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Some of the different types of ratios that can be calculated from data in the financial

statements and used to evaluate a business include:

• Liquidity ratios

• Solvency ratios

• Activity ratios

• Profitability ratios

Liquidity ratios

Liquidity ratios measure a business’s ability to cover its obligations, without having to

borrow or invest more money in the business. The idea is that there should be sufficient

cash and assets that can be readily converted into cash to cover liabilities as they come

due.

Current assets basically include cash, short-term investments and marketable securities,

accounts receivable, inventory, and prepaid expenses. Current liabilities include accounts

payable to vendors and employees, and installments on notes or loans that are due within

one year. This ratio could also be seen as a measure of working capital – the difference

between current assets and current liabilities. A company with a lot of working capital

will be in a better position to expand and improve its operations. On the contrary, a

company with negative working capital does not have sufficient resources to meet its

current obligations, and therefore is not in a position to take advantage of opportunities

for growth.

Inventory is a current asset that may or may not be quickly converted into cash. This

depends on the rate at which inventory is being turned over. By excluding inventory, the

acid-test ratio only considers that part of current assets that can be readily converted into

cash. This ratio, also called the Quick Ratio, tells how much of the business's short-term

debt can be met by using the company's liquid assets at short notice.

A ratio that shows how many times inventory is turned over, or sold during the period is:

A high turnover ratio is a sign that products are being produced and sold quickly during

the period. A ratio of 1.0, for example, would mean that at any given time you have

enough inventory on hand to cover sales for the entire period. The higher this ratio, the

more quickly inventory is being turned over and producing assets that are more liquid --

accounts receivable and then cash.

If you want an even clearer idea of exactly how much ready cash is on hand to cover

current liabilities, you can use the:

The cash ratio measures the extent to which a business could quickly cover short-term

liabilities, and therefore is of particular interest to short-term creditors. A ratio of 1.0

would indicate that all current liabilities would be covered at any average point in time by

cash and marketable securities that could be readily sold and converted to cash. A ratio of

less than 1.0 would mean that other assets, such as accounts receivable or inventory,

would have to be converted to cash to cover short-term obligations. A ratio of greater

than 1.0 means that there is more than enough cash on hand.

Solvency Ratios

Solvency ratios are measures to assess a company’s ability to meet its long-term

obligations and thereby remain solvent and avoid bankruptcy. Two general, overall

solvency ratios include:

and

These ratios basically tell whether a company owns more than it owes. The higher the

ratio, the more solvent the company.

Another ratio that can tell how much a company relies on debt to finance its assets is:

Traditionally, both short-term and long-term debts and assets are used in determining this

ratio. In general, the lower a company’s reliance on debt to finance its assets, the less

risky the company.

The debt to equity ratio is a measure of a company’s leverage – how much financing it

has in the form of debt as compared with how much it has invested in the business.

Debt-equity Ratio = Long-Term Liabilities / Total Owners’ Equity

company’s liabilities. Not all liabilities are debt in the form of bank loans or notes

payable, for example. There are also accounts payable to vendors, salaries and wages

payable, taxes payable, and accrued liabilities, among others. One of the measures of

what debt constitutes in terms of total liabilities is:

In general, a company that is heavy on debt may be better leveraged, but is also less

solvent.

The debt repayment terms are another consideration. Short-term debt, payable within one

year, may pose a greater burden on cash flow and eventual solvency than long-term debt,

which is due beyond one year. A ratio used to quantify this is:

A lower value for this ratio would indicate less concern for installments coming due

within a year.

There are other ratios intended to assess a company’s capacity to cover its debt

repayments and financing costs. One of these ratios measures how interest expense is

being covered by the net income the company is generating:

Interest expense coverage = Net income before interest and taxes / Interest expense

This ratio is also called Number of Times Interest Earned, and represents how many

times the net income generated by the company, without considering interest and taxes,

covers the total interest charge. The higher the ratio the more solvent the company.

Another similar ratio often used to measure a company’s capacity to cover its fixed

charges is:

Ratio of Earnings to Fixed Charges = Earnings before income tax and fixed charges /

Interest expense (including capitalized interest) and amortization of bond discount and

issue costs

of fixed assets, that has been capitalized and included as part of the cost of the project or

asset on the balance sheet. You will probably need to see the notes to the financial

statements to find this figure

Activity Ratios

Many useful gauges of operations can be calculated from data reported in the financial

statements. For example, you can determine the average number of days it takes to collect

on customer accounts, the average number of days to pay vendors, and how much of the

operation is effectively being financed with payment terms extended by vendors.

This tells you the average duration of accounts receivable for credit sales to customers.

This in turn can be expressed in terms of the collection period, as follows:

or

A similar calculation can be made on the liabilities side, with accounts payable to

vendors:

effectively being financed by the credit extended to the company by its vendors:

Accounts Payable / Trade Accounts Receivable

Inventory

Effectively managing the credit extended by vendors can help a company’s cash flow and

therefore its liquidity and solvency.

From data reported on the income statement, various relationships can be calculated

between different expenses and revenues, or a certain type of expense as a percentage of

total expenses.

Labor Cost Percentage = Payroll and Related Expenses / Total Revenue or Total

Expenses

These types of ratios or percentages can be calculated for any item on the income

statement. Which accounts are more important will depend on the nature of the business.

For example, some operations are more labor intensive and some are more capital

intensive. In a labor intensive operation, the percentage that employee-related expenses,

including wages, salaries and benefits, represent in terms of total operating expense is

relevant. In a capital intensive operation, repairs and maintenance may take on more

importance.

Profitability Ratios

One of the most common profitability ratios is the profit margin. This can be expressed as

the gross profit margin or net profit margin, and it can be expressed by company, by

sector, by product, or by individual unit. The information reported on the income

statement will enable you to determine the overall profit margin. If additional

breakdowns are provided, more detailed margins can be calculated.

Other commonly used ratios are returns, expressed as return on investment or equity,

return on assets, and return on capital employed. These ratios measure a company’s

ability to use its capital, or its assets, to generate additional value.

Owners’ Equity

Return on Capital Employed (ROCE) = Net Income Before Interest and Tax / Capital

Employed (Total Assets minus Current Liabilities)

When evaluating investment opportunities, profits are often measured per share:

Earnings per Share = Net Profit After Tax and Dividends / Ordinary Shareholders' Equity

Dividend Yield Ratio = Dividends per Share / Market Value per Share

And, to measure how the price of an investment correlates with the earnings on that

investment, you can use the:

Price to Earnings Ratio = Market Value per Share / After-Tax Earnings per Share

Summary

The bottom line on the income statement is not the only important figure on the financial

statements, and may not even be the most important. There is another whole dimension of

valuable information that can be obtained from the data reported in the financial

statements. Ratio analysis is one of many tools that can be used to evaluate a company’s

performance, its current status, and its evolution over time. And if you are the owner of

the business, this type of analysis can help you make the right decisions to improve your

operations and make your business stronger and more successful.

Price/Earnings Ratio

The price/earnings ratio (P/E) is the best known of the investment valuation indicators.

The P/E ratio has its imperfections, but it is nevertheless the most widely reported and

used valuation by investment professionals and the investing public. The financial

reporting of both companies and investment research services use a basic earnings per

share (EPS) figure divided into the current stock price to calculate the P/E multiple (i.e.

how many times a stock is trading (its price) per each dollar of EPS).

It's not surprising that estimated EPS figures are often very optimistic during bull

markets, while reflecting pessimism during bear markets. Also, as a matter of historical

record, it's no secret that the accuracy of stock analyst earnings estimates should be

looked at skeptically by investors. Nevertheless, analyst estimates and opinions based on

forward-looking projections of a company's earnings do play a role in Wall Street's stock-

pricing considerations.

Historically, the average P/E ratio for the broad market has been around 15, although it

can fluctuate significantly depending on economic and market conditions. The ratio will

also vary widely among different companies and industries.

Formula:

Components:

The dollar amount in the numerator is the closing stock price for Zimmer Holdings as of

December 31, 2005 as reported in the financial press or over the Internet in online quotes.

In the denominator, the EPS figure is calculated by dividing the company's reported net

earnings (income statement) by the weighted average number of common shares

outstanding (income statement) to obtain the $2.96 EPS figure. By simply dividing, the

equation gives us the P/E ratio that indicates (as of Zimmer Holdings' 2005 fiscal

yearend) its stock (at $67.44) was trading at 22.8-times the company's basic net earnings

of $2.96 per share. This means that investors would be paying $22.80 for every dollar of

Zimmer Holdings' earnings.

Variations:

The basic formula for calculating the P/E ratio is fairly standard. There is never a

problem with the numerator - an investor can obtain a current closing stock price from

various sources, and they'll all generate the same dollar figure, which, of course, is a per-

share number.

However, there are a number of variations in the numbers used for the EPS figure in the

denominator. The most commonly used EPS dollar figures include the following:

• Basic earnings per share - based on the past 12 months as of the most recent

reported quarterly net income. In investment research materials, this period is

often identified as trailing twelve months (TTM). As noted previously, diluted

earnings per share could also be used, but this is not a common practice. The term

"trailing P/E" is used to identify a P/E ratio calculated on this basis.

• Estimated basic earnings per share - based on a forward 12-month projection as

of the most recent quarter. This EPS calculation is not a "hard number", but rather

an estimate generated by investment research analysts. The term, estimated P/E

ratio, is used to identify a P/E ratio calculated on this basis.

• The Value Line Investment Survey's combination approach - This well-

known and respected independent stock research firm has popularized a P/E ratio

that uses six months of actual trailing EPS and six months of forward, or

estimated, EPS as its earnings per share component in this ratio.

• Cash Earnings Per Share - Some businesses will report cash earnings per share,

which uses operating cash flow instead of net income to calculate EPS.

• Other Earnings Per Share - Often referred to as "headline EPS", "whisper

numbers", and "pro forma", these other earnings per shares metrics are all based

on assumptions due to special circumstances. While the intention here is to

highlight the impact of some particular operating aspect of a company that is not

part of its conventional financial reporting, investors should remember that the

reliability of these forms of EPS is questionable.

Investor Ratios

There are several ratios commonly used by investors to assess the performance of a business as an

investment:

Earnings per Earnings (profits) A requirement of the London Stock Exchange - an important ratio.

share ("EPS") attributable to ordinary EPS measures the overall profit generated for each share in

shareholders / existence over a particular period.

Weighted average

ordinary shares in issue

during the year

Price- Market price of share / At any time, the P/E ratio is an indication of how highly the market

Earnings Earnings per Share "rates" or "values" a business. A P/E ratio is best viewed in the

Ratio ("P/E context of a sector or market average to get a feel for relative

Ratio") value and stock market pricing.

Dividend (Latest dividend per This is known as the "payout ratio". It provides a guide as to the

Yield ordinary share / current ability of a business to maintain a dividend payment. It also

market price of share) x measures the proportion of earnings that are being retained by the

100 business rather than distributed as dividends.

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