Financial Ratio Analysis

Quick Ratio

The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay
its current liabilities when they come due with only quick assets. Quick assets are current assets
that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-
term investments or marketable securities, and current accounts receivable are considered quick
assets. Short-term investments or marketable securities include trading securities and available for
sale securities that can easily be converted into cash within the next 90 days. Marketable securities
are traded on an open market with a known price and readily available buyers. Any stock on the
New York Stock Exchange would be considered a marketable security because they can easily be
sold to any investor when the market is open. The quick ratio is often called the acid test ratio in
reference to the historical use of acid to test metals for gold by the early miners. If the metal passed
the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base
metal and of no value. The acid test of finance shows how well a company can quickly convert
its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets
to current liabilities.

Formula: The quick ratio is calculated by adding cash, cash equivalents, short-term investments,
and current receivables together then dividing them by current liabilities.

Sometimes company financial statements don’t give a breakdown of quick assets on the balance
sheet. In this case, you can still calculate the quick ratio even if some of the quick asset totals are
unknown. Simply subtract inventory and any current prepaid assets from the current asset total
for the numerator. Here is an example.

The acid test ratio measures the liquidity of a company by showing its ability to pay off its current
liabilities with quick assets. If a firm has enough quick assets to cover its total current liabilities,
the firm will be able to pay off its obligations without having to sell off any long-term or capital
assets. Since most businesses use their long-term assets to generate revenues, selling off these
capital assets will not only hurt the company it will also show investors that current operations
aren’t making enough profits to pay off current liabilities. Higher quick ratios are more favorable
for companies because it shows there are more quick assets than current liabilities. A company
with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the
company could pay off its current liabilities without selling any long-term assets. An acid ratio of
2 shows that the company has twice as many quick assets than current liabilities. Obviously, as the
ratio increases so does the liquidity of the company. More assets will be easily converted into cash
if need be. This is a good sign for investors, but an even better sign to creditors because creditors
want to know they will be paid back on time.

Example: Let’s assume Carole’s Clothing Store is applying for a loan to remodel the storefront.
The bank asks Carole for a detailed balance sheet, so it can compute the quick ratio. Carole’s
balance sheet included the following accounts:

 Cash: $10,000
 Accounts Receivable: $5,000
 Inventory: $5,000
 Stock Investments: $1,000
 Prepaid taxes: $500
 Current Liabilities: $15,000

The bank can compute Carole’s quick ratio like this.

As you can see Carole’s quick ratio is 1.07. This means that Carole can pay off all of her current
liabilities with quick assets and still have some quick assets left over. Now let’s assume the same
scenario except Carole did not provide the bank with a detailed balance sheet. Instead Carole’s
balance sheet only included these accounts:

 Inventory: $5,000
 Prepaid taxes: $500
 Total Current Assets: $21,500
 Current Liabilities: $15,000

Since Carole’s balance sheet doesn’t include the breakdown of quick assets, the bank can
compute her quick ratio like this:
Current Ratio: The current ratio is a liquidity and efficiency ratio that measures a firm’s ability
to pay off its short-term liabilities with its current assets. The current ratio is an important measure
of liquidity because short-term liabilities are due within the next year. This means that a company
has a limited amount of time in order to raise the funds to pay for these liabilities. Current assets
like cash, cash equivalents, and marketable securities can easily be converted into cash in the short
term. This means that companies with larger amounts of current assets will more easily be able to
pay off current liabilities when they become due without having to sell off long-term, revenue
generating assets.

Formula: The current ratio is calculated by dividing current assets by current liabilities. This ratio
is stated in numeric format rather than in decimal format. Here is the calculation:

GAAP requires that companies separate current and long-term assets and liabilities on the balance
sheet. This split allows investors and creditors to calculate important ratios like the current ratio.
On U.S. financial statements, current accounts are always reported before long-term accounts.

Example: Charlie’s Skate Shop sells ice-skating equipment to local hockey teams. Charlie is
applying for loans to help fund his dream of building an indoor skate rink. Charlie’s bank asks
for his balance sheet so they can analysis his current debt levels. According to Charlie’s balance
sheet he reported $100,000 of current liabilities and only $25,000 of current assets. Charlie’s
current ratio would be calculated like this:

As you can see, Charlie only has enough current assets to pay off 25 percent of his current
liabilities. This shows that Charlie is highly leveraged and highly risky. Banks would prefer a
current ratio of at least 1 or 2, so that all the current liabilities would be covered by the current
assets. Since Charlie’s ratio is so low, it is unlikely that he will get approved for his loan.

Working Capital Ratio: The working capital ratio, also called the current ratio, is a liquidity
ratio that measures a firm’s ability to pay off its current liabilities with current assets. The working
capital ratio is important to creditors because it shows the liquidity of the company. Current
liabilities are best paid with current assets like cash, cash equivalents, and marketable securities
because these assets can be converted into cash much quicker than fixed assets. The faster the
assets can be converted into cash, the more likely the company will have the cash in time to pay
its debts. The reason this ratio is called the working capital ratio comes from the working capital
calculation. When current assets exceed current liabilities, the firm has enough capital to run its
day-to-day operations. In other words, it has enough capital to work. The working capital ratio
transforms the working capital calculation into a comparison between current assets and current
liabilities.

Formula: The working capital ratio is calculated by dividing current assets by current liabilities.

Both of these current accounts are stated separately from their respective long-term accounts on
the balance sheet. This presentation gives investors and creditors more information to analyze
about the company. Current assets and liabilities are always stated first on financial statements and
then followed by long-term assets and liabilities. This calculation gives you a firm understanding
what percentage a firm’s current assets are of its current liabilities.

Example: Let’s take a look at an example. Kay’s Machine Shop has several loans from banks for
equipment she purchased in the last five years. All of these loans are coming due which is
decreasing her working capital. At the end of the year, Kay had $100,000 of current assets and
$125,000 of current liabilities. Here is her WCR:

As you can see, Kay’s WCR is less than 1 because her debt is increasing. This makes her business
riskier to new potential credits. If Kay wants to apply for another loan, she should pay off some of
the liabilities to lower her working capital ratio before she applies.

 Current assets increase = increase in Working Capital Ratio

 Current assets decrease= decrease in Working Capital Ratio
 Current liabilities increase = decrease in Working Capital Ratio
 Current liabilities decrease = increase in Working Capital Ratio
Positive vs. Negative Working Capital: Positive working capital is always a good thing because it
means that the business is about to meet its short-term obligations and bills with its liquid assets.
It also means that the business should be able to finance some degree of growth without having to
acquire and outside loan or raise funds with a new stock issuance. Negative working capital, on
the other hand, means that the business doesn’t have enough liquid assets to meet it current or
short-term obligations. This is often caused by inefficient asset management and poor cash flow.
If the business does not have enough cash to pay the bills as they become due, it will have to
borrow more money, which will in turn increase its short-term obligations.

Is Negative Working Capital Bad: Negative working capital is never a sign that a company is doing
well, but it also doesn’t mean that the company is failing either. Many large companies often report
negative working capital and are doing fine, like Wal-Mart. Companies, like Wal-Mart, are able
to survive with a negative working capital because they turn their inventory over so quickly; they
are able to meet their short-term obligations. These companies purchase their inventory from
suppliers and immediately turn around and sell it at a small margin.

Times Interest Earned Ratio: The times interest earned ratio, sometimes called the interest
coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be
used to cover interest expenses in the future. In some respects, the times interest ratio is considered
a solvency ratio because it measures a firm’s ability to make interest and debt service payments.
Since these interest payments are usually made on a long-term basis, they are often treated as an
ongoing, fixed expense. As with most fixed expenses, if the company can’t make the payments, it
could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.

Formula: The times interest earned ratio is calculated by dividing income before interest and
income taxes by the interest expense.

Both of these figures can be found on the income statement. Interest expense and income taxes are
often reported separately from the normal operating expenses for solvency analysis purposes. This
also makes it easier to find the earnings before interest and taxes or EBIT.
Example: Tim’s Tile Service is a construction company that is currently applying for a new loan
to buy equipment. The bank asks Tim for his financial statements before they will consider his
loan. Tim’s income statement shows that he made $500,000 of income before interest expense and
income taxes. Tim’s overall interest expense for the year was only $50,000. Tim’s time interest
earned ratio would be calculated like this:

As you can see, Tim has a ratio of ten. This means that Tim’s income is 10 times greater than his
annual interest expense. In other words, Tim can afford to pay additional interest expenses. In this
respect, Tim’s business is less risky and the bank shouldn’t have a problem accepting his loan.

Equity Ratio: The equity ratio is an investment leverage or solvency ratio that measures the
amount of assets that are financed by owners’ investments by comparing the total equity in the
company to the total assets. The equity ratio highlights two important financial concepts of a
solvent and sustainable business. The first component shows how much of the total company assets
are owned outright by the investors. In other words, after all of the liabilities are paid off, the
investors will end up with the remaining assets. The second component inversely shows how
leveraged the company is with debt. The equity ratio measures how much of a firm’s assets were
financed by investors. In other words, this is the investors’ stake in the company. This is what they
are on the hook for. The inverse of this calculation shows the amount of assets that were financed
by debt. Companies with higher equity ratios show new investors and creditors that investors
believe in the company and are willing to finance it with their investments.

Formula: The equity ratio is calculated by dividing total equity by total assets. Both of
these numbers truly include all of the accounts in that category. In other words, all of the
assets and equity reported on the balance sheet are included in the equity ratio calculation.
Example: Tim’s Tech Company is a new startup with a number of different investors. Tim is
looking for additional financing to help grow the company, so he talks to his business partners
about financing options. Tim’s total assets are reported at $150,000 and his total liabilities are
$50,000. Based on the accounting equation, we can assume the total equity is $100,000. Here is
Tim’s equity ratio.

As you can see, Tim’s ratio is .67. This means that investors rather than debt are currently
funding more assets. 67 percent of the company’s assets are owned by shareholders and not
creditors. Depending on the industry, this is a healthy ratio.

Equity Multiplier: The equity multiplier is a financial leverage ratio that measures the amount
of a firm’s assets that are financed by its shareholders by comparing total assets with total
shareholder’s equity. In other words, the equity multiplier shows the percentage of assets that are
financed or owed by the shareholders. Conversely, this ratio also shows the level of debt financing
is used to acquire assets and maintain operations. Like all liquidity ratios and financial leverage
ratios, the equity multiplier is an indication of company risk to creditors. Companies that rely too
heavily on debt financing will have high debt service costs and will have to raise more cash flows
in order to pay for their operations and obligations. Both creditors and investors use this ratio to
measure how leveraged a company is.

Formula: The equity multiplier formula is calculated by dividing total assets by total
stockholder’s equity.

Both of these accounts are easily found on the balance sheet.

Example: Tom’s Telephone Company works with the utility companies in the area to maintain
telephone lines and other telephone cables. Tom is looking to bring his company public in the next
two years and wants to make sure his equity multiplier ratio is favorable. According to
Tom’s financial statements, he has $1,000,000 of total assets and $900,000 of total equity. Tom’s
multiplier is calculated like this:

As you can see, Tom has a ratio of 1.11. This means that Tom’s debt levels are extremely low.
Only 10 percent of his assets are financed by debt. Conversely, investors finance 90 percent of
his assets. This makes Tom’s company very conservative as far as creditors are concerned.
Tom’s return on equity will be negatively affected by his low ratio, however.

Debt to Equity Ratio: The debt to equity ratio is a financial, liquidity ratio that compares a
company’s total debt to total equity. The debt to equity ratio shows the percentage of company
financing that comes from creditors and investors. A higher debt to equity ratio indicates that more
creditor financing (bank loans) is used than investor financing (shareholders).

Formula: The debt to equity ratio is calculated by dividing total liabilities by total equity. The
debt to equity ratio is considered a balance sheet ratio because all of the elements are reported on
the balance sheet.

Example: Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its
property. The shareholders of the company have invested $1.2 million. Here is how you calculate
the debt to equity ratio.

Debt Ratio: Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage
of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with
its assets. In other words, this shows how many assets the company must sell in order to pay off
all of its liabilities. This ratio measures the financial leverage of a company. Companies with
higher levels of liabilities compared with assets are considered highly leveraged and riskier for
lenders. This helps investors and creditors analysis the overall debt burden on the company as well
as the firm’s ability to pay off the debt in future, uncertain economic times.

Formula: The debt ratio is calculated by dividing total liabilities by total assets. Both of these
numbers can easily be found the balance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation. The debt ratio
shows the overall debt burden of the company not just the current debt.

Example: Dave’s Guitar Shop is thinking about building an addition onto the back of its existing
building for more storage. Dave consults with his banker about applying for a new loan. The bank
asks for Dave’s balance to examine his overall debt levels. The banker discovers that Dave has
total assets of $100,000 and total liabilities of $25,000. Dave’s debt ratio would be calculated like
this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as many
assets as he has liabilities. This is a relatively low ratio and implies that Dave will be able to pay
back his loan. Dave shouldn’t have a problem getting approved for his loan.

Accounts Receivable Turnover Ratio: Accounts receivable turnover is an efficiency

ratio or activity ratio that measures how many times a business can turn its accounts receivable
into cash during a period. In other words, the accounts receivable turnover ratio measures how
many times a business can collect its average accounts receivable during the year. A turn refers to
each time a company collects its average receivables. If a company had $20,000 of average
receivables during the year and collected $40,000 of receivables during the year, the company
would have turned its accounts receivable twice because it collected twice the amount of average
receivables. This ratio shows how efficient a company is at collecting its credit sales from
customers. Some companies collect their receivables from customers in 90 days while other take
up to 6 months to collect from customers. In some ways the receivables turnover ratio can be
viewed as a liquidity ratio as well. Companies are more liquid the faster they can convert their
receivables into cash.

Formula: Accounts receivable turnover is calculated by dividing net credit sales by the average
accounts receivable for that period.
The reason net credit sales are used instead of net sales is that cash sales don’t create receivables.
Only credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales
simply refers to sales minus returns and refunded sales. The net credit sales can usually be found
on the company’s income statement for the year although not all companies report cash and
credit sales separately. Average receivables is calculated by adding the beginning and ending
receivables for the year and dividing by two. In a sense, this is a rough calculation of the average
receivables for the year.

Example: Bill’s Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers
accounts to all of his main customers. At the end of the year, Bill’s balance sheet shows $20,000
in accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year’s balance
sheet showed $10,000 of accounts receivable. The first thing we need to do in order to calculate
Bill’s turnover is to calculate net credit sales and average accounts receivable. Net credit sales
equals gross credit sales minus returns (75,000 – 25,000 = 50,000). Average accounts receivable
can be calculated by averaging beginning and ending accounts receivable balances ((10,000 +
20,000) / 2 = 15,000). Finally, Bill’s accounts receivable turnover ratio for the year can be like
this.

As you can see, Bill’s turnover is 3.33. This means that Bill collects his receivables about 3.3
times a year or once every 110 days. In other words, when Bill makes a credit sale, it will take
him 110 days to collect the cash from that sale.

Asset Turnover Ratio: The asset turnover ratio is an efficiency ratio that measures a
company’s ability to generate sales from its assets by comparing net sales with average total assets.
In other words, this ratio shows how efficiently a company can use its assets to generate sales. The
total asset turnover ratio calculates net sales as a percentage of assets to show how many sales are
generated from each dollar of company assets. For instance, a ratio of .5 means that each dollar of
assets generates 50 cents of sales.
Formula: The asset turnover ratio is calculated by dividing net sales by average total assets.

Net sales, found on the income statement, are used to calculate this ratio returns and refunds must
be backed out of total sales to measure the truly measure the firm’s assets’ ability to generate sales.
Average total assets are usually calculated by adding the beginning and ending total asset balances
together and dividing by two. This is just a simple average based on a two-year balance sheet. A
more in-depth, weighted average calculation can be used, but it is not necessary.

Example: Sally’s Tech Company is a tech startup company that manufactures a new tablet
computer. Sally is currently looking for new investors and has a meeting with an angel investor.
The investor wants to know how well Sally uses her assets to produce sales, so he asks for her
financial statements.

Here is what the financial statements reported:

 Beginning Assets: $50,000

 Ending Assets: $100,000
 Net Sales: $25,000

The total asset turnover ratio is calculated like this:

As you can see, Sally’s ratio is only .33. This means that for every dollar in assets, Sally only
generates 33 cents. In other words, Sally’s start up in not very efficient with its use of assets.

Inventory Turnover Ratio: The inventory turnover ratio is an efficiency ratio that shows
how effectively inventory is managed by comparing cost of goods sold with average inventory for
a period. This measures how many times average inventory is “turned” or sold during a period. In
other words, it measures how many times a company sold its total average inventory dollar amount
during the year. A company with $1,000 of average inventory and sales of $10,000 effectively sold
its 10 times over. This ratio is important because total turnover depends on two main components
of performance. The first component is stock purchasing. If larger amounts of inventory are
purchased during the year, the company will have to sell greater amounts of inventory to improve
its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs
and other holding costs. The second component is sales. Sales have to match inventory purchases
otherwise the inventory will not turn effectively. That’s why the purchasing and sales departments
must be in tune with each other.

Formula: The inventory turnover ratio is calculated by dividing the cost of goods sold for a
period by the average inventory for that period.

Average inventory is used instead of ending inventory because many companies’ merchandise
fluctuates greatly throughout the year. For instance, a company might purchase a large quantity of
merchandise January 1 and sell that for the rest of the year. By December almost the entire
inventory is sold and the ending balance does not accurately reflect the company’s actual inventory
during the year. Average inventory is usually calculated by adding the beginning and ending
inventory and dividing by two. The cost of goods sold is reported on the income statement.

Example: Donny’s Furniture Company sells industrial furniture for office buildings. During the current
year, Donny reported cost of goods sold on its income statement of $1,000,000. Donny’s beginning
inventory was $3,000,000 and its ending inventory was $4,000,000. Donny’s turnover is calculated like
this:

As you can see, Donny’s turnover is .29. This means that Donny only sold roughly a third of its
inventory during the year. It also implies that it would take Donny approximately 3 years to sell
his entire inventory or complete one turn. In other words, Danny does not have very good inventory
control.

Days Sales in Inventory: The day’s sales in inventory calculation, also called days’ inventory
outstanding or simply days in inventory, measures the number of days it will take a company to
sell all of its inventory. In other words, the day’s sales in inventory ratio shows how many days a
company’s current stock of inventory will last. This is an important to creditors and investors for
three main reasons. It measures value, liquidity, and cash flows. Both investors and creditors want
to know how valuable a company’s inventory is. Older, more obsolete inventory is always worth
less than current, fresh inventory. The day’s sales in inventory shows how fast the company is
moving its inventory. In other words, it shows how fresh the inventory is. This calculation also
shows the liquidity of inventory. Shorter days inventory outstanding means the company can
convert its inventory into cash sooner. In other words, the inventory is extremely liquid. Along the
same line, more liquid inventory means the company’s cash flows will be better.
Formula: The day’s sales inventory is calculated by dividing the ending inventory by the cost of
goods sold for the period and multiplying it by 365.

Ending inventory is found on the balance sheet and the cost of goods sold is listed on the income
statement. Note that you can calculate the days in inventory for any period, just adjust the multiple.
Since this inventory calculation is based on how many times a company can turn its inventory, you
can also use the inventory turnover ratio in the calculation. Just divide 365 by the inventory
turnover ratio. Days inventory usually focuses on ending inventory whereas inventory turnover
focuses on average inventory.

Example: Keith’s Furniture Company’s management have been extremely happy with their sales
staff because they have been moving more inventory this year than in any previous year. At the
end of the year, Keith’s financial statements show an ending inventory of $50,000 and a cost of
goods sold of $150,000. Keith’s day’s sales in inventory is calculated like this:

As you can see, Keith’s ratio is 122 days. This means Keith has enough inventories to last the next
122 days or Keith will turn his inventory into cash in the next 122 days. Depending on Keith’s
industry, this length of time might be short or long.

Gross Margin Ratio: Gross margin ratio is a profitability ratio that compares the gross margin
of a business to the net sales. This ratio measures how profitable a company sells its inventory or
merchandise. In other words, the gross profit ratio is essentially the percentage markup on
merchandise from its cost. This is the pure profit from the sale of inventory that can go to paying
operating expenses. Gross margin ratio is often confused with the profit margin ratio, but the two
ratios are completely different. Gross margin ratio only considers the cost of goods sold in its
calculation because it measures the profitability of selling inventory. Profit margin ratio on the
other hand considers other expenses.

Formula: Gross margin ratio is calculated by dividing gross margin by net sales.
The gross margin of a business is calculated by subtracting cost of goods sold from net sales. Net
sales equals gross sales minus any returns or refunds. The broken down formula looks like this:

Profit Margin Ratio

The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability
ratio that measures the amount of net income earned with each dollar of sales generated by
comparing the net income and net sales of a company. In other words, the profit margin ratio shows
what percentage of sales are left over after all expenses are paid by the business. Creditors and
investors use this ratio to measure how effectively a company can convert sales into net income.
Investors want to make sure profits are high enough to distribute dividends while creditors want
to make sure the company has enough profits to pay back its loans. In other words, outside users
want to know that the company is running efficiently. An extremely low profit margin formula
would indicate the expenses are too high and the management needs to budget and cut expenses.
The return on sales ratio is often used by internal management to set performance goals for the
future.

Formula: The profit margin ratio formula can be calculated by dividing net income by net sales.

Net sales is calculated by subtracting any returns or refunds from gross sales. Net income equals
total revenues minus total expenses and is usually the last number reported on the income
statement.
Example: Trisha’s Tackle Shop is an outdoor fishing store that selling lures and other fishing
gear to the public. Last year Trisha had the best year in sales she has ever had since she opened
the business 10 years ago. Last year Trisha’s net sales were $1,000,000 and her net income was
$100,000. Here is Trisha’s return on sales ratio.

As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that with this
year’s numbers of $800,000 of net sales and $200,000 of net income. This year Trisha may have
made less sales, but she cut expenses and was able to convert more of these sales into profits with
a ratio of 25 percent.

Return on Assets Ratio: The return on assets ratio, often called the return on total assets, is
a profitability ratio that measures the net income produced by total assets during a period by
comparing net income to the average total assets. In other words, the return on assets ratio or ROA
measures how efficiently a company can manage its assets to produce profits during a period.
Since company assets’ sole purpose is to generate revenues and produce profits, this ratio helps
both management and investors see how well the company can convert its investments in assets
into profits. You can look at ROA as a return on investment for the company since capital assets
are often the biggest investment for most companies. In this case, the company invests money into
capital assets and the return is measured in profits. In short, this ratio measures how profitable a
company’s assets are.

Formula: The return on assets ratio formula is calculated by dividing net income by average
total assets.

This ratio can also be represented as a product of the profit margin and the total asset turnover.
Either formula can be used to calculate the return on total assets. When using the first formula,
average total assets are usually used because asset totals can vary throughout the year. Simply add
the beginning and ending assets together on the balance sheet and divide by two to calculate the
average assets for the year. It might be obvious, but it is important to mention that average total
assets is the historical cost of the assets on the balance sheet without taking into consideration
the accumulated depreciation. The net income can be found on the income statement.

Example: Charlie’s Construction Company is a growing construction business that has a few
contracts to build storefronts in downtown Chicago. Charlie’s balance sheet shows beginning
assets of $1,000,000 and an ending balance of $2,000,000 of assets. During the current year,
Charlie’s company had net income of $20,000,000. Charlie’s return on assets ratio looks like
this.

As you can see, Charlie’s ratio is 1,333.3 percent. In other words, every dollar that Charlie invested
in assets during the year produced $13.3 of net income. Depending on the economy, this can be a
healthy return rate no matter what the investment is. Investors would have to compare Charlie’s
return with other construction companies in his industry to get a true understanding of how well
Charlie is managing his assets.

Return on Capital Employed: Return on capital employed or ROCE is a profitability ratio

that measures how efficiently a company can generate profits from its capital employed by
comparing net operating profit to capital employed. In other words, return on capital employed
shows investors how many dollars in profits each dollar of capital employed generates. ROCE is
a long-term profitability ratio because it shows how effectively assets are performing while taking
into consideration long-term financing. This is why ROCE is a more useful ratio than return on
equity to evaluate the longevity of a company. This ratio is based on two important calculations:
operating profit and capital employed. Net operating profit is often called EBIT or earnings before
interest and taxes. EBIT is often reported on the income statement because it shows the company
profits generated from operations. EBIT can be calculated by adding interest and taxes back into
net income if need be. Capital employed is a fairly convoluted term because it can be used to refer
to many different financial ratios. Most often capital employed refers to the total assets of a
company less all current liabilities. This could also be looked at as stockholders’ equity less long-
term liabilities. Both equal the same figure.

Formula: Return on capital employed formula is calculated by dividing net operating profit or
EBIT by the employed capital.

If employed capital is not given in a problem or in the financial statement notes, you can
calculate it by subtracting current liabilities from total assets. In this case the ROCE formula
would look like this:
It isn’t uncommon for investors to use averages instead of year-end figures for this ratio, but it
isn’t necessary.

Example: Scott’s Auto Body Shop customizes cars for celebrities and movie sets. During the
year, Scott had a net operating profit of $100,000. Scott reported $100,000 of total assets and
$25,000 of current liabilities on his balance sheet for the year. Accordingly, Scott’s return on
capital employed would be calculated like this:

As you can see, Scott has a return of 1.33. In other words, every dollar invested in employed
capital, Scott earns $1.33. Scott’s return might be so high because he maintains low assets level.
Companies with large cash reserves usually skew this ratio because cash is included in the
employed capital computation even though it isn’t technically employed yet.

Return on Equity (ROE) Ratio: The return on equity ratio or ROE is a profitability ratio
that measures the ability of a firm to generate profits from its shareholder’s investments in the
company. In other words, the return on equity ratio shows how much profit each dollar of common
stockholders’ equity generates. So a return on 1 means that every dollar of common stockholders’
equity generates 1 dollar of net income. This is an important measurement for potential investors
because they want to see how efficiently a company will use their money to generate net income.
ROE is also an indicator of how effective management is at using equity financing to fund
operations and grow the company.

Formula: The return on equity ratio formula is calculated by dividing net income by
shareholder’s equity.

Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are
not included in the calculation because these profits are not available to common stockholders.
Preferred dividends are then taken out of net income for the calculation.Also, average common
stockholder’s equity is usually used, so an average of beginning and ending equity is calculated.
Example: Tammy’s Tool Company is a retail store that sells tools to construction companies across
the country. Tammy reported net income of $100,000 and issued preferred dividends of $10,000
during the year. Tammy also had 10,000, $5 par common shares outstanding during the year.
Tammy would calculate her return on common equity like this:

As you can see, after preferred dividends are removed from net income Tammy’s ROE is 1.8. This
means that every dollar of common shareholder’s equity earned about $1.80 this year. In other
words, shareholders saw a 180 percent return on their investment. Tammy’s ratio is most likely
considered high for her industry. This could indicate that Tammy’s is a growing company. An
average of 5 to 10 years of ROE ratios will give investors a better picture of the growth of this
company. Company growth or a higher ROE doesn’t necessarily get passed onto the investors
however. If the company retains these profits, the common shareholders will only realize this gain
by having an appreciated stock.

Earnings Per Share (EPS):Earnings per share (EPS), also called net income per share, is a market
prospect ratio that measures the amount of net income earned per share of stock outstanding. In
other words, this is the amount of money each share of stock would receive if all of the profits
were distributed to the outstanding shares at the end of the year. Earnings per share is also a
calculation that shows how profitable a company is on a shareholder basis. So a larger company’s
profits per share can be compared to smaller company’s profits per share. Obviously, this
calculation is heavily influenced on how many shares are outstanding. Thus, a larger company will
have to split its earning amongst many more shares of stock compared to a smaller company.

Formula: Earnings per share or basic earnings per share is calculated by subtracting preferred
dividends from net income and dividing by the weighted average common shares outstanding. The
earnings per share formula looks like this.

You’ll notice that the preferred dividends are removed from net income in the earnings per share
calculation. This is because EPS only measures the income available to common stockholders.
Preferred dividends are set-aside for the preferred shareholders and can’t belong to the common
shareholders. Most of the time earning per share is calculated for year-end financial statements.
Since companies often issue new stock and buy back treasury stock throughout the year, the
weighted average common shares are used in the calculation. The weighted average common
shares outstanding is can be simplified by adding the beginning and ending outstanding shares and
dividing by two.
Example: Quality Co. has net income during the year of $50,000. Since it is a small company,
there are no preferred shares outstanding. Quality Co. had 5,000 weighted average shares
outstanding during the year. Quality’s EPS is calculated like this.

As you can see, Quality’s EPS for the year is $10. This means that if Quality distributed every
dollar of income to its shareholders, each share would receive 10 dollars.

Price Earnings P/E Ratio: The price earnings ratio, often called the P/E ratio or price to
earnings ratio, is a market prospect ratio that calculates the market value of a stock relative to its
earnings by comparing the market price per share by the earnings per share. In other words, the
price earnings ratio shows what the market is willing to pay for a stock based on its current
earnings. Investors often use this ratio to evaluate what a stock’s fair market value should be by
predicting future earnings per share. Companies with higher future earnings are usually expected
to issue higher dividends or have appreciating stock in the future. Obviously, fair market value of
a stock is based on more than just predicted future earnings. Investor speculation and demand also
help increase a share’s price over time. The PE ratio helps investors analyze how much they should
pay for a stock based on its current earnings. This is why the price to earnings ratio is often called
a price multiple or earnings multiple. Investors use this ratio to decide what multiple of earnings a
share is worth. In other words, how many times earnings they are willing to pay.

Formula: The price earnings ratio formula is calculated by dividing the market value price per
share by the earnings per share.

This ratio can be calculated at the end of each quarter when quarterly financial statements are
issued. It is most often calculated at the end of each year with the annual financial statements. In
either case, the fair market value equals the trading value of the stock at the end of the current
period. The earnings per share ratio is also calculated at the end of the period for each share
outstanding. A trailing PE ratio occurs when the earnings per share is based on previous period. A
leading PE ratios occurs when the EPS calculation is based on future predicted numbers. A justified
PE ratio is calculated by using the dividend discount analysis.
Example: The Island Corporation stock is currently trading at $50 a share and its earnings per
share for the year is 5 dollars. Island’s P/E ratio would be calculated like this:

As you can see, the Island’s ratio is 10 times. This means that investors are willing to pay 10 dollars
for every dollar of earnings. In other words, this stock is trading at a multiple of ten. Since the
current EPS was used in this calculation, this ratio would be considered a trailing price earnings
ratio. If a future predicted EPS was used, it would be considered a leading price to earnings ratio.

Dividend Payout Ratio: The dividend payout ratio measures the percentage of net income that is
distributed to shareholders in the form of dividends during the year. In other words, this ratio shows
the portion of profits the company decides to keep to fund operations and the portion of profits
that is given to its shareholders. Investors are particularly interested in the dividend payout ratio
because they want to know if companies are paying out a reasonable portion of net income to
investors. For instance, most startup companies and tech companies rarely give dividends at all. In
fact, Apple, a company formed in the 1970s, just gave its first dividend to shareholders in
2012.Conversely, some companies want to spur investors’ interest so much that they are willing
to pay out unreasonably high dividend percentages. Inventors can see that these dividend rates
can’t be sustained very long because the company will eventually need money for its operations.

Formula: The dividend payout formula is calculated by dividing total dividend by the net
income of the company.

This calculation will give you the overall dividend ratio. Both the total dividends and the net
income of the company will be reported on the financial statements. You can also calculate the
dividend payout ratio on a share basis by dividing the dividends per share by the earnings per
share. Obviously, this calculation requires a little more work because you must figure out
the earnings per share as well as divide the dividends by each outstanding share. Both of these
formulas will arrive at the same answer however.
Example: Joe’s Kitchen is a restaurant change that has several shareholders. Joe reported $10,000
of net income on his income statement for the year. Joe’s issued $3,000 of dividends to its
shareholders during the year. Here is Joe’s dividend payout ratio calculation.

As you can see, Joe is paying out 30 percent of his net income to his shareholders. Depending on
Joe’s debt levels and operating expenses, this could be a sustainable rate since the earnings
appear to support a 30 percent ratio.

Dividend Yield Ratio: The dividend yield is a financial ratio that measures the amount of
cash dividends distributed to common shareholders relative to the market value per share. The
dividend yield is used by investors to show how their investment in stock is generating either cash
flows in the form of dividends or increases in asset value by stock appreciation. Investors invest
their money in stocks to earn a return either by dividends or stock appreciation. Some companies
choose to pay dividends on a regular basis to spur investors’ interest. These shares are often called
income stocks. Other companies choose not to issue dividends and instead reinvest this money in
the business. These shares are often called growth stocks. Investors can use the dividend yield
formula to help analyze their return on investment in stocks.

Formula: The dividend yield formula is calculated by dividing the cash dividends per share by
the market value per share.

Cash dividends per share are often reported on the financial statements, but they are also reported
as gross dividends distributed. In this case, you’ll have to divide the gross dividends distributed
by the average outstanding common stock during that year. The shares’ market value is usually
calculated by looking at the open stock exchange price as of the last day of the year or period
Example: Stacy’s Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly
Hills. Stacy’s is listed on a smaller stock exchange and the current market price per share is $15.
As of last year, Stacy paid $15,000 in dividends with 1,000 shares outstanding. Stacy’s yield is
computed like this.

As you can see, Stacy’s yield is one dollar. This means that Stacy’s investors receive 1 dollar in
dividends for every dollar they have invested in the company. In other words, the investors are
getting a 100 percent return on their investment every year Stacy maintains this dividend level.

Fixed Charge Coverage Ratio: The fixed charge coverage ratio is a financial ratio that
measures a firm’s ability to pay all of its fixed charges or expenses with its income before interest
and income taxes. The fixed charge coverage ratio is basically an expanded version of the times
interest earned ratio or the times interest coverage ratio. The fixed charge coverage ratio is very
adaptable for use with almost any fixed cost since fixed costs like lease payments, insurance
payments, and preferred dividend payments can be built into the calculation.

Formula: The fixed charge coverage ratio starts with the times earned interest ratio and adds in
applicable fixed costs. We will use lease payments for this example, but any fixed cost can be
added in. This ratio would be calculated like this:

Note that any number of fixed costs can be used in this formula. This coverage ratio is not
limited to only one cost.
Example: Quinn’s Harp Shop is an instrument retailer that specializes in selling and repairing
harps. Quinn has been interest in remodeling the inside of his store but needs a loan in order to
afford it. After giving his financial statements to the bank, the loan officer calculates Quinn’s fixed
charge coverage ratio. According to Quinn’s income statement, he has $300,000 of income before
interest and taxes and interest expense of $30,000. Quinn’s current lease payment is $2,000 a
month or $24,000 a year. Here is how Quinn’s ratio is calculated:

As you can see, Quinn’s ratio is six. That means that Quinn’s income is 6 times greater than his
interest and lease payments. This is a healthy ratio and he should be able to receive his loan from
the bank.

Debt Service Coverage Ratio – DSCR: The debt service coverage ratio is a financial ratio
that measures a company’s ability to service its current debts by comparing its net operating
income with its total debt service obligations. In other words, this ratio compares a company’s
available cash with its current interest, principle, and sinking fund obligations. The debt service
coverage ratio is important to both creditors and investors, but creditors most often analyze it.
Since this ratio measures a firm’s ability to make its current debt obligations, current and future
creditors are particularly interest in it. Creditors not only want to know the cash position and cash
flow of a company, they also want to know how much debt it currently owes and the available
cash to pay the current and future debt. Unlike the debt ratio, the debt service coverage ratio takes
into consideration all expenses related to debt including interest expense and other obligations like
pension and sinking fund obligation. In this way, the DSCR is more telling of a company’s ability
to pay its debt than the debt ratio.

Formula: The debt service coverage ratio formula is calculated by dividing net operating
income by total debt service.

Net operating income is the income or cash flows that are left over after all of the operating
expenses have been paid. This is often called earnings before interest and taxes or EBIT. Net
operating income is usually stated separately on the income statement. Total debt service refers to
all costs related to servicing a company’s debt. This often includes interest payments, principle
payments, and other obligations. The debt service amount is rarely given in a set of financial
statements. Many times this is mentioned in the financial statement notes, however.
Example: Burton’s Shoe Store is looking to remodel its storefront, but it doesn’t have enough
cash to pay for the remodel itself. Thus, Burton is talking with several banks in order to get a loan.
Burton is a little worried that he won’t get a loan because he already has several loans.

According to his financial statements and documents, Burton’s had the following:

Net Operating Profits $150,000

Interest Expense $55,000

Principle Payments $35,000

Sinking Fund Obligations $25,000

Here is Burton’s debt service coverage calculation:

As you can see, Burton has a ratio of 1.3. This means that Burton makes enough in operating
profits to pay his current debt service costs and be left with 30 percent of his profits.

Accounts Receivable Turnover Ratio: Accounts receivable turnover is an efficiency

ratio or activity ratio that measures how many times a business can turn its accounts receivable
into cash during a period. In other words, the accounts receivable turnover ratio measures how
many times a business can collect its average accounts receivable during the year. A turn refers to
each time a company collects its average receivables. If a company had $20,000 of average
receivables during the year and collected $40,000 of receivables during the year, the company
would have turned its accounts receivable twice because it collected twice the amount of average
receivables. This ratio shows how efficient a company is at collecting its credit sales from
customers. Some companies collect their receivables from customers in 90 days while other take
up to 6 months to collect from customers. In some ways the receivables turnover ratio can be
viewed as a liquidity ratio as well. Companies are more liquid the faster they can convert their
receivables into cash.
Formula: Accounts receivable turnover is calculated by dividing net credit sales by the average
accounts receivable for that period.

The reason net credit sales are used instead of net sales is that cash sales don’t create receivables.
Only credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales
simply refers to sales minus returns and refunded sales. The net credit sales can usually be found
on the company’s income statement for the year although not all companies report cash and credit
sales separately. Average receivables is calculated by adding the beginning and ending receivables
for the year and dividing by two. In a sense, this is a rough calculation of the average receivables
for the year.

Example: Bill’s Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts
to all of his main customers. At the end of the year, Bill’s balance sheet shows $20,000 in accounts
receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year’s balance sheet showed
$10,000 of accounts receivable. The first thing we need to do in order to calculate Bill’s turnover
is to calculate net credit sales and average accounts receivable. Net credit sales equals gross credit
sales minus returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by
averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Bill’s accounts receivable turnover ratio for the year can be like this.

As you can see, Bill’s turnover is 3.33. This means that Bill collects his receivables about 3.3
times a year or once every 110 days. In other words, when Bill makes a credit sale, it will take
him 110 days to collect the cash from that sale.

Cash Conversion Cycle: The cash conversion cycle is a cash flow calculation that attempts
to measure the time it takes a company to convert its investment in inventory and other resource
inputs into cash. In other words, the cash conversion cycle calculation measures how long cash is
tied up in inventory before the inventory is sold and cash is collected from customers. The cash
cycle has three distinct parts. The first part of the cycle represents the current inventory level and
how long it will take the company to sell this inventory. This stage is calculated by using the day’s
inventory outstanding calculation. The second stage of the cash cycle represents the current sales
and the amount of time it takes to collect the cash from these sales. This is calculated by using the
day’s sales outstanding calculation. The third stage represents the current outstanding payables. In
other words, this represents how much a company owes its current vendors for inventory and goods
purchases and when the company will have to pay off its vendors. This is calculated by using the
day’s payables outstanding calculation.

Formula: The cash conversion cycle is calculated by adding the day’s inventory outstanding to
the day’s sales outstanding and subtracting the days payable outstanding.

All three of these smaller calculations will have to be made before the CCC can be calculated.

Example: Tim’s Tackle is a retailer that sells outdoor and fishing equipment. Tim buys its
inventory from one main vendor and pays its accounts within 10 days in order to get a purchase
discount. Tim has a fairly high inventory turnover ratio for his industry and can collect accounts
receivable from his customer within 30 days on average.

Tim’s day’s calculations are as follows:

 Days Inventory Outstanding represents days’ inventory outstanding: 15 days

 Days Sales Outstanding’s represents days’ sales outstanding: 2 days
 Days Payables Outstanding represents days payable outstanding: 12 days

Tim’s conversion cycle is calculated like this:

As you can see, Tim’s cash conversion cycle is 5 days. This means it takes Tim 5 days from
paying for his inventory to receive the cash from its sale. Tim would have to compare his cycle
to other companies in his industry over time to see if his cycle is reasonable or needs to be
improved.
Cash Ratio: The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm’s
ability to pay off its current liabilities with only cash and cash equivalents. The cash ratio is much
more restrictive than the current ratio or quick ratio because no other current assets can be used to
pay off current debt–only cash. This is why many creditors look at the cash ratio. They want to see
if a company maintains adequate cash balances to pay off all of their current debts as they come
due. Creditors also like the fact that inventory and accounts receivable are left out of the equation
because both of these accounts are not guaranteed to be available for debt servicing. Inventory
could take months or years to sell and receivables could take weeks to collect. Cash is guaranteed
to be available for creditors.

Formula: The cash coverage ratio is calculated by adding cash and cash equivalents and
dividing by the total current liabilities of a company.

Most companies list cash and cash equivalents together on their balance sheet, but some companies
list them separately. Cash equivalents are investments and other assets that can be converted into
cash within 90 days. These assets are so close to cash that GAAP considers them an equivalent.
Current liabilities are always shown separately from long-term liabilities on the face of the balance
sheet.

Example: Sophie’s Palace is a restaurant that is looking to remodel its dining room. Sophie is
asking her bank for a loan of $100,000. Sophie’s balance sheet lists these items:

 Cash: $10,000
 Cash Equivalents: $2,000
 Accounts Payable: $5,000
 Current Taxes Payable: $1,000
 Current Long-term Liabilities: $10,000

Sophie’s cash ratio is calculated like this:

As you can see, Sophie’s ratio is .75. This means that Sophie only has enough cash and equivalents
to pay off 75 percent of her current liabilities. This is a fairly high ratio which means Sophie
maintains a relatively high cash balance during the year. Obviously, Sophie’s bank would look at
other ratios before accepting her loan application, but based on this coverage ratio, Sophie would
most likely be accepted.
Compound Annual Growth Rate: CAGR stands for Compound Annual Growth Rate and
is a financial investment calculation that measures the percentage an investment increases or
decreases year over year. You can think of this as the annual average rate of return for an
investment over a period of time. Since most investments’ annual returns vary from year to year,
the CAGR calculation averages the good years’ and bad years’ returns into one return percentage
that investors and management can use to make future financial decisions. It’s important to
remember that the compound annual growth rate percentage isn’t the actual annual rate of return.
It’s an average of all the annual returns the investment has produced. It evens all the years’ rates
out to make it easier compare the returns to other investment opportunities. For example, a
company might fund a capital project that loses money for five straight years and makes a huge
profit on the sixth year. This CAGR would even out first five years’ worth of negative returns with
the sixth year’s positive return.

Compound Annual Growth Rate Formula: The CAGR formula is calculated by first dividing
the ending value of the investment by the beginning value to find the total growth rate. This is then
taken to the Nth root where the N is the number of years’ money has been invested. Finally, one
is subtracted from product to arrive at the compound annual growth rate percentage. Here’s what
it looks like:

The equation might seem a little complex at first, but it really isn’t after you use it in an example
or two. Just remember that we are calculating the average return over the life of an investment,
so you can think of the first part of the equation as measuring the total return. The second part of
the equation annualizes the return over the life of the investment. After you understand that, it’s a
pretty easy formula.

Example: Some of these financial ratios are easier to understand by looking at an example. Let’s
assume that Bill’s Auto Manufacturing plant invested $75,000 in new automated manufacturing
equipment. Without considering saving the amount saved in labor costs, Bill was able to bring in
an extra $25,000 of work over the past five years because of this capital investment. Thus, Bill’s
ending value of his investment would be $100,000. Here’s how to calculate CAGR for his
business:
As you can see, Bill made an average of 5.86% on his investment in new automated equipment.
This means that if we could smooth out the earnings and make them equal over the five span, Bill
would have made 5.86% every single year. Like I said before, we are trying to simplify the
example, so we aren’t considering the effects of labor savings on the return. Now let’s assume that
Bill also put some of the company’s profits into a stocks. He purchased $35,000 of stocks five
years ago. Immediately after he bought the shares, the market dropped and his investment hovered
around $20,000 for the next four years. During the fifth year, the economy rebounded and today
the shares are worth $50,000. Bill’s compound annual growth rate for his stock investment would
be calculated like this:

Even though Bill had four straight years of losses with his stock, he was able to achieve a growth
rate of 7.39% year over year. Comparing the stock investment with the capital investment in
machinery, Bill would have been better off investing all of the company’s money into stock
because he earned an additional 1.53% year over year with the stock purchases.

Contribution Margin: The contribution margin, sometimes used as a ratio, is the difference
between a company’s total sales revenue and variable costs. In other words, the contribution
margin equals the amount that sales exceed variable costs. This is the sales amount that can be
used to, or contributed to, pay off fixed costs. The concept of this equation relies on the difference
between fixed and variable costs. Fixed costs are production costs that remain the same as
production efforts increase. Variable costs, on the other hand, increase with production levels. The
contribution margin measures how efficiently a company can produce products and maintain low
levels of variable costs. It is considered a managerial ratio because companies rarely report margins
to the public. Instead, management uses this calculation to help improve internal procedures in the
production process.
Formula: The contribution margin formula is calculated by subtracting total variable costs from
net sales revenue.

Contribution Margin = Net Sales – Variable Costs

Contribution Margin Formula Components: There are two main components in the
contribution margin equation: net sales and variable costs. Let’s take a look at each.

What are net sales: Net sales are basically total sales less any returns or allowances. This is the
net amount that the company expects to receive from its total sales. This revenue number can easily
be found on the income statement. Some income statements report net sales as the only sales figure,
while others actually report total sales and make deductions for returns and allowances. Either
way, this number will be reported at the top of the income statement.

What are variable costs: Variable costs are expenses that increase proportionately as revenues or
operations increase. A good example of this is raw materials. As a manufacturer produces more
units, it will naturally need more materials. Thus, the cost of materials varies with the level of
production. As production increases, material costs increase. As production decreases, material
costs decrease. Other examples of variable costs include:

 Shipping costs
 Sales commissions
 Utilities
 Labor costs
 Production supplies

Variable costs are not typically reported on general purpose financial statements as a separate
category. Thus, you will need to scan the income statement for variable costs and tally the list.
Some companies do issue contribution margin income statements that split variable and fixed
costs, but this isn’t common.
What is the difference between variable and fixed costs: The difference between fixed and
variable costs has to do with their correlation to the production levels of a company? As we said
earlier, variable costs have a direct relationship with production levels. As production levels
increase, so do variable costs and vice versa. This is the not the case with fixed costs. Fixed costs
stay the same no matter what the level of production. Take rent for example. It doesn’t matter how
many units are produced. Rent will always be the same. Let’s look at an example.

Example: Casey owes and runs a manufacturing plant that makes grapple grommets. In the past
year, Casey had sales of $1,000,000 and the following variable costs:

 Shipping costs: $100,000

 Utilities: $50,000
 Labor costs $400,000
 Production supplies: $300,000

Here’s how to calculate his company’s contribution margin.

As you can see, Casey has a CM of $150,000. This means that he has $150,000 to put toward his
fixed costs. The remainder of the margin after the fixed costs have been paid off is company
profit. So let’s assume that Casey’s fixed costs include the following:

 Rent: $50,000
 Insurance: $35,000
 Property Taxes: $20,000

Casey’s total fixed costs equal $105,000. This means that the production of grapple grommets
produce enough revenue to cover the fixed costs and still leave Casey with a profit of $45,000 at
the end of the year.
High vs. Low Contribution Margin: A high margin is almost always a better sign than a low
margin because this means one of two things: either the company’s variable costs are very low or
the company is able to sell its product for much more than its variable costs. Both scenarios are
favorable because it shows that the company is able to generate enough revenue to pay its variable
costs and will have funds to cover its fixed costs. A low margin typically means that the company,
product line, or department isn’t that profitable. This could be caused by a number of different
circumstances. For instance, the price of steel might have increased. An increase like this will have
rippling effects as production increases. Management must be careful and analyze why CM is low
before making any decisions about closing an unprofitable department or discontinuing a product,
as things could change in the near future. Management should also use different variations of the
CM formula to analyze departments and product lines on a trending basis like the following.

Contribution Margin Per Unit: It’s also common for management to calculate the contribution
margin on a per unit basis. This formula shows how much each unit sold contributes to fixed
costs after variable costs have been paid.

This metric is typically used to calculate the breakeven point of a production process and set the
pricing of a product. They also use this to forecast the profits of the budgeted production
numbers after the prices have been set.

Contribution Margin Ratio: The contribution margin ratio takes the concept of the contribution
margin per unit produced and calculates it as a percentage of the sales price per unit. This shows
what percentage of sales is made up of the contribution margin.

Managerial accountants also use the contribution margin ratio to calculate break-even points in
the break-even analysis.
Income Statement: The contribution margin income statement separates the fixed and variables
costs on the face of the income statement. This highlights the margin and helps illustrate where a
company’s expenses. Variable expenses can be compared year over year to establish a trend and
show how profits are affected.

Days Sales Outstanding: The day’s sales outstanding calculation, also called the average
collection period or days’ sales in receivables, measures the number of days it takes a company to
collect cash from its credit sales. This calculation shows the liquidity and efficiency of a company’s
collections department. In other words, it shows how well a company can collect cash from its
customers. The sooner cash can be collected; the sooner this cash can be used for other operations.
Both liquidity and cash flows increase with a lower day’s sales outstanding measurement.

Formula: The ratio is calculated by dividing the ending accounts receivable by the total credit
sales for the period and multiplying it by the number of days in the period. Most often this ratio
is calculated at year-end and multiplied by 365 days.

Accounts receivable can be found on the year-end balance sheet. Credit sales, however, are rarely
reported separate from gross sales on the income statement. The credit sales figure will most often
have to be provided by the company. This formula can also be calculated by using the accounts
receivable turnover ratio.

Example: Devin’s Long Boards is a retailer that offers credit to customers. Devin often selling
inventory to customers on account with the agreement that these customers will pay for the
merchandise within 30 days. Some customers promptly pay for their goods, while others are
delinquent. Devin’s year-end financial statements list the following accounts:

 Accounts Receivable: $15,000

 Net Credit Sales: $175,000

Devin’s days sales is calculated like this:

As you can see, it takes Devin approximately 31 days to collect cash from his customers on
average. This is a good ratio since Devin is aiming for a 30 day collection period.
Dividend Payout Ratio: The dividend payout ratio measures the percentage of net income
that is distributed to shareholders in the form of dividends during the year. In other words, this
ratio shows the portion of profits the company decides to keep to fund operations and the portion
of profits that is given to its shareholders. Investors are particularly interested in the dividend
payout ratio because they want to know if companies are paying out a reasonable portion of net
income to investors. For instance, most startup companies and tech companies rarely give
dividends at all. In fact, Apple, a company formed in the 1970s, just gave its first dividend to
shareholders in 2012. Conversely, some companies want to spur investors’ interest so much that
they are willing to pay out unreasonably high dividend percentages. Inventors can see that these
dividend rates can’t be sustained very long because the company will eventually need money for
its operations.

Formula: The dividend payout formula is calculated by dividing total dividend by the net income
of the company.

This calculation will give you the overall dividend ratio. Both the total dividends and the net
income of the company will be reported on the statements. You can also calculate the dividend
payout ratio on a share basis by dividing the dividends per share by the earnings per share.
Obviously, this calculation requires a little more work because you must figure out the earnings
per share as well as divide the dividends by each outstanding share. Both of these formulas will
arrive at the same answer however.

Example: Joe’s Kitchen is a restaurant change that has several shareholders. Joe reported $10,000
of net income on his income statement for the year. Joe’s issued $3,000 of dividends to its
shareholders during the year. Here is Joe’s dividend payout ratio calculation.

As you can see, Joe is paying out 30 percent of his net income to his shareholders. Depending on
Joe’s debt levels and operating expenses, this could be a sustainable rate since the earnings
appear to support a 30 percent ratio.
Dividend Yield Ratio: The dividend yield is a financial ratio that measures the amount of
cash dividends distributed to common shareholders relative to the market value per share. The
dividend yield is used by investors to show how their investment in stock is generating either cash
flows in the form of dividends or increases in asset value by stock appreciation. Investors invest
their money in stocks to earn a return either by dividends or stock appreciation. Some companies
choose to pay dividends on a regular basis to spur investors’ interest. These shares are often called
income stocks. Other companies choose not to issue dividends and instead reinvest this money in
the business. These shares are often called growth stocks. Investors can use the dividend yield
formula to help analyze their return on investment in stocks.

Formula: The dividend yield formula is calculated by dividing the cash dividends per share by
the market value per share.

Cash dividends per share are often reported on the financial statements, but they are also reported
as gross dividends distributed. In this case, you’ll have to divide the gross dividends distributed by
the average outstanding common stock during that year. The shares’ market value is usually
calculated by looking at the open stock exchange price as of the last day of the year or period.

Example: Stacy’s Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly
Hills. Stacy’s is listed on a smaller stock exchange and the current market price per share is $15.
As of last year, Stacy paid $15,000 in dividends with 1,000 shares outstanding. Stacy’s yield is
computed like this.

As you can see, Stacy’s yield is one dollar. This means that Stacy’s investors receive 1 dollar in
dividends for every dollar they have invested in the company. In other words, the investors are
getting a 100 percent return on their investment every year Stacy maintains this dividend level.
DuPont Analysis: The Dupont analysis also called the Dupont model is a financial ratio based
on the return on equity ratio that is used to analyze a company’s ability to increase its return on
equity. In other words, this model breaks down the return on equity ratio to explain how companies
can increase their return for investors. The Dupont analysis looks at three main components of the
ROE ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage

Based on these three performances measures the model concludes that a company can raise its
ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more
effectively. The Dupont Corporation developed this analysis in the 1920s. The name has stuck
with it ever since.

Formula: The Dupont Model equates ROE to profit margin, asset turnover, and financial
leverage. The basic formula looks like this.

Since each one of these factors is a calculation in and of itself, a more explanatory formula for
this analysis looks like this.

Every one of these accounts can easily be found on the financial statements. Net income and
sales appear on the income statement, while total assets and total equity appear on the balance
sheet

Example: Let’s take a look at Sally’s Retailers and Joe’s Retailers. Both of these companies
operate in the same apparel industry and have the same return on equity ratio of 45 percent. This
model can be used to show the strengths and weaknesses of each company. Each company has the
following ratios:
Ratio Sally Joe

Profit Margin 30% 15%

Total Asset Turnover .50 6.0

Financial Leverage 3.0 .50

As you can see, both companies have the same overall ROE, but the companies’ operations are
completely different.

Sally’s is generating sales while maintaining a lower cost of goods as evidenced by its higher profit
margin. Sally’s is having a difficult time turning over large amounts of sales. Joe’s business, on
the other hand, is selling products at a smaller margin, but it is turning over a lot of products. You
can see this from its low profit margin and extremely high asset turnover. This model helps
investors compare similar companies like these with similar ratios. Investors can then apply
perceived risks with each company’s business model.

Earnings Before Interest, Taxes, Depreciation, and Amortization: EBITDA, which

stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a financial
calculation that measures a company’s profitability before deductions that are often considered
irrelevant in the decision making process. In other words, it’s the net income of a company with
certain expenses like amortization, depreciation, taxes, and interest added back into the total.
Investors and creditors often use EBITDA as a coverage ratio to compare big companies that either
have significant amounts of debt or large investments in fixed assets because this measurement
excludes the accounting effects of non-operating expenses like interest and paper expenses like
depreciation. Adding these expenses back into net income allows us to analyze and compare the
true operating cash flows of the businesses.
EBITDA Formula: The EBITDA formula is calculated by subtracting all expenses except
interest, taxes, depreciation, and amortization from net income.

Often the equation is calculated inversely by starting with net income and adding back the ITDA.
Many companies use this measurement to calculate different aspects of their business. For
instance, since it is a non-GAAP calculation, you can pick and choose what expenses are added
back into net income. For example, it’s not uncommon for an investor to want to see how debt
affects a company’s financial position without the distraction of the depreciation expenses. Thus,
the formula can be altered to exclude only taxes and depreciation.

Formula Components: Here are five main components to the EBITDA equation.

Earnings – The acronym uses the word earnings, but it really means net profit or simply net
income. This is the bottom line profit for the company found at the bottom of the income statement.

Taxes – Tax expense changes from year to year and business to business. This often depends on
the industry, location, and size of the company. This figure is usually found in the non-operating
expenses section of the income statement.

Interest Expense – As with taxes, interest expense varies among companies and across industries.
Some more capital intensive industries are more likely to have more interest expenses on their
income statement than companies in less capital intensive industries. This expense is also found in
the non-operating expense section.

Depreciation and Amortization – These expenses appear in the operating expense section of the
income statement to allocate the cost of a capital asset during the period and record its use.
EBITDA Margin: The EBITDA margin takes the basic profitability formula and turns it into a
financial ratio that can be used to compare all different sized companies across and industry. The
EBITDA margin formula divides the basic earnings before interest, taxes, depreciation, and
amortization equation by the total revenues of the company– thus, calculating the earnings left
over after all operating expenses (excluding interest, taxes, dep, and amort) are paid as a percentage
of total revenue. Using this formula, a large company like Apple could be compared to a new start
up in Silicon Valley.

The basic earnings formula can also be used to compute the enterprise multiple of a company. The
EBITDA multiple ratio is calculated by dividing the enterprise value by the earnings before ITDA
to measure how low or high a company is valued compared with it metrics. For instance, a high
ratio would indicate a company might be currently overvalued based on its earnings.

Example: Let’s look at an example and calculate both the adjusted EBITDA and margin for Jake’s
Ski House. Jake manufactures custom skis for both pro and amateur skiers. At the end of the year,
Jake earned $100,000 in total revenues and had the following expenses.

 Salaries: $25,000
 Rent: $10,000
 Utilities: $4,000
 Cost of Goods Sold: $35,000
 Interest: $5,000
 Depreciation: $15,000
 Taxes: $3,000

Jake’s net income at the end of the year equals $3,000. Jake’s EBITDA is calculated like this:
As you can see, the taxes, depreciation and interest are added back into the net income for the year
showing the amount of earnings Jake was able to generate to cover his interest and tax payments
at the end of the year. Conversely, you can also compute EBITDA by subtracting out all expenses
other than interest, taxes, and depreciation like this:

If investor or creditors wanted to compare Jake’s Ski shop with another business in the same
industry, they could calculate his margin like this:

The EBITDA margin ratio shows that every dollar Jake generates in revenues results in 26 cents
of profits before all taxes and interest is paid. This percentage can be used to compare Jake’s
efficiency and profitability to other companies regardless of size.

Interest Coverage Ratio: The interest coverage ratio is a financial ratio that measures a
company’s ability to make interest payments on its debt in a timely manner. Unlike the debt service
coverage ratio, this liquidity ratio really has nothing to do with being able to make principle
payments on the debt itself. Instead, it calculates the firm’s ability to afford the interest on the debt.
Creditors and investors use this computation to understand the profitability and risk of a company.
For instance, an investor is mainly concerned about seeing his investment in the company increase
in value. A large part of this appreciation is based on profits and operational efficiencies. Thus,
investors want to see that their company can pay its bills on time without having to sacrifice its
operations and profits. A creditor, on the other hand, uses the interest coverage ratio to identify
whether a company is able to support additional debt. If a company can’t afford to pay the interest
on its debt, it certainly won’t be able to afford to pay the principle payments. Thus, creditors use
this formula to calculate the risk involved in lending.

Formula: The interest coverage ratio formula is calculated by dividing the EBIT, or earnings
before interest and taxes, by the interest expense. Here is what the interest coverage equation
looks like.
As you can see, the equation uses EBIT instead of net income. Earnings before interest and taxes
is essentially net income with the interest and tax expenses added back in. The reason we use EBIT
instead of net income in the calculation is because we want a true representation of how much the
company can afford to pay in interest. If we used net income, the calculation would be screwed
because interest expense would be counted twice and tax expense would change based on the
interest being deducted. To avoid this problem, we just use the earnings or revenues before interest
and taxes are paid. You might also want to note that this formula can be used to measure any
interest period. For example, monthly or partial year numbers can be calculated by dividing the
EBIT and interest expense by the number of months you want to compute.

Example: Let’s take a look at an interest coverage ratio example. Sarah’s Jam Company is a jelly
and jam jarring business that cans preservatives and ships them across the country. Sarah wants to
expand her operations, but she doesn’t have the funds to purchase the canning machines she needs.
Thus, she goes to several banks with her financial statements to try to get the funding she wants.
Sarah’s earnings before interest and taxes is $50,000 and her interest and taxes are $15,000 and
$5,000 respectively. The bank would compute Sarah’s interest coverage ratio like this:

As you can see, Sarah has a ratio of 3.33. This means that has makes 3.33 times more earnings
than her current interest payments. She can well afford to pay the interest on her current debt along
with its principle payments. This is a good sign because it shows her company risk is low and her
operations are producing enough cash to pay her bills.

Internal Rate of Return (IRR): Internal rate of return (IRR) is the minimum discount rate
that management uses to identify what capital investments or future projects will yield an
acceptable return and be worth pursuing. The IRR for a specific project is the rate that equates
the net present value of future cash flows from the project to zero. In other words, if we computed
the present value of future cash flows from a potential project using the internal rate as the discount
rate and subtracted out the original investment, our net present value of the project would be zero.
This sounds a little confusing at first, but it’s pretty simple. Think of it in terms of capital investing
like the company’s management would. They want to calculate what percentage return is required
to break even on an investment adjusted for the time value of money. You can think of the internal
rate of return as the interest percentage that company has to achieve in order to break even on its
investment in new capital. Since management wants to do better than break even, they consider
this the minimum acceptable return on an investment.
Formula: The IRR formula is calculated by equating the sum of the present value of future cash
flow less the initial investment to zero. Since we are dealing with an unknown variable, this is a
bit of an algebraic equation. Here’s what it looks like:

As you can see, the only variable in the internal rate of return equation that management won’t
know is the IRR. They will know how much capital is required to start the project and they will
have a reasonable estimate of the future income of the investment. This means we will have solve
for the discount rate that will make the NPV equal to zero.

Example: It might be easier to look at an example than to keep explaining it. Let’s look at Tom’s
Machine Shop. Tom is considering purchasing a new machine, but he is unsure if it’s the best use
of company funds at this point in time. With the new $100,000 machine, Tom will be able to take
on a new order that will pay $20,000, $30,000, $40,000, and $40,000 in revenue. Let’s calculate
Tom’s minimum rate. Since it’s difficult to isolate the discount rate unless you use an excel IRR
calculator. You can start with an approximate rate and adjust from there. Let’s start with 8 percent.

As you can see, our ending NPV is not equal to zero. Since it’s a positive number, we need to
increase the estimated internal rate. Let’s increase it to 10 percent and recalculate.

As you can see, Tom’s internal return rate on this project is 10 percent. He can compare this to
other investing opportunities to see if it makes sense to spend $100,000 on this piece of
equipment or investment the money in another venture.
Net Income: Net income, also called net profit, is a calculation that measures the amount of
total revenues that exceed total expenses. It other words, it shows how much revenues are left over
after all expenses have been paid. This is the amount of money that the company can save for a
rainy day, use to pay off debt, invest in new projects, or distribute to shareholders. Many people
refer to this measurement as the bottom line because it generally appears at the bottom of
the income statement. Investors, creditors, and company management tend to focus on the net
income calculation because it is a good indicator of the company’s financial position and ability
to manage assets efficiently. Investors what to know that their investment will continue to
appreciate and that the company will have enough cash to pay them a dividend. Creditors want to
know the company if financially sound and able to pay off its debt with successful operations.
Company management is typically concerned with both investor and credit concerns along with
the company’s ability to pay salaries and bonuses. So we’ve established that is an important
measurement, but what is net income?

Formula: The net income formula is calculated by subtracting total expenses from total revenues.
Many different textbooks break the expenses down into subcategories like cost of goods sold,
operating expenses, interest, and taxes, but it doesn’t matter. All revenues and all expenses are
used in this formula.

As you can see, the net income equation is quite simple. It measures excess revenues over total
expenses. This way investors, creditors, and management can see how efficient the company was
a producing profit. You can look that the net profit formula a step further by looking at the income
statement. For instance, if you don’t what the total revenues of the company are, here is how to
calculate net income using the gross profit instead of total revenues. Since gross profit is simply
total revenues less cost of goods sold, you can substitute it for revenues. Just remember not to
subtract the cost of goods sold twice. This is a pretty easy equation, so you don’t really need a net
income calculator to figure it out.

Example: Let’s take a look at the simple equation for this net income example. Aaron owns a
database and server technology company that he runs out of his house. He manages data, security,
and servers for many different medical companies that require strict compliance with federal rules.
As such, Aaron is able to make large amounts of revenue while keeping his expenses low. Here is
a list of his income statement items for the year.

 Revenues $200,000
 Computer expenses $10,000
 Salaries $50,000
 Utilities $5,000
 Taxes $2,500
 Aaron would compute his annual net income by subtracting total expenses ($67,500) from
total income.

Since Aaron’s revenues exceed his expenses, he will show $132,500 profit. If Aaron only made
$50,000 of revenues for the year, he would not have negative earnings, however. Instead, he would
have a net loss of $17,500. The net income definition goes against the concept of negative profits.
If the company loses money, it is classified as a loss. If the company makes money, it is considered
income or profits.

Net Working Capital: Net working capital is a liquidity calculation that measures a
company’s ability to pay off its current liabilities with current assets. This measurement is
important to management, vendors, and general creditors because it shows the firm’s short-term
liquidity as well as management’s ability to use its assets efficiently. Much like the working capital
ratio, the net working capital formula focuses on current liabilities like trade debts, accounts
payable, and vendor notes that must be repaid in the current year. It only makes sense the vendors
and creditors would like to see how much current assets, assets that are expected to be converted
into cash in the current year, are available to pay for the liabilities that will become due in the
coming 12 months. If a company can’t meet its current obligations with current assets, it will be
forced to use its long-term assets, or income producing assets, to pay off its current obligations.
This can lead decreased operations, sales, and may even be an indicator of more severe
organizational and financial problems.

Formula: The net working capital formula is calculated by subtracting the current liabilities
from the current assets. Here is what the basic equation looks like.

Typical current assets that are included in the net working capital calculation are cash, accounts
receivable, inventory, and short-term investments. The current liabilities section typically
includes accounts payable, accrued expenses and taxes, customer deposits, and other trade debt.
Some people also choice to include the current portion of long-term debt in the liabilities section.
This makes sense because although it stems from a long-term obligation, the current portion will
have to be repaid in the current year. Thus, it’s appropriate to include it in with the other obligations
that must be met in the next 12 months.
Example: Let’s look at Paula’s Retail store as an example. Paula owns and operates a women’s
clothing and apparel store that has the following current assets and liabilities:

 Cash: $10,000
 Accounts Receivable: $5,000
 Inventory: $15,000
 Accounts Payable: $7,500
 Accrued Expenses: $2,500
 Other Trade Debt: $5,000

Paula would can use a net working capital calculator to compute the measurement like this:

Since Paula’s current assets exceed her current liabilities her WC is positive. This means that Paula
can pay all of her current liabilities using only current assets. In other words, her store is very
liquid and financially sound in the short-term. She can use this extra liquidity to grow the business
or branch out into additional apparel niches. If Paula’s liabilities exceeded her assets, her WC
would be negative indicating that her short-term liquidity isn’t as high as it could be.

What is Net Working Capital Used for: Obviously, a positive net WC is better than a negative
one. A positive calculation shows creditors and investors that the company is able to generate
enough from operations to pay for its current obligations with current assets. A large positive
measurement could also mean that the business has available capital to expand rapidly without
taking on new, additional debt or investors. It can fund its own expansion through its current
growing operations.
What is Negative Net Working Capital: A negative net working capital, on the other hand, shows
creditors and investors that the operations of the business aren’t producing enough to support the
business’ current debts. If this negative number continues over time, the business might be required
to sell some of its long-term, income producing assets to pay for current obligations like AP and
payroll. Expanding without taking on new debt or investors would be out of the question and if the
negative trend continues, net WC could lead to a company declaring bankruptcy. Keep in mind
that a negative number is worse than a positive one, but it doesn’t necessarily mean that the
company is going to go under. It’s just a sign that the short-term liquidity of the business isn’t that
good. There are many factors in what creates a healthy, sustainable business. For example, a
positive WC might not really mean much if the company can’t convert its inventory or receivables
to cash in a short period of time. Technically, it might have more current assets than current
liabilities, but it can’t pay its creditors off in inventory, so it doesn’t matter. Conversely, a negative
WC might not mean the company is in poor shape if it has access to large amounts of financing to
meet short-term obligations such as a line of credit. What is a more telling indicator of a company’s
short-term liquidity is an increasing or decreasing trend in their net WC. A company with a
negative net WC that has continual improvement year over year could be viewed as a more stable
business than one with a positive net WC and a downward trend year over year.

Change in Net Working Capital: You might ask, “how does a company change its net working
capital over time?” There are three main ways the liquidity of the company can be improved year
over year. First, the company can decrease its accounts receivable collection time. Second, it can
reduce the amount of carrying inventory by sending back unmarketable goods to suppliers. Third,
the company can negotiate with vendors and suppliers for longer accounts payable payment terms.
Each one of these steps will help improve the short-term liquidity of the company and positively
impact the analysis of net working capital.

Operating Margin Ratio: The operating margin ratio, also known as the operating profit
margin, is a profitability ratio that measures what percentage of total revenues is made up by
operating income. In other words, the operating margin ratio demonstrates how much revenues are
left over after all the variable or operating costs have been paid. Conversely, this ratio shows what
proportion of revenues is available to cover non-operating costs like interest expense. This ratio is
important to both creditors and investors because it helps show how strong and profitable a
company’s operations are. For instance, a company that receives 30 percent of its revenue from its
operations means that it is running its operations smoothly and this income supports the company.
It also means this company depends on the income from operations. If operations start to decline,
the company will have to find a new way to generate income. Conversely, a company that only
converts 3 percent of its revenue to operating income can be questionable to investors and
creditors. The auto industry made a switch like this in the 1990’s. GM was making more money
on financing cars than actually building and selling the cars themselves. Obviously, this did not
turn out very well for them. GM is a prime example of why this ratio is important.
Formula: The operating margin formula is calculated by dividing the operating income by the
net sales during a period.

Operating income, also called income from operations, is usually stated separately on the income
statement before income from non-operating activities like interest and dividend income. Many
times operating income is classified as earnings before interest and taxes. Operating income can
be calculated by subtracting operating expenses, depreciation, and amortization from gross income
or revenues. The revenue number used in the calculation is just the total, top-line revenue or net
sales for the year.

Example: If Christie’s Jewelry Store sells custom jewelry to celebrities all over the country.
Christie reports the follow numbers on her financial statements:

 Cost of Goods Sold: $500,000Net Sales: $1,000,000

 Rent: $15,000
 Wages: $100,000
 Other Operating Expenses: $25,000

Here is how Christie would calculate her operating margin.

As you can see, Christie’s operating income is $360,000 (Net sales – all operating expenses).
According to our formula, Christie’s operating margin .36. This means that 64 cents on every
dollar of sales is used to pay for variable costs. Only 36 cents remain to cover all non-operating
expenses or fixed costs. It is important to compare this ratio with other companies in the same
industry. The gross margin ratio is a helpful comparison.