Financial Ratios: Accounting

(Book: Accounting Text and Cases)

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Overall Performance Measures

Price to Earnings Ratio (P/E ratio)
Market Price per Share/Net Income (earnings) per Share
The P/E ratio is the broadest and most widely used overall measure of performance. This is the
best indicator of how investors judge the firms future performance, because it involves an
amount not directly controlled by the company (the market price of its common stock), and the
market price shows shareholders expectations about future returns. A decline in this not
explainable by an overall decline in the stock market should be a concern. Management should
compare their companys P/E ratio with those of similar companies to see the marketplaces
relative rankings of companies (text 375).
Return on Assets (ROA)
Net Income/Total Assets
The ROA shows how much a company has earned on the investment of all the financial
resources committed to them (current and long-term liabilities, and owners equity). This is
useful to tell how well an entity has used their funds without considering the sources of the
funds (short- and long-term creditors, bond & shareholders). The ROA is often used by top
management to evaluate individual business units. (text 368)
Return on Shareholders Equity (ROE)
Net Income/Shareholders Equity
The ROE shows how much a company has earned on the funds invested by the shareholders
(directly or through retained earnings). This ratio is interesting for present or potential
shareholders, but also to management because it is an important indicator of shareholder value
creation. The ROE is not usually of interest to division managers because their concern is not
on the roles of creditors and shareholders in financing the assets. (text 368)
Capital Expenditure Ratio
Cash from Operations/Capital Expenditures
Profitability Measures (focus on income statement figures)
Gross Margin Percentage
Operating Income/Net Sales Revenues
? or Gross Margin (sales - cost of goods sold)/Net Sales Revenue
This ratio is associated with inventory accounting - because the gross margin is affected by the
COGS number, different inventory accounting methods will lead to different gross margins. The
Gross Margin Percentage is one measure of a companys profitability: it measures the
percentage of each sales dollar a company earns before considering period costs. (text 161)
Profit Margin/ROS (return on sales)
Net Income/Sales
Profit margins vary widely among industries (what is typical for train/transportation industry?)
(text 68)
Comparing profit margins of companies in the same industry is useful, if the companies are
similar enough that they have equal investment turnover (text 377).
The profit margin is a ratio for overall profitability. Some say that it is in fact the most important
measure of a companys performance. If the profit margin is not what it should be, management

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could look to see if: dollar sales volume has declined, cost of sales are up, certain expenses
have gotten out of control, etc. (text 376)
Earnings per Share (basic)
Basic: Net Income/# of Shares Outstanding
Net income applicable to the common stock/# of shares of common stock outstanding
Investors are very interested in the basic and diluted earnings per share. IASB and FASB state
that these numbers must be on the income statement, and have given detailed guidelines for
how they made the calculations. (text 265)
Diluted earnings per share: the amount of earnings for the period applicable to each share of
common stock outstanding (basic earnings per share) adjusted to reflect dilution (lower earnings
per share) assuming all potentially dilutive common shares were outstanding during the period.
Investors usually use diluted earnings per share to judge a corporations per share
performance and to value its common stock (text 266)
Basic earnings per share: measures a companys performance per share, over a certain period
of time (text 265)
Free Cash Flow
Net Income + Depreciation Expense - Changes in Working Capital - Capital Expenditures
Free cash flow is cash from operations minus cash used by essential investing activities,
scheduled debt repayments and normal dividend payments. It is necessary for planning the
amount, timing, and character of new financing. If this number is positive it means that some
cash is available to put towards more debt, increase the dividends, or invest in new areas of
business. If the amount is negative, this shows the amount of finncing needed just to continue
supporting regular business. Analyzinf cash flow statements helps to understand what has
happened in the past, as well as what future cash flow may look like. These calculations are
important for management for planning future cash needs as well as for potential lenders to
assess a companys ability to repay debt on time. (text 336)
Cash Realization Ratio (or quality of earnings ratio)
Cash generated by Operations/net income
The cash realization ratio shows how close net income is to being realized in cash. If the ratio
is higher than one, this shows high-quality earnings. Be careful because it can be deceiving if
the company is doinm sokething like slowing down payments on accounts payable (text 335)
Tests of Investment Utilization (involve both balance sheet and income statement amounts)
Asset Turnover
Sales Revenue/Total Assets
An overall ratio for investment utilization=Sales/Investment (text 374)
Comparing the turnovers in two similar companies is useful, and may help explain why one is
achieving a higher ROI than the other (text 377)
Current Ratio 126
Current Assets/Current Liabilities
The current ratio is an important indicator of whether or not a company can meet its current
obligations. If current assets do not exceed current liabilities by a comfortable margin, the entity
may be unable to pay its current bills, because current means that this will be done within the
year. A company should have a current ratio of at least 2 to 1(?) (text 42)
The current ratio is the most commonly used of all balance sheet ratios. It measures a
companys liquidity and the margin of safety that management maintains in order to allow for
the inevitable unevenness in the flow of funds through the current asset and current liability

accounts. The current ratio is the size of the buffer of funds since money in and money out are
never exactly equal. ...but different industries need different ratios (what should a train company
have?). Be careful in interpreting this though, because even if 2 companies have the same
current ratio, the one with a high percentage of its current assets in the form of monetary assets
is more liquid than one with a high percentage in inventory.(text 126)
3. Quick Ratio/Acid-Test Ratio
a. Monetary Current Assets/Current Liabilities
b. The quick ratio focuses on the relationship of monetary current assets to current liabilities. Quick
assets are current assets that are also monetary assets (so not including inventories and
prepaid items). (text 127)

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Tests of Financial Condition

Debt to Equity Ratio/debt ratio
Including current liabilities: Total Liabilities/Shareholders Equity
Excluding current liabilities: Long-term liabilities/shareholders equity
If a company has a a lot of debt it is leveraged. The debt to equity ratio shows the balance that a
company has between risk and cost, through the debt to equity. It can be calculated in many
different ways, and the user must be careful to always specify which method is being used.
Tests of Dividend Policy
Dividend per Share??
Dividends/# of Shares Outstanding
Dividend Payout Ratio
Dividends/Net Income