PROFITABILITY RATIOS

Perhaps the type of ratios most often used and considered by those outside a firm are the profitability ratios. Profitability ratios provide measures of profit performance that serve to evaluate the periodic financial success of a firm. One of the most widely-used financial ratios is net profit margin, also known as return on sales. Return on sales provides a measure of bottom-line profitability. For example, a net profit margin of 6 percent means that for every dollar in sales, the firm generated six cents in net income. Two other margin measures are gross profit margin and operating margin. Gross margin measures the direct production costs of the firm. A gross profit margin of 30 percent would indicate that for each dollar in sales, the firm spent seventy cents in direct costs to produce the good or service that the firm sold. Operating margin goes one step further, incorporating nonproduction costs such as selling, general, and administrative expenses of the firm. Operating profit is also commonly referred to as earnings before interest and taxes, or EBIT. An operating margin of 15 percent would indicate that the firm spent an additional fifteen cents out of every dollar in sales on nonproduction expenses, such as sales commissions paid to the firm's sales force or administrative labor expenses. Two very important measures of the firm's profitability are return on assets and return on equity.

Return on assets (ROA) measures how effectively the firm's assets are used to generate profits net of expenses. An ROA of 7 percent would mean that for each dollar in assets, the firm generated seven cents in profits. This is an extremely useful measure of comparison among firms's competitive performance, for it is the job of managers to utilize the assets of the firm to produce profits. Return on equity (ROE) measures the net return per dollar invested in the firm by the owners, the common shareholders. An ROE of 11 percent means the firm is generating an 11-cent return per dollar of net worth. One should note that in each of the profitability ratios mentioned above, the numerator in the ratio comes from the firm's income statement. Hence, these are measures of periodic performance, covering the specific period reported in the firm's income statement. Therefore, the proper interpretation for a profitability ratio such as an ROA of 11 percent would be that, over the specific period (such as fiscal year 2004), the firm returned eleven cents on each dollar of asset investment.

Table 1 Profitability Ratios

Gross profit margin Return on assets Operating margin Net profit margin Return on equity

LIQUIDITY RATIOS
Managers and creditors must closely monitor the firm's ability to meet short-term obligations. The liquidity ratios are measures that indicate a firm's ability to repay short-term debt. Current liabilities represent obligations that are typically due in one year or less. The current and quick ratios are used to gauge a firm's liquidity. A current ratio of 1.5 indicates that for every dollar in current liabilities, the firm has $1.50 in current assets. Such assets could, theoretically, be sold and the proceeds used to satisfy the liabilities if the firm ran short of cash. However, some current assets are more liquid than others. Obviously, the most liquid current asset is cash. Accounts receivable are usually collected within one to three months, but this varies by firm and industry. The least liquid of current assets is often inventory. Depending on the type of industry or product, some inventory has no ready market. Since the economic definition of liquidity is the ability to turn an asset into cash at or near fair market value, inventory that is not easily sold will not be helpful in meeting shortterm obligations. The quick (or acid test) ratio incorporates this concern. By excluding inventories, the quick ratio is a more strident liquidity measure than the current ratio. It is a more appropriate measure for industries that involve long product production cycles, such as in manufacturing.

Table 4 Liquidity Ratios Current ratio Quick ratio

DEBT RATIOS
Leverage ratios, also known as capitalization ratios, provide measures of the firm's use of debt financing. These are extremely important for potential creditors, who are concerned with the firm's ability to generate the cash flow necessary to make interest payments on outstanding debt. Thus, these ratios are used extensively by analysts outside the firm to make decisions concerning the provision of new credit or the extension of existing credit arrangements. It is also important for management to monitor the firm's use of debt financing. The commitment to service outstanding debt is a fixed cost to a firm, resulting in decreased flexibility and higher break-even production rates. Therefore, the use of debt financing increases the risk associated with the firm. Managers and creditors must constantly monitor the trade-off between the additional risk that comes with borrowing money and the increased opportunities that the new capital provides. Leverage ratios provide a means of such monitoring. Perhaps the most straightforward measure of a firm's use of debt financing is the total-debt ratio. It is important to recall that there are only two ways to finance the acquisition of any asset: debt (using borrowed funds) and equity (using funds from internal operations or selling stock in the company). The total debt ratio captures this idea. A debt ratio of 35 percent means that, for every dollar of assets the firm has, 35 cents was financed with borrowed money. The natural corollary is that the other 65 cents came from equity financing. This is known as the

firm's capital structure35 percent debt and 65 percent equity. Greater debt means greater leverage, and more leverage means more risk. How much debt is too much is a highly subjective question, and one that managers constantly attempt to answer. The answer depends, to a large extent, on the nature of the business or industry. Large manufacturers, who require heavy investment in fixed plant and equipment, will require higher levels of debt financing than will service firms such as insurance or advertising agencies. The total debt of a firm consists of both long- and short-term liabilities. Short-term (or current) liabilities are often a necessary part of daily operations and may fluctuate regularly depending on factors such as seasonal sales. Many creditors prefer to focus their attention on the firm's use of long-term debt. Thus, a common variation on the total debt ratio is the long-term debt ratio, which does not incorporate current liabilities in the numerator. In a similar vein, many analysts prefer a direct comparison of the firm's capital structure. Such a measure is provided by the debt-toequity ratio. This is perhaps one of the most misunderstood financial ratios, as many confuse it with the total debt ratio. A debt-to-equity ratio of 45 percent would mean that for each dollar of equity financing, the firm has 45 cents in debt financing. This does not mean that the firm has 45 percent of its total financing as debt; debt and equity percentages, together, must sum to one (100 percent of the firm's total financing). A little algebra will illustrate this point. Let x = the

percent of equity financing (in decimal form), so 0.45 x is the percent of debt financing. Then x + 0.45 x = 1, and x = 0.69. So, a debt to equity ratio of 45 percent indicates that each dollar of the firm's assets are financed with 69 cents of equity and 31 cents with debt. The point here is to caution against confusing the interpretation of the debt-to-equity ratio with that of the total debt ratio. Two other leverage ratios that are particularly important to the firm's creditors are the times-interest-earned and the fixed-charge coverage ratios. These measure the firm's ability to meet its ongoing commitment to service debt previously borrowed. The timesinterest-earned (TIE) ratio, also known as the EBIT coverage ratio, provides a measure of the firm's ability to meet its interest expenses with operating profits. For example, a TIE of 3.6 indicates that the firm's operating profits from a recent period exceeded the total interest expenses it was required to pay by 360 percent. The higher this ratio, the more financially stable the firm and the greater the safety margin in the case of fluctuations in sales and operating expenses. This ratio is particularly important for lenders of short-term debt to the firm, since short-term debt is usually paid out of current operating revenue. Similarly, the fixed charge coverage ratio, also known as the debt service coverage ratio, takes into account all regular periodic obligations of the firm.

The adjustment to the principal repayment reflects the fact that this portion of the debt repayment is not tax deductible. By including the payment of both principal and interest, the fixed charge coverage ratio provides a more conservative measure of the firm's ability to meet fixed obligations.

Table 3 Leverage Ratios

Total debt ratio Times interest earned Long-term debt ratio Fixed charge coverage Debt-to-equity ratio