# Firmsconsulting

## Overview of financial ratios

In Debt Ratios, Finance, Liquidity Ratios, MBA, Profitability Ratios on October 27, 2010 at 7:39 pm

Liquidity ratios

Current ratios measure liquidity, which refers to the ability of the firm to meet its short-term debt obligations. The formula for current ratio is as follows:

Current ratio=Current assets/Current liabilities

A positive current ratio is a must. A current ratio of at least two is generally advisable. If a company has current ratio of two, it means that it has current assets which would be able to cover current liabilities twice.

Activity ratios

Total asset turnover calculates how efficiently assets are used to generate sales. In other words, how efficiently the balance sheet is managed.

Total asset turnover=Sales/Total assets

The health of this ratio is an important factor which contributes to a healthy return on investment (ROI/ROA).

Inventory turnover ratio measures the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory.

Inventory turnover ratio = Cost of goods sold/Inventory

The result of this ratio is only meaningful in comparison. It can be compared to industry averages; to firms past inventory turnover ratios and to inventory turnover ratios of competitors.

Industry averages differ significantly between industries for inventory turnover ratio. Inventory turnover is positive (higher than zero) as long as firm has any inventory. Generally high inventory turnover is considered to be a good indicator.

However, the norm would differ significantly between industries. If industry turnover is too high compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales.

Debt ratios

Debt ratio measures how many of firm’s assets are financed by debt. The formula for debt ratio is as follows:

Debt ratio=Total liabilities/Total assets

For example, assume that ABC’s total liabilities are \$1,700,000 and total assets are \$4,000,000. The debt ratio of ABC is as follows: \$1,700,000/\$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Debt-equity ratio measures how much of equity and how much of debt a company uses to finance its assets.

Debt-equity ratio = Total debt / Equity

If the debt-equity ratio is less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that debt is mostly used for financing. If the debt-equity ratio is equal to one, then it means that half of financing comes from debt and half from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher potential return. Financial risk refers to risk of firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (Interest Coverage Ratio) measures the ability of the enterprise to meet its financial obligations (interest payments on debt that come due). The formula for the Times Interest Earned Ratio is as follows:

TIER=EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to Income Statement format to see how it is calculated).

For example, assume that ABC has an operating profit of \$550,000 and interest charges of \$100,000. The TIER of ABC is as follows:

\$550,000/\$100,000=5.5

One should also compare ratios of individual firms to industry averages, to obtain a better understanding. It is generally advisable that TIER should be between 3 and 5.

ABC’s TIER could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk the firm takes is lower than average, but so is the return.

Profitability ratios

Operating profit margin measures how much of each sales dollar remains after all costs except for interest, tax and preferred dividends are deducted. In other words it measures how efficient the business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

Operating profit margin = Operating profit/Sales

For example, if ABC has a operating profit of \$500,000 and sales of \$3,000,000 then the operating profit margin is calculated as follows

Operating profit margin = \$500,000/\$3,000,000

Operating profit margin = 0.167 or 16.7%

The higher the operating profit margin, the better it is.

Return on total assets (ROA) is also called return on investment (ROI). It refers to how effective management is in generating returns on assets of the firm.

ROA/ROI=Earnings available for common stockholders/Total assets

For example, if ABC’s total assets are \$3,500,000 and the earnings available for common stockholders is \$400,000 than

ROA/ROI=400,000/3,500,000

ROA/ROI=0.11

This means that for every dollar of assets, ABC earned 11 cents. The more the firm earns on every dollar of assets the better.

## How to calculate EPS (Earnings per Share)?

In Finance, Income Statement, MBA, Profitability Ratios on October 27, 2010 at 5:47 pm

To calculate EPS allows us to understand how much dollars were earned on each outstanding shares of common stock.

In summary, in order to find EPS, we need to take earnings available for common stockholders (the bottom line of the income statement ) and divide it by number of shares of common stock outstanding.

Therefore, in order to determine EPS (earnings per share), we need to know earnings available for common stockholders.

Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

In other words, to find EPS we need to use the formula:

EPS = Earnings Available for Common Stockholders/ Number of Shares of Common Stock Outstanding.

## Net Profit Margin Ratio

In Finance, Income Statement, MBA, Profitability Ratios on October 27, 2010 at 5:46 pm

Net profit margin ratio (NPMR) is one of the profitability ratios and measures how much of each sales dollar is remaining after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

NPMR = Net Profit/Sales

For example, if ABC has a net profit of \$300,000 and sales of \$3,000,000. The NPMR is calculated as follows.

= 300,000/3,000,000

= 0.1 or 10%

### Test yourself

Dillon Corporation has a net profit of \$500,000 and sales of \$3,500,000.

REQUIRED: Find the NPMR

SOLUTION:

The calculation of NPMR of Dillon Corporation will be as follows:

= 500,000/3,500,000

= 0.14 or 14%

The higher the NPMR , the better it is for the company’s health.

## Operating Profit Margin Ratio

In Finance, Income Statement, MBA, Profitability Ratios on October 27, 2010 at 5:45 pm

Operating profit margin ratio (OPMR) is a profitability ratio. It measures how much of each sales dollar remains after all costs, besides interest, tax and preferred stock dividends, are deducted. In other words it measures how efficiently a business manages its operations or how efficiently the firm manages its income statement (keeping a healthy balance between sales and costs).

OPMR = Operating Profit/Sales

### Example

For example, if ABC Company has operating profit of \$500,000 and sales of \$3,000,000 then OPMR is calculated as follows:

= 500,000/3,000,000

= 0.167 or 16.7%

### Test yourself

Dillon Corporation has operating profits of \$600,000 and sales of \$3,500,000.

REQUIRED: Find the OPMR

SOLUTION:

The calculation of OPMR of Dillon Corporation will be as follows: OPMR = 600,000/3,500,000 OPMR = 0.17 or 17%

The higher the OPMR the better it is for a business.

## Gross Profit Margin Ratio

In Finance, Income Statement, MBA, Profitability Ratios on October 27, 2010 at 5:44 pm

Gross profit margin ratio (GPMR) is one of the profitability ratios. It measures how much of each sales dollar remains after costs of goods are deducted. In other words it measures the relative costs of goods sold.

GPMR = Gross Profit/Sales

EXAMPLE:

For example, if ABC has a gross profit of \$1,000,000 and sales of \$3,000,000, then the GPMR is calculated as follows:

= 1,000,000/3,000,000 = 0.3333 or 33%

### Test yourself

Dillon Corporation has a gross profit of \$1,200,000 and sales of \$3,500,000.

REQUIRED: Find the GPMR

SOLUTION:

The calculation of GPMR of Dillon Corporation will be as follows: = 1,200,000/3,500,000 = 0.34 or 34%

CONCLUSION:

The higher the GPMR the lower the relative cost of goods sold. Therefore, the higher the GPMR, the better.