well a company uses debt to produce incremental returns.

Using these three factors, a DuPont analysis allows analysts to dissect a company, efficiently
determine where the company is weak and strong and quickly know what areas of the business to
look at (i.e., inventory management, debt structure, margins) for more answers. The measure is
still broad, however, and is not a substitute for detailed analysis.

The DuPont analysis looks uses both the income statement as well as the balance sheet to
perform the examination. As a result, major asset purchases, acquisitions, or other significant
changes can distort the ROE calculation. Many analysts use average assets and shareholders'
equity to mitigate this distortion, although that approach assumes the balance sheet changes
occurred steadily over the course of the year, which may not be accurate either.

DuPont Identity
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What it is:
The DuPont identity breaks down return on equity (ROE) into its components -- profit margin,
total asset turnover, and financial leverage -- so that each one can be examined in depth.

How it works (Example):

The DuPont identity is also referred to as DuPont analysis.

Before we use the DuPont identity, the basic formula for ROE is:

ROE = Profit Margin x Asset Turnover x Leverage Factor

The Dupont identity breaks ROE down further:

ROE = (Net Income/Revenues) x (Revenues/Total Assets) x (Total Assets/ Shareholders'

Equity)

For example, let's consider the following information for Company XYZ:
Using the formula above, we can calculate that Company XYZ's ROE is:

ROE = ($2,000/$10,000) x ($10,000/$25,000) x ($25,000/$5,000) = 0.20 x 0.40 x 5 = 0.40 or

40%

The DuPont identity analyzes the numbers shown in profit margin ($2,000/$10,000), asset
turnover ($10,000/$25,000) and leverage factor ($25,000/$5,000) to find Company XYZ's ROE.

Why it Matters:
The DuPont Identity is important because it helps an analyst understand what is driving a
company's ROE; profit margin is a reflection of operating efficiency; asset turnover is a
reflection of the efficient use of assets; and leverage shows how much a firm relies on debt to
drive profitability.

The method recognizes that in addition to profitability, it is also important to understand how
efficiently a company's assets generate sales or cash and how well a company uses debt to
produce incremental returns.

Using these three factors, a DuPont identity allows analysts to dissect a company, efficiently
determine where the company is weak and strong and quickly know what areas of the business to
look at (i.e., inventory management, debt structure, margins) for more answers. The measure is
still broad, however, and is not a substitute for detailed analysis.

It is important to note that DuPont identities use both balance sheet measures (which are
calculated at a fixed point in time) and income statement measures (which encompass an interval
of time). As a result, major asset purchases, acquisitions, or other significant changes can distort
the ROE calculation. Many analysts use average assets and shareholders' equity to mitigate this
distortion, although that approach assumes the balance sheet changes occurred steadily over the
course of the year, which may not be accurate either.

Acid-Test Ratio
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What it is:
The acid-test ratio is a measure of how well a company can meet its short-term financial
liabilities.

How it works (Example):

Also known as the quick ratio, the acid-test ratio can be calculated as follows:
Acid-Test Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

A common alternative formula is:

Acid-Test Ratio = (Current assets – Inventory) / Current Liabilities

The acid-test ratio is a more conservative version of another well-known liquidity metric -- the
current ratio. Although the two are similar, the Acid-Test ratio provides a more rigorous
assessment of a company's ability to pay its current liabilities. It does this by eliminating all but
the most liquid of current assets from consideration. Inventory is the most notable exclusion,
because it is not as rapidly convertible to cash and is often sold on credit. Some analysts include
inventory in the ratio, though, if it is more liquid than certain receivables.

To demonstrate, let's assume this information was pulled from the balance sheet of our
theoretical firm -- Company XYZ:

Cash $60,000 Accounts Payable $30,000

Marketable Securities $10,000 Accrued Expenses $20,000

Accounts Receivable $40,000 Notes Payable $5,000

Inventory $50,000 Current Portion of Long-Term Debt $10,000

Total Current Assets $160,000 Total Current Liabilities $65,000

Using the primary quick ratio formula and the information above, we can calculate Company
XYZ's Acid-Test ratio as follows:

($60,000 + $10,000 + $40,000) / $65,000 = 1.7

This means that for every dollar of Company XYZ's current liabilities, the firm has $1.70 of very
liquid assets to cover those immediate obligations.

Why it Matters:
Obviously, it is vital that a company have enough cash on hand to meet accounts payable,
interest expenses, and other bills when they become due. The higher the ratio, the more
financially secure a company is in the short term. A common rule of thumb is that companies
with a Acid-Test or quick ratio of greater than 1.0 are sufficiently able to meet their short-term
liabilities.

In general, low or decreasing acid- test ratios generally suggest that a company is over-leveraged,
struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too
slowly. On the other hand, a high or increasing acid-test ratio generally indicates that a company
is experiencing solid top-line growth, quickly converting receivables into cash, and easily able to
cover its financial obligations. Such companies often have faster inventory turnover and cash
conversion cycles.

Like most other measures, acid-test ratio does have its potential drawbacks. To begin, analysts
commonly point out that it provides no information about the level and timing of cash flows,
which are what really determine a company's ability to pay liabilities when due. The acid-
test ratio also assumes that accounts receivable are readily available for collection, which may
not be the case for many companies. Finally, the formula assumes that a company would
liquidate its current assets to pay current liabilities, which is not always realistic, considering
some level of working capital is needed to maintain operations.

It is also important to understand that the timing of asset purchases, payment and collection
policies, allowances for bad debt, and even capital-raising efforts can all impact the calculation
and can result in different acid-test ratios for similar companies. Capital needs that vary from
industry to industry can also have an effect on acid-test ratios. For these reasons, liquidity
comparisons are generally most meaningful among companies within the same industry.

Debt Ratio
What it is:

 Financial Dictionary
 Calculators
 Articles

Debt Ratio
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What it is:
A debt ratio is simply a company's total debt divided by its total assets.

How it works (Example):

The formula for the debt ratio is:
Debt Ratio = Total Debt / Total Assets

For example, if Company XYZ had $10 million of debt on its balance sheet and $15 million of
assets, then Company XYZ's debt ratio is:

Debt Ratio = $10,000,000 / $15,000,000 = 0.67 or 67%

This means that for every dollar of Company XYZ assets, Company XYZ had $0.67 of debt. A
ratio above 1.0 indicates that the company has more debt than assets.

Why it Matters:
The debt ratio quantifies how leveraged a company is, and a company's degree of leverage is
often a measure of risk. When the debt ratio is high, the company has a lot of debt relative to its
assets. It is thus carrying a bigger burden in the sense that principal and interest payments take a
significant amount of the company's cash flows, and a hiccup in financial performance or a rise
in interest rates could result in default.

When the debt ratio is low, principal and interest payments don't command such a large portion
of the company's cash flows, and the company is not as sensitive to changes in business or
interest rates from this perspective. However, a low debt ratio may also indicate that the
company has an opportunity to use leverage as a means of responsibly growing the business that
it is not taking advantage of.

http://www.investinganswers.com/financial-dictionary/ratio-analysis

http://www.myaccountingcourse.com/financial-ratios/debt-to-equity-ratio

http://accssountingexplained.com/financial/ratios/net-profit-margin