1. Key Financial Ratios 1

2. Profitability Ratios Key ratios – Return on shareholders’ equity (ROE) – Return on assets (ROA) – Return on sales (ROS) – Gross profit margin ratio 2

3. Profitability Ratios 3 Return on Shareholders’ Equity Net Income – Preferred Stock Dividends Shareholders’ Equity = Indicates the rate of return generated by a business for its common shareholders. Return on Assets Net Income + Interest Expense (1- Tax rate) Total Assets = Indicates the rate of return generated on a company’s investment in assets from all sources. How did Apple do?

4. Profitability Ratios (cont.) 4 Return on Sales Net Income Net Sales = Indicates the percentage of net income remaining from a dollar of sales after subtracting all expenses. Gross Profit Margin Ratio Net Sales – Cost of Goods Sold Net Sales = Indicates the percentage of income generated from sales after deducting the cost of goods sold.

5. Asset Management Ratios Common ratios used to calculate – Receivable turnover – Receivable collection period – Inventory turnover – Inventory-on-hand period – Asset turnover Desired effects – Collect receivables as quickly as possible – Sell inventory as quickly as possible – Generate large amounts of sales using assets 5

6. Asset Management 6 Receivable Turnover Net Sales Accounts Receivable = Indicates the number of sales/collection cycles experienced by a firm. Receivable Collection Period 365 Net Sales / Accounts Receivable = Indicates the number of days required, on average, to collect an outstanding account receivable

7. Asset Management 7 Inventory Turnover Cost of Goods Sold Inventory = Indicates the number of production/sales cycles experienced by a firm Inventory-on- Hand Period 365 Cost of Goods Sold / Inventory = Indicates the number of days, on average, required to sell the inventory currently on hand

8. Asset Management 8 Asset Turnover Net Sales Total Assets = Amount of sales generated from each dollar invested in assets. Remember from Chapter 2: ROA = ROS x Asset Turnover And ROE = ROA x Fin’l Leverage

9. Liquidity Ratios Refers to the amount of liquid resources available to pay current obligations as they come due Common liquidity measures – Cash and marketable securities to total assets – Quick ratio – Current ratio – Accounts payable turnover – Days’ payable period Goal is to maintain adequate but not excessive liquidity 9

10. Liquidity 10 Cash and Marketable Securities to Total Assets Cash + Marketable Securities Total Assets = Percentage of total assets held as highly liquid assets. Quick Ratio Cash + Marketable Securities + Accounts Receivable Current Liabilities = Amount of liquid assets available to pay short-term liabilities.

11. Liquidity 11 Current Ratio Current Assets Current Liabilities = Amount of current assets available to service current liabilities. Accounts Payable Turnover Cost of Goods Sold Accounts Payable = Number of account payable cycles experienced by a firm.

12. Credit Risk Analysis What are creditors concerned about? – The risk of not getting paid interest and principal Common measures – Long-term debt to total assets – Long-term debt to shareholders’ equity – Interest coverage ratio 12

13. Solvency 13 Long-term Debt to Total Assets Ratio Long-term Debt + Current Portion of Long-Term Debt Total Assets = Percentage of total assets provided by creditors. Long-term Debt to Shareholders’ Equity Ratio Long-term Debt + Current Portion of Long-Term Debt Shareholders’ Equity = Relative investment of long-term creditors versus shareholders in a business.

14. Solvency 14 Interest Coverage Ratio Net Income Before Taxes + Interest Expense Interest Expense = Extent to which current operating income covers current debt service charges.

15. Factors that Make Ratios Not Completely Comparable Liabilities not reported on the balance sheet, such as operating leases Industry differences Incomplete data and intangible assets Differences in management discretion Lack of timeliness

16. Practice The best way to understand these key financial ratios is to practice calculating and interpreting them. Use trend analysis to examine changes in key ratios over time. Consider what various stakeholders would be interested in.