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Types of ratios

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.

One of the most common liquidity ratios is:

Current Ratio = Current Assets / Current Liabilities

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.

Another stringent test of liquidity is the:

Acid-test Ratio = Current Assets minus Inventories / Current Liabilities

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:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory


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:

Cash ratio = Cash + Marketable securities / Current Liabilities

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:

Solvency Ratio = Total Assets / Total Liabilities

and

Solvency Ratio = Net Worth (Total Capital or Equity) / Total Liabilities

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:

Debt Ratio = Total Debt / Total Assets

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 = Total Liabilities / Total Owners’ Equity, or


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

In assessing solvency, it is also important to take into consideration the breakdown of a


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:

Indebtedness Ratio = Total Debts / Total Liabilities

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:

Short-term Debt Ratio or Quality of Debt = Short-term Debt / Total Debt

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

Capitalized interest is the amount of interest on a loan to finance a project or acquisition


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.

Accounts Receivable Turnover = Total Credit Sales / Average Accounts Receivable

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:

Average Collection Period = Days in Year / Accounts Receivable Turnover

or

Days to Collect = Trade Accounts Receivable / Credit Sales x 365

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

Days to Pay = Trade Accounts Payable / Purchases x 365

To determine how much of a company’s accounts receivable and inventory are


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

Financing of Trade Accounts Receivable in terms of Trade Accounts Payable = Trade


Accounts Payable / Trade Accounts Receivable

Financing of Inventory in terms of Trade Accounts Payable = Trade Accounts Payable /


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

Interest Expense Percentage = Interest Expense / 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.

Gross Profit Margin = Gross Income / Total Revenue

Net Profit Margin = Net Income / Total Revenue

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.

Return on Investment (ROI) or Return on Owners’ Equity = Net Income / Average


Owners’ Equity

Return on Assets (ROA) = Net Income / Average Total Assets

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

Another commonly used ratio to show the yield on an investment is:

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.

Investment Valuation Ratios:


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:

Ratio Calculation Comments


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.