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| Calculate Financial Ratios |
Financial Analysts and managers find it helpful to calculate financial ratios when interpreting a company's financial statements. A financial ratios is simply one quantity divided by another. You'll find almost any decision that uses accounting information relies on financial ratios that focus on specific aspects of the company. The number of financial ratios that might be created is virtually limitless, but there are certain basic ratios that are frequently used. These ratios can be placed into six classes; liquidity ratios, asset turnover ratios, leverage ratios, coverage ratios, profitability ratios and market value ratios.
Liquidity Ratios
Recall that liquidity refers to how quickly and efficiently (in the sense of low transaction costs) an asset can be exchanged for cash. Liquidity ratios provide a measure of the company's liquidity, that is, its ability to meet its financial obligations on time. Four widely used liquidity ratios are the current ratio, quick ratio, working capital ratio and the cash ratio.
The most commonly used measure of overall liquidity is the current ratio
Current ratio = Current assets/Current liabilities = 1816/1460= 1.24x ----------------- (1)
The current ratio measures the number of times the company's current assets cover its current liabilities. The higher the current ratio, the greater the company's ability to meet its short term obligations as they come due. A widely held but conservative rule of thumb holds that a current ratio of 2.0 is an appropriate target for most companies. In fact, the average current ratio for companies included in the S&P 500 is about 1.5.
Inventories are considered current assets, so they are included in the current ratio calculation. Inventories, however are less liquid than marketable securities and accounts receivable. This is because it is normally more difficult to turn inventory into cash on short notice. Thus analysts often exclude inventories from the numerator in the current ratio and calculate the quick ratio (also called the acid test ratio).
Quick (Acid test) ratio=Current assets - Inventories/Current liabilities=1816-661/1460=0.79x ------(2)
Another widely held but rough rule of thumb holds that a quick ratio of at least 1.0 is desirable. The average S&P 500 company has a quick ratio of about 0.9.
Net working capital (or, simply, working capital) is the difference between current assets and current liabilities. The working capital ratio is simply net working capital expressed as a proportion of sales.
Working capital ratio = Current assets - Current liabilities/Sales = 1816-1460/11,394 = 3.1% -------(3)
Net Working capital is often considered a measure of liquidity. This ratio shows the amount of liquidity relative to sales.
The cash ratio is calculated by dividing cash and equivalents by total assets.
Cash ratio = Cash and equivalents/ Total assets = 215/10,538 = 2.0% ----------------------------------(4)
Cash and equivalents (which include marketable securities) is the most liquid asset. The cash ratio simply shows the proportion of its assets that the company is holding in the most liquid possible form.
Asset Turnover Ratios
Asset turnover ratios are designed to measure how effectively a company manages its assets. A business faces fundamental decisions about how much to invest in assets such as receivable, inventories and fixed assets and then it has the responsibility of using these assets effectively. Several ratios have evolved that focus on the management of specific assets as well as total assets.
The receivables turnover ratio is:
Receivables turnover = Annual credit sales/ Accounts receivable = 11,394/650 = 17.53x-------------(5)
It measures the number of times the accounts receivable balance "turns over" during the year. Note that annual credit sales, which give rise to receivables, are used in the numerator. If a figure for annual credit sales is not available, the company's net sales figure is used instead. Making that substitution is like assuming all sales were credit sales.
A closely related figure is the days sales outstanding (DSO). It is the number of days in a year divided by the receivables turnover ratio.
Days sales outstanding = 365/Receivables turnover= Accounts receivable/Annual credit sales/365=365/17.53=20.8 days --------------------------------------------------------------------------------(6)
The days sales outstanding shows approximately how many days on average it takes to collect the company's accounts receivable. The days sales outstanding is also called the average collection period.
A more detailed picture of the company's accounts receivable can be obtained by preparing an aging schedule for accounts receivable. An aging schedule shows the amounts of receivables that have been outstanding for different periods, such as 0 to 30 days, 30 to 60 days, 60 to 90 days and more than 90 days. An example of an accounts receivable aging schedule is given in the below table. An external analyst typically lacks the detailed information in an aging schedule unless the company has chosen to provide it. Of course, managers within the company want this information to help monitor the quality of their accounts receivable.
A measure of the effectiveness of inventory management is the inventory turnover ratio, which is calculated as follows.
Inventory turnover = Cost of goods sold/Inventory = 6742/661 = 10.20x--------------------------------(7)
Inventory turnover is a good estimate of how many times per year the inventory is physically turning over. In the past, some analysts calculated the inventory turnover by dividing net sales by inventory. However, this calculation overstates the turnover rate of physical inventory.
Another way to measure inventory turnover is the days sales in inventory ratio. This is the time for "one turnover". For example, if inventory turnover were 12.0x, one turnover would be 1/12 of a year, which in days is 30.42 (=365/12). For Anheuser-Busch, it is
Days sales in inventory= 365/Inventory turnover =Inventory/Cost of goods sold/365=365/10.20=35.8days----------------------------------------------------------------------------------(8)
The days sales in inventory ratio estimates the average time inventory stays with the company before it's sold.
Finally, two more ratios show how productively the company is using its assets. They are the fixed asset turnover ratio and the total asset turnover ratio.
Fixed asset turnover = Sales/Net fixed assets = 11,394/7524=1.51x -------------------------------------(9)
Total asset turnover = Sales/Total Assets = 11,394/10538=1.08x ---------------------------------------(10)
These two ratios show the sales volume generated per book value dollar of fixed assets and total assets, respectively. Because total assets is never smaller than fixed assets, the total asset turnover is virtually always smaller than the fixed asset turnover.
Table
Accounts Receivable Aging Schedule
Leverage Ratios
Financial leverage is the extent to which a company is financed with debt. The amount of debt a company uses has both positive and negative effects. The more debt, the more likely it is that the company will have trouble meeting its obligations. Thus the more debt, the higher the probability of financial distress and even bankruptcy. Furthermore, the chance of financial distress, and debt obligations generally, may create conflicts of interest among the stakeholders.
Despite this , debt is a major source of financing. It provides a significant tax advantage, because interest is tax deductible, as we noted in this post. Debt also has lower transaction costs and is generally easier to obtain. Finally, debt affects how the company's stakeholders bear the risk of the company. One particular effect is that debt makes the stock riskier because of the increased chance of financial distress. These factors are discussed at length later in the book. At this point, suffice it to say that leverage is very important, and leverage ratios measure the amount of (financial) leverage.
Three common leverage ratios are the debt ratio, the debt/equity ratio, and the equity multiplier. The debt ratio is the proportion of debt financing.
Debt ratio= Total debt/Total assets=10,538 - 4620/10,538=5918/10,538=0.56x-----------------------(11)
The debt/equity ratio is a simply rearrangement of the debt ratio and expresses the same in formation on a different scale. Whereas the debt ratio can be as small as zero but, assuming positive equity, is always less than 1.0, the debt/equity ratio ranges from zero to infinity. The debt/equity ratio is
Debt/equity ratio=Total debt/Stockholders equity=5918/4620=1.28x-----------------------------------(12)
The equity multiplier is yet another representation of the same information. It shows how much total assets the company has for each dollar of equity. The equity multiplier is
Equity multiplier = Total assets/Stockholders equity=10,538/4620=2.28x -----------------------------(13)
All three of the leverage ratios are widely used. As we have said, they are simply different representations of the same information. If you know any one of them, you can derive the other two. For example, suppose a company has a debt ratio of 0.40x, so it's 40% debt financed. From this we know that the company is 60% equity financed. Therefore, the company's debt/equity ratio is 40/60=0.67x. Because total assets are equal to 100% of the financing (the balance sheet identity, A=L+SE), the equity multiplier is 100/60=1.67. Generalizing we have
Debt/equity ratio = Debt ratio/1.0 - Debt ratio
Equity multiplier=Debt/equity ratio + 1.0 = 1.0/1.0-Debt ratio
Because it does not make any difference which of the three measures is used, we use the debt ratio throughout this post and its related for simplicity and consistency.
Coverage Ratios
Coverage ratios show the number of times a company can "cover" or meet a particular financial obligation. The times interest earned ratio, which is also called the interest coverage ratio, measures the number of times the income available to pay interest charges covers the company's interest expense. It is Earnings Before Interest and Income Taxes (EBIT) divided by the company's interest expense. For Anheuser Busch, EBIT is 1767 (=operating profit (1776) plus nonoperating profit(-9). So the time interest earned ratio is
Times-interest-earned ratio=EBIT/Interest expense=1767/200=8.84x----------------------------------(14)
Many companies lease or rent assets that require contractual payments. Long term leases are reported on the balance sheet and the periodic lease payments are included in the company's interest expense. Rental agreements are different. They are not on the balance sheet. Renting an asset is an alternative to owing it. (Rental payments are therefore an alternative to the interest payments the company would make if it borrowed the money to buy the same assets). Rental expense is reported in the notes to the financial statements. For these companies, the fixed charge coverage ratio is useful, where fixed charges consist of interest expense plus rental payments.
Fixed charge coverage ratio=EBIT+Rental payments/Interest charges + Rental payments=1767+5/200+5=8.64x------------------------------------------------------------------------------(15)
The cash flow coverage ratio is the company's operating cash flows divided by its payment obligations for interest, principal, preferred stock dividends and rent.
Cash flow coverage ratio = EBIT+Rental payments + Depreciation/Prefferred stock
Rental payments + Interest charges + dividends /1-T+repayment/1-T-------------(16)
Cash flow coverage ratio = 3.01x
Note that two of the financial obligations in the denominator of the cash flow coverage ratio are divided by (1-T), where T is the marginal income tax rate. Rental payments and interest charges are tax deductible expenses. Only one dollar of before tax cash flow is required to meet one dollar of these obligations. In contrast, preferred stock dividends and principal repayments must be made out of after tax cash flows. As a consequence, they are divided by (1-T) to calculate the equivalent before tax operating cash flow necessary to meet them. For example, with a marginal tax rate of 40% and a $100 non tax deductible obligation, the company needs $166.67 (=100/(1-0.4) of before tax dollars to meet this obligation. Note that the $166.67 before tax cash flow provides $100 after taxes of $66.67 (=[0.40]166.67).
Profitability Ratios
Profitability ratios focus on the company's effectiveness at generating profit. They reflect the operating performance, its riskiness and the effect of leverage. We'll look at two kinds of profitability ratios, profit margins, which measure performance in relation to sales and return ratios, which measure performance relative to some measure of the size of the investment.
Gross profit is the difference between sales and the cost of goods sold. Gross profit is critical because it represents the amount of money remaining to pay operating costs, financing costs and taxes and to provide for profit. The gross profit margin is the amount of each sales dollar left over after paying the cost of goods sold.
Gross profit margin=Gross profit/Sales=Sales-Cost of goods sold/Sales=4652/11,394=40.8%-----(17)
The net profit margin measures the profit that is available from each dollar of sales after all expenses have been paid, including cost of goods sold, selling, general and administrative expenses, depreciation interest and taxes.
Net profit margin = Net income before extraordinary items/Sales=994/11,394=8.7%----------------(18)
Note that the gross profit margin and net profit margin are identical to the percentages of sales for gross profit and net profit on the common size income statement.
Unlike profit return ratios express profitability in relation to various measures of the investment in the company. Their potential usefulness is inherently limited, however, because they are based on book values. Three ratios are commonly used, return on assets, earning power and the return on equity.
Return on assets (ROA) corresponds to the net profit margin, except that net income is expressed as a proportion of total assets.
ROA=Return on assets=Net income/Total assets=994/10,538=9.4%------------------------------------(19)
Earning power is EBIT divided by total assets.
Earning Power = EBIT/Total Assets = 1767/10,538=16.8%----------------------------------------------(20)
The difference between ROA and earning power is due to debt financing. Net income is EBIT minus interest and taxes, so ROA will always be less than earning power. Earning power represents the "raw" operating results, whereas ROA represents the combined results of operating and financing.
Return on equity (ROE) is the return on common stock holders equity.
ROE=Return on common Stockholders equity=Earnings available for common stock before extraordinary items/Common stockholders equity=994/4620/21.5%------------------------------------(21)
Where common stockholders equity includes common stock (at par value), capital surplus and retained earnings. ROE shows the company's residual profits as a proportion of the book value of common stockholders equity. The amount of financial leverage affects both the numerator and denominator of the ROE. Typically, ROE is greater than ROA for healthy companies. In bad years, however, ROE can be below ROA. This is because financial leverage increases the risk of the stock, as we noted earlier.
The price/earnings ratio (P/E) is the market price per share of common stock divided by the earnings per share (EPS)
P/E=Price/earnings ratio=Market price per share/Earnings per share=58.50/3.48=16.8x-------------(22)
Negative earnings make EPS negative. Which in turn make the P/E negative. Also, when EPS gets close to zero, the P/E becomes extremely large, because of dividing by the EPS. In such cases, the P/E is not considered economically meaningful. As a result, the P/E is not generally reported when EPS is negative or excessively small.
The earnings yield is another form of the same information. It is the reciprocal.
Earnings yield= Earnings per share/Market price per share=3.48/58.50=5.95%-----------------------(23)
EPS is in the numerator of the earnings yield and so avoids the division by zero problem. So, unlike the P/E the earnings yield does not "break down" when EPS is negative or excessively small. A very small EPS simply leads to a very small earnings yield. A negative EPS simply represents such losses as a negative return, a rate of losing value.
The ratio of dividends per share to market price per share is called the dividend yield.
Dividend yield = Dividend per share/Market price per share=1.20/58.50=2.05%---------------------(24)
Many companies are not currently paying a cash dividend. Such companies will have a dividend yield of zero. The decision to pay cash dividends is essentially a choice between paying out earnings to the owners or reinvesting the money in the company.
Finally, the market to book ratio is the market price per share divided by the book value per share. The book value per share is total common equity divided by the number of common shares outstanding. At year end 1992, Anheuser-Busch's book value per share was $16.17(=4620/285.69).
Market to book ratio=Market price per share/Book value per share=58.50/16.17=3.62x-------------(25)
The market to book ratio is a very rough index of a company's historical performance. The higher the ratio, the greater is market value relative to book value. A high ratio says the company has created more in market value than the GAAP rules have recorded in book value. The implied message is that the company has done well. Of course, as we noted earlier, there are many possible explanations for a difference between market and book values. Although the implied message of a high market to book ratio is likely to be correct in most cases, additional information is generally needed to reach a confident conclusion. Financial Analysts and managers find it helpful to calculate financial ratios when interpreting a company's financial statements.
Times-interest-earned ratio=EBIT/Interest expense=1767/200=8.84x----------------------------------(14)
Many companies lease or rent assets that require contractual payments. Long term leases are reported on the balance sheet and the periodic lease payments are included in the company's interest expense. Rental agreements are different. They are not on the balance sheet. Renting an asset is an alternative to owing it. (Rental payments are therefore an alternative to the interest payments the company would make if it borrowed the money to buy the same assets). Rental expense is reported in the notes to the financial statements. For these companies, the fixed charge coverage ratio is useful, where fixed charges consist of interest expense plus rental payments.
Fixed charge coverage ratio=EBIT+Rental payments/Interest charges + Rental payments=1767+5/200+5=8.64x------------------------------------------------------------------------------(15)
The cash flow coverage ratio is the company's operating cash flows divided by its payment obligations for interest, principal, preferred stock dividends and rent.
Cash flow coverage ratio = EBIT+Rental payments + Depreciation/Prefferred stock
Rental payments + Interest charges + dividends /1-T+repayment/1-T-------------(16)
Cash flow coverage ratio = 3.01x
Note that two of the financial obligations in the denominator of the cash flow coverage ratio are divided by (1-T), where T is the marginal income tax rate. Rental payments and interest charges are tax deductible expenses. Only one dollar of before tax cash flow is required to meet one dollar of these obligations. In contrast, preferred stock dividends and principal repayments must be made out of after tax cash flows. As a consequence, they are divided by (1-T) to calculate the equivalent before tax operating cash flow necessary to meet them. For example, with a marginal tax rate of 40% and a $100 non tax deductible obligation, the company needs $166.67 (=100/(1-0.4) of before tax dollars to meet this obligation. Note that the $166.67 before tax cash flow provides $100 after taxes of $66.67 (=[0.40]166.67).
Profitability Ratios
Profitability ratios focus on the company's effectiveness at generating profit. They reflect the operating performance, its riskiness and the effect of leverage. We'll look at two kinds of profitability ratios, profit margins, which measure performance in relation to sales and return ratios, which measure performance relative to some measure of the size of the investment.
Gross profit is the difference between sales and the cost of goods sold. Gross profit is critical because it represents the amount of money remaining to pay operating costs, financing costs and taxes and to provide for profit. The gross profit margin is the amount of each sales dollar left over after paying the cost of goods sold.
Gross profit margin=Gross profit/Sales=Sales-Cost of goods sold/Sales=4652/11,394=40.8%-----(17)
The net profit margin measures the profit that is available from each dollar of sales after all expenses have been paid, including cost of goods sold, selling, general and administrative expenses, depreciation interest and taxes.
Net profit margin = Net income before extraordinary items/Sales=994/11,394=8.7%----------------(18)
Note that the gross profit margin and net profit margin are identical to the percentages of sales for gross profit and net profit on the common size income statement.
Unlike profit return ratios express profitability in relation to various measures of the investment in the company. Their potential usefulness is inherently limited, however, because they are based on book values. Three ratios are commonly used, return on assets, earning power and the return on equity.
Return on assets (ROA) corresponds to the net profit margin, except that net income is expressed as a proportion of total assets.
ROA=Return on assets=Net income/Total assets=994/10,538=9.4%------------------------------------(19)
Earning power is EBIT divided by total assets.
Earning Power = EBIT/Total Assets = 1767/10,538=16.8%----------------------------------------------(20)
The difference between ROA and earning power is due to debt financing. Net income is EBIT minus interest and taxes, so ROA will always be less than earning power. Earning power represents the "raw" operating results, whereas ROA represents the combined results of operating and financing.
Return on equity (ROE) is the return on common stock holders equity.
ROE=Return on common Stockholders equity=Earnings available for common stock before extraordinary items/Common stockholders equity=994/4620/21.5%------------------------------------(21)
Where common stockholders equity includes common stock (at par value), capital surplus and retained earnings. ROE shows the company's residual profits as a proportion of the book value of common stockholders equity. The amount of financial leverage affects both the numerator and denominator of the ROE. Typically, ROE is greater than ROA for healthy companies. In bad years, however, ROE can be below ROA. This is because financial leverage increases the risk of the stock, as we noted earlier.
Market Value Ratios
At the time the 1992 statements were prepared, the price of Anheuser Busch common stock was $58.50 per share. Analysts look at several ratios that use the market value of the company's common stock.The price/earnings ratio (P/E) is the market price per share of common stock divided by the earnings per share (EPS)
P/E=Price/earnings ratio=Market price per share/Earnings per share=58.50/3.48=16.8x-------------(22)
Negative earnings make EPS negative. Which in turn make the P/E negative. Also, when EPS gets close to zero, the P/E becomes extremely large, because of dividing by the EPS. In such cases, the P/E is not considered economically meaningful. As a result, the P/E is not generally reported when EPS is negative or excessively small.
The earnings yield is another form of the same information. It is the reciprocal.
Earnings yield= Earnings per share/Market price per share=3.48/58.50=5.95%-----------------------(23)
EPS is in the numerator of the earnings yield and so avoids the division by zero problem. So, unlike the P/E the earnings yield does not "break down" when EPS is negative or excessively small. A very small EPS simply leads to a very small earnings yield. A negative EPS simply represents such losses as a negative return, a rate of losing value.
The ratio of dividends per share to market price per share is called the dividend yield.
Dividend yield = Dividend per share/Market price per share=1.20/58.50=2.05%---------------------(24)
Many companies are not currently paying a cash dividend. Such companies will have a dividend yield of zero. The decision to pay cash dividends is essentially a choice between paying out earnings to the owners or reinvesting the money in the company.
Finally, the market to book ratio is the market price per share divided by the book value per share. The book value per share is total common equity divided by the number of common shares outstanding. At year end 1992, Anheuser-Busch's book value per share was $16.17(=4620/285.69).
Market to book ratio=Market price per share/Book value per share=58.50/16.17=3.62x-------------(25)
The market to book ratio is a very rough index of a company's historical performance. The higher the ratio, the greater is market value relative to book value. A high ratio says the company has created more in market value than the GAAP rules have recorded in book value. The implied message is that the company has done well. Of course, as we noted earlier, there are many possible explanations for a difference between market and book values. Although the implied message of a high market to book ratio is likely to be correct in most cases, additional information is generally needed to reach a confident conclusion. Financial Analysts and managers find it helpful to calculate financial ratios when interpreting a company's financial statements.
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