Unit 3: Financial Ratios

Ratio Defined A comparison between two numbers showing how many times one number exceeds the other

Why Analyze Financial Statements? Analyzing a financial statement is the first step you need to take when deciding whether or not a company is sound enough to risk investing your money in

Types of Ratios Liquidity Ratios: Financial ratios that tell how well a company can pay off its short-term debts and meet unexpected needs for cash Efficiency Ratios: Financial ratios that indicate how effectively a company uses its resources to generate sales Leverage Ratios: Financial ratios that show how and to what degree a company has financed its assets Profitability Ratios: Financial ratios that tell how much of each dollar of sales, assets, and owner’s investment resulted in net profit

Liquidity Ratios Working Capital Current Assets - Current Liabilities Amount of money that would be left over after current liabilities are paid off Current Ratio Current Assets/Current Liabilities The amount of current assets available to pay off $1 of current debt. Stated 2:1.

Liquidity Ratios Acid Test/Quick Ratio Cash + Marketable Securities + Accounts Receivable = Quick Assets Quick Assets/Current Liabilities A firm’s ability to liquidate assets quickly to pay off debt

Efficiency Ratios Asset Turnover Ratio Net Sales/Total Assets The number of dollars in sales the firm generates from each dollar it has invested in assets Inventory Turnover Average Inventory = Beginning Inventory + Ending Inventory divided by 2 Cost of Goods Sold /Average Inventory The number of times during an operating period that the average inventory was sold

Efficiency Ratios Average Collection Period Accounts Receivable X 365 /Credit Sales How quickly a firm’s credit accounts are being collected

Leverage Ratios Debt-to-Assets Ratio Total Liabilities/Total Assets Measures to what degree the assets of the firm have been financed with borrowed funds Debt-to-Equity Ratio Total Liabilities/Owner’s Equity The amount of debt incurred by the company for each $1.00 of equity

Profitability Ratios Gross Profit Margin Gross Profit/Net Sales An assessment of how well the cost of goods sold category of expenses was controlled Net Profit Margin Net Income/Net Sales An assessment of management’s overall ability to control the cost of goods sold and the operating expenses of the firm

Profitability Ratios Return on Investment Net Income/Owner’s Equity The amount of profit generated by the firm in relation to the amount invested by the owners

Why Analyze? Brainstorm! What would the LIQUIDITY ratios tell you about a company? How could the company use these to make decisions? What would the EFFICIENCY ratios tell you about a company? How could the company use these to make decisions? What would the LEVERAGE ratios tell you about a company? How could the company use these to make decisions? What would the PROFITABILITY ratios tell you about a company? How could the company use these to make decisions?