I.

LIQUIDITY RATIO

- Ratios that show the relationship of a firm’s cash and other current assets to its current
liabilities.
* Liquidity Asset - An asset that can be converted to cash quickly without having to
reduce the asset’s price very much.

A. CURRENT RATIO
-It indicates the extent to which current liabilities are covered by those assets
expected to be converted to cash in the near
-Most commonly used measure of short-term solvency.

CURRENT ASSETS___ = ? TIMES

CURRENT LIABILITIES

B. QUICK / ACID TEST

- A measure of the firm’s ability to pay off short-term obligations without relying on the
sale of inventories is important.
* Inventories least liquid, thus they are the assets on which losses are most likely to
occur in the event of liquidation.

CURRENT ASSETS - INVENTORIES___ = ? TIMES

CURRENT LIABILITIES

C. WORKING CAPITAL

= CURRENT ASSETS – CURRENT LIABILITIES

D. CASH RATIO

= CASH + M.S.
CURRENT LIABILITIES

II. ASSET MANAGEMENT RATIO

-Measures how effectively the firm is managing its assets.

- If a firm has too many assets, its cost of capital will be too high, hence its profits will be
depressed. On the other hand, if assets are too low, profitable sales will be lost.

A. INVENTORY TURNOVER

- How many trips or replenishment of inventory?

** Allied’s turnover of 4.9 times is much lower than the industry average of 9 times.
This suggests that Allied is holding too much inventory. Excess inventory is, of course,
unproductive, and it represents an investment with a low or zero rate of return. Allied’s
low inventory turnover ratio also makes us question the current ratio. With such a low
turnover, we must wonder whether the firm is actually holding obsolete goods not worth
their stated value.

COST of GOODS SOLD = ? TIMES

AVERAGE INVENTORY

B. DAYS SALES IN INVENTORY DAYS

 365 DAYS OR AVERAGE INVENTORY = ? DAYS
ITO AVERAGE DAILY CGS

C. ACCOUNTS RECEIVABLE TURNOVER

SALES = ? TIMES
AVERAGE INVENTORY

D. DAYS SALES OUTSTANDING

-Indicates the average length of time the firm must wait after making a sale before it
receives cash, which is the average collection period.
-Also called the “average collection period” (ACP), is used to appraise accounts
receivable.
-Customers, on the average, are not paying their bills on time. This deprives Allied of
funds that it could use to invest in productive assets. Moreover, in some instances
the fact that a customer is paying late may signal that the customer is in financial
trouble, in which case Allied may have a hard time ever collecting the receivable.

365 DAYS OR AVERAGE ACCOUNTS RECEIVABLE = ? DAYS

ARTO AVERAGE DAILY SALES

E. FIXED ASSET TURNOVER

- Measures how effectively the firm uses its plant and equipment.
-Recall from accounting that fixed assets reflect the historical costs of the assets.
Inflation has caused the value of many assets that were purchased in the past to be
seriously understated.

SALES = ? TIMES
NET FIXED ASSETS

F. TOTAL ASSET TURNOVER

-Allied’s ratio is somewhat below the industry average, indicating that the company is
not generating a sufficient volume of business given its total assets investment. Sales
should be increased, some assets should be disposed of, or a combination of these
steps should be taken.

SALES = ? TIMES
TOTAL ASSETS

III. DEBT MANAGEMENT RATIO

-The extent to which a firm uses debt financing, or financial leverage, has three
important implications: (1) By raising funds through debt, stockholders can maintain
control of a firm while limiting their investment. (2) Creditors look to the equity, or owner-
supplied funds, to provide a margin of safety, so the higher the proportion of the total
capital that was provided by stockholders, the less the risk faced by creditors. (3) If the
firm earns more on investments financed with borrowed funds than it pays in interest, the
return on the owners’ capital is magnified, or “leveraged.”
- Firms with relatively high debt ratios have higher expected returns when the economy is
normal, but they are exposed to risk of loss when the economy goes into a recession.
Therefore, decisions about the use of debt require firms to balance higher expected
returns against increased risk.
 A. TOTAL DEBT
-Creditors prefer low debt ratios because the lower the ratio, the greater the cushion
against creditors’ losses in the event of liquidation. Stockholders, on the other hand,
may want more leverage because it magnifies expected earnings.
-Creditors may be reluctant to lend the firm more money, and management would
probably be subjecting the firm to the risk of bankruptcy if it sought to increase the
debt ratio any further by borrowing additional funds.

TOTAL DEBT = %
TOTAL ASSETS

B. TIMES- INTEREST EARNED RATIO (ABILITY TO PAY INTEREST)

-Measures the extent to which operating income can decline before the firm is unable
-To meet its annual interest costs. Allied’s interest is covered 3.2 times. Since the
industry average is 6 times, Allied is covering its interest charges by a relatively low
margin of safety. Thus, the TIE ratio reinforces the conclusion from our analysis of
the debt ratio that Allied would face difficulties if it attempted to borrow additional
funds.

EBIT = ? TIMES
INTEREST CHARGES

** TWO SHORTCOMINGS:
(1) Interest is not the only fixed financial charge — companies must also reduce
debt on schedule, and many firms lease assets and thus must make lease
payments. If they fail to repay debt or meet lease payments, they can be forced
into bankruptcy.
(2) EBIT does not represent all the cash flow available to service debt, especially
if a firm has high depreciation and/or amortization charges.

C. EBITDA COVERAGE RATIO (ABILITY TO SERVICE DEBT)

-A ratio whose numerator includes all cash flows available to meet fixed financial charges
and whose denominator includes all fixed financial charges.
- Allied’s ratio is well below the industry average, so again, the company seems to have a
relatively high level of debt.
-Banks and other relatively short-term lenders focus on the EBITDA coverage ratio,
whereas long-term bondholders focus on the TIE ratio.

EBITDA = ? TIMES
INTEREST + PRINCIPAL + LEASE
PAYMENTS PAYMENTS

D. DEBT TO EQUITY RATIO

LONG TERM DEBT = %

EQUITY

IV. PROFITABILTY RATIO

-A group of ratios that show the combined effects of liquidity, asset management, and
debt on operating results.
A. NET PROFIT MARGIN

NET INCOME = %
SALES

B. PROFIT MARGIN ON SALES

-This ratio measures net income per dollar of sales

NET INCOME AVAIL TO

COMMON STOCKHOLDERS = %
SALES
- Allied’s profit margin is below the industry average of 5 percent. This sub-par result
occurs because costs are too high. High costs, in turn, generally occur because of
inefficient operations. However, Allied’s low profit margin is also a result of its heavy use
of debt. Recall that net income is income after interest. Therefore, if two firms have
identical operations in the sense that their sales, operating costs, and EBIT are the same,
but if one firm uses more debt than the other, it will have higher interest charges. Those
interest charges will pull net income down, and since sales are constant, the result will be
a relatively low profit margin. In such a case, the low profit margin would not indicate an
operating problem, just a difference in financing strategies. Thus, the firm with the low
profit margin might end up with a higher rate of return on its stockholders’ investment due
to its use of financial leverage.

C. OPERATING PROFIT MARGIN

NET INCOME + INTEREST = %

SALES

D. BASIC EARNING POWER

-This ratio indicates the ability of the firm’s assets to generate operating income.
-This ratio shows the raw earning power of the firm’s assets, before the influence of
taxes and leverage, and it is useful for comparing firms with different tax situations
and different degrees of financial leverage. Because of its low turnover ratios and low
profit margin on sales, Allied is not earning as high a return on its assets as is the
average food-processing company.

EBIT = %
TOTAL ASSETS

E. RETURN ON TOTAL ASSETS (ROA)

-The ratio of net income to total assets.

NET INCOME + INTEREST = %

TOTAL ASSETS

F. RETURN ON EQUITY (ROE)

NET INCOME = %
EQUITY

G. PAY-OUT
DIVIDENDS OR DPS
EARNINGS EPS

H. EPS = NET INCOME OR NET INCOME – PREFERENCE DIVIDENDS

# OF O/S COMMON SHARES
 I. PLOWBACK
EARNINGS – DIVIDENDS = % OR 1 – PAY OUT RATIO
EARNINGS

J. GROWTH IN EQUITY PLOWBACK

EARNINGS RETAINED = % OR ROE x PLOWBACK RATIO
EQUITY

*** DU PONT

Du Pont Chart - A chart designed to show the relationships among return on investment, asset
turnover, profit margin, and leverage.

Du Pont Equation- A formula which shows that the rate of return on assets can be found as the
product of the profit margin times the total assets turnover.

ROA = NET INCOME + INTEREST = %

TOTAL ASSETS

ROA = OPERATING PROFIT MARGIN x TOTAL ASSET TURNOVER

ROA = NET INCOME + INTEREST x SALES

TOTAL ASSETS TOTAL ASSETS

V. MARKET VALUE RATIOS

- A set of ratios that relate the firm’s stock price to its earnings, cash flow, and book value per
share.

A. PRICE/EARNINGS (P/E) RATIO

-shows the dollar amount investors will pay for $1 of current earnings.
-P/E ratios are higher for firms with strong growth prospects, other things held
constant, but they are lower for riskier firms.

STOCK PRICE = ? TIMES

EPS

B. PRICE/CASH FLOW RATIO

-Shows the dollar amount investors will pay for $1 of cash flow.
-Cash flow per share is calculated as net income plus depreciation and amortization
divided by common shares outstanding. Allied’s price/cash flow ratio is also below
the industry average, once again suggesting that its growth prospects are below
average, its risk is above average, or both.

PRICE PER SHARE

CASH FLOW PER SHARE

C. MARKET/BOOK RATIO
-The ratio of a stock’s market price to its book value gives another
indication of how investors regard the company. Companies with relatively
high rates of return on equity generally sell at higher multiples of book
value than those with low returns.

COMMON EQUITY = $
# OF O/S
 MARKET PRICE PER SHARE = ? TIMES
BOOK VALUE PER SHARE

- M/B ratios typically exceed 1.0, this means that investors are willing to pay
more for stocks than their accounting book values. This situation occurs primarily
because asset values, as reported by accountants on corporate balance sheets, do
not reflect either inflation or “goodwill.” Thus, assets purchased years ago at
preinflation prices are carried at their original costs, even though inflation might have
caused their actual values to rise substantially, and successful going concerns have a
value greater than their historical costs. If a company earns a low rate of return on its
assets, then its M/B ratio will be relatively low versus an average company. Thus,
some airlines, which have not fared well in recent years, sell at M/B ratios below 1.0,
while very successful firms such as Microsoft (which makes the operating systems for
virtually all PCs) achieve high rates of return on their assets, causing their market
values to be well in excess of their book values. In February 2001, Microsoft’s book
value per share was $8.71 versus a market price of $64.69, so its market/book ratio
was $64.69/$8.71 = 7.43 times.

D. CASH FLOW PER SHARE

NET INCOME + DA =$
SHARES OUTSTANDING

E. DIVIDEND YIELD
DIVIDENDS PER SHARE =%
STOCK PRICE