Ch.4 Financial Ratios Goals: I. Define 5 Major Categories of Ratios II. Use financial ratios to assess a firm’s past performance, identify its current problems and suggest future strategies for dealing with these problems.

I. 5 Categories 1) Liquidity ratios 2) Efficiency ratios 3) Leverage ratios 4) Coverage ratios 5) Profitability ratios

1. Liquidity ratios: Ability of a firm to meet its current obligation The higher, the better (not always) 1) Current Ratio = Current assets/current liabilities The higher, the higher the likelihood that a firm will be able to pay its bills

But shareholders expect minimum amounts of current assets inside. 2) Quick Ratios=(current asset - inventories)/current liabilities Among current assets, inventory may not be liquid, compared to other current assets

2. Efficiency Ratios: Information about how well the company is using their assets to generate sales. 1) Inventory turnover ratio=Cost of goods sold (Sales) /Inventory Number of dollars of costs (sales) that are generated per dollar of inventory Number of times that a firm replaces its inventory

Higher turnover ratio is considered to be good, but if it is too high, it is bad for customers and indicates something wrong in inventory systems. 2) Account receivable ratio=credit sales/account receivable. Number of dollars of credit sales that are generated per dollar of account receivable. The higher, the better. (not too much)

3) Account collection period=Account receivable / (Annual Credit Sales/360) = 360/ Account Receivable Turnover Ratio. The lower, the better. 4) Fixed Asset Turnover Ratio= Sales/ Net Fixed Assets Dollar amounts of sales that are generated by each dollar invested in assets.

5) Total Asset Turnover Ratio = Sales/Total Assets The higher, the better isn’t it? Why? 3. Leverage Ratios : degree to which the firm uses debt in its capital structure.

1) Total Debt Ratio=Total Debt/Total Assets 2) Long Term Debt Ratio= Long Term Debt/Total Assets 3) Long Term Debt to Total Capitalization ratio=LTD/(LTD+Preferred Equity +Common Equity) : Percentage of long term sources of capital that is provided by long-term debt.

4) Debts to Equity Ratio=Total Debt/Total Equity= (Total debts/Total Assets) * (Total Assets/Total Equity) 5) Long term debt to equity ratio = LTD/(preferred equity + common equity)

4. Coverage Ratios: ability of a firm to pay certain expenses The higher, the better Too high ratios indicate that the firm is under- utilizing its debts 1) Time Interest Earned = EBIT/Interest Expenses 2) Cash Coverage Ratio = (EBIT+Non-Cash Expenses)/Interest Expense

5. Profitability Ratios: Information about firms’ profitability The higher, the better 1) Gross Profit Margin =Gross Profit / Sales 2) Operating Profit Margin = EBIT/ Sales 3) Net Profit Margin = Net Income / Sales 4) Return on Total Assets =Net Income / Total Assets 5) Return on Equity = Net Income / Total Equity

6) Return on Common Equity= Net Income Available to Common / Common Equity II. Using Financial Ratios A single ratio may mislead you to ???? 1. Trend Analysis Analyze historical changes Problem of seasonality

2. Comparing to Industry average 3. Company Goals and Debt Convenants. 4. Z-scores 5. Automating Ratio Analysis 6. EVA or Economic profits