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Current Ratio
The current ratio is a liquidity ratio that measures a company's ability to pay shortterm and long-term obligations. To gauge this ability, the current ratio considers the
current total assets of a company (both liquid and illiquid) relative to that companys
current total liabilities.
The formula for calculating a companys current ratio, then, is:
Current Ratio = Current Assets / Current Liabilities
The current ratio is called current because, unlike some other liquidity ratios, it
incorporates all current assets and liabilities.
The current ratio is also known as the working capital ratio.
An example: assume that Big-Sale Stores has $2 billion in cash, $1 billion in securities,
$4 billion in inventory, $2 billion in accounts receivable and $6 billion in liabilities. To
calculate Big-Sales current ratio, you would take the sum of its various assets and divide
them by its liabilities, for a current ratio of 1.5 (($2B + $1B + $4B + $2B) / $6B = $9B /
$6B = 1.5). Big-Sale Stores, then, appears to have healthy financials.
The current ratio can give a sense of the efficiency of a company's operating cycle or its
ability to turn its product into cash. Companies that have trouble getting paid on
their receivables or have long inventory turnover can run into liquidity problems because
they are unable to alleviate their obligations.
One popular ratio is the working capital ratio, which is the same as the current ratio.
Another class of liquidity ratios works in a similar way to the current ratio, but are more
specific as to the kinds of assets they incorporate. The cash asset ratio (or cash ratio),
for example, compares only a companys marketable securities and cash to its current
liabilities. The acid-test ratio (or quick ratio) compares a companys easily liquidated
assets (including cash, accounts receivable and short-term investments, excluding
inventory and prepaids) to its current liabilities. The operating cash flow ratio compares a
companies active cash flow from operations to its current liabilities. These liquidity ratios
have a more specific purpose than the current ratio, that is, to gauge a companys ability
to pay off short term debts.
Another similar liquidity ratio is the debt ratio, which is the opposite of the current ratio.
Debt ratio calculations take current liabilities as the numerator and current assets as the
denominator in an attempt to measure a companys leverage.
2. Quick Ratio
Cash $5 million, marketable securities $10 million, accounts receivable $15 million,
inventories $20 million.
This is offset by current liabilities of $20 million.
The quick ratio in this case is 1.5 and the current ratio is 2.5.
The quick ratio is more conservative than the current ratio because it excludes
inventories from current assets. The ratio derives its name presumably from the fact that
assets such as cash and marketable securities are quick sources of cash. Inventories
generally take time to be converted into cash, and if they have to be sold quickly, the
company may have to accept a lower price than book value of these inventories. As a
result, they are justifiably excluded from assets that are ready sources of immediate
cash.
Whether accounts receivable is a source of ready cash is debatable, however, and
depends on the credit terms that the company extends to its customers. A firm that gives
its customers only 30 days to pay will obviously be in a better liquidity position than one
that gives them 90 days. But the liquidity position also depends on the credit terms the
company has negotiated from its suppliers. For example, if a firm gives its customers 90
days to pay, but has 120 days to pay its suppliers, its liquidity position may be
reasonable.
The other issue with including accounts receivable as a source of quick cash is that
unlike cash and marketable securities which can typically be converted into cash at
the full value shown on the balance sheet the total accounts receivable amount
actually received may be slightly below book value because of discounts for early
payment and credit losses.
To learn more about assessing a company's liquidity, check out How do you calculate
working capital?
of accounts receivable during a given period by the total value of credit sales during the
same period, and multiplying the result by the number of days in the period measured.
The formula for calculating days sales outstanding can be represented with the following
formula:
A low DSO value means that it takes a company fewer days to collect its accounts
receivable. A high DSO number shows that a company is selling its product to customers
on credit and taking longer to collect money.
Days sales outstanding is also often referred to as days receivables and is an element
of the cash conversion cycle.
an individual DSO value. If a companys DSO is increasing, it may indicate a few things.
It may be that customers are taking more time to pay their expenses, suggesting either
that customer satisfaction is declining, that salespeople within the company are offering
longer terms of payment to drive increased sales or that the company is allowing
customers with poor credit to make purchases. Additionally, too sharp of an increase in
DSO can cause a company serious cash flow problems. If a company is accustomed to
paying its expenses at a certain rate on the basis of consistent payments on its accounts
receivable, a sharp rise in DSO can disrupt this flow and force the company to make
drastic changes.
Generally, when looking at a given companys cash flow, it is helpful to track that
companys DSO over time to determine if its DSO is trending in any particular direction
or if there are any patterns in the companys cash flow history. DSO may often vary on a
monthly basis, particularly if the company is affected by seasonality. If a company has a
volatile DSO, this may be cause for concern, but if a companys DSO dips during a
particular season each year, this is often less of a reason to worry.
use alongside DSO. Like any metric measuring a companys performance, DSO should
not be considered alone, but instead should be considered with other metrics as well.
For more on DSO and how to lower it, read Understanding The Cash Conversion Cycle.
4. Inventory Turnover
Asset turnover ratio is the ratio of the value of a companys sales or revenues generated
relative to the value of its assets. The Asset Turnover ratio can often be used as
an indicator of the efficiency with which a company is deploying its assets in generating
revenue.
2.00
The asset turnover ratio tends to be higher for companies in certain sectors than in
others. Retail, for example, is the sector that most often yields the highest asset turnover
ratios, scoring a 2.05 in 2014. Both it and consumer staples have relatively small asset
bases but have high sales volume.
Conversely, firms in sectors like utilities and telecommunications, which have large asset
bases, will have lower asset turnover. The financial sector, for example, often trails in its
asset turnover ratio, scoring a 0.08 in 2014.
assets were $203 billion at the beginning of that fiscal year and $205 billion at fiscal
year-end, for an average of $204 billion. Wal-Marts asset turnover ratio was therefore
2.36 ($476 billion/ $204 billion).
In contrast, AT&T Inc. (T) had total revenues of $132 billion when the fiscal year ended
on December 31, 2014. Total assets at the beginning and end of the 2014 fiscal year
were $278 billion and $293 billion respectively, for an average asset base of $287 billion.
AT&Ts asset turnover ratio in 2014 was therefore 0.46 ($132 billion / $287 billion).
Clearly, it would not make much sense to compare the asset turnover ratios for Wal-Mart
and AT&T, since they operate in very different industries. But comparing the asset
turnover ratios for AT&T and Verizon Communications Inc. (VZ), for instance, may
provide a clearer picture of asset use efficiency for these telecom companies. In the
same fiscal year as in the AT&T example above, Verizon had total revenues of $127
billion. Total assets at the beginning and end of the year were $274 billion and $232
billion, respectively, for an average asset base of $253 billion. As such, in 2014 Verizons
asset turnover ratio was 0.50 ($127 billion / $253 billion), about 9% higher than AT&Ts in
the same year.
Yet, this kind of comparison does not necessarily paint the clearest possible picture. It is
possible that a companys asset turnover ratio in any single year differs substantially
from previous or subsequent years. For example, while AT&Ts asset turnover ratio was
0.30 in 2006, it rose nearly a full fifty percent to reach 0.44 in 2007, the following year.
For any specific company, then, one would do well to review the trend in the asset
turnover ratio over a period of time to check whether asset usage is improving or
deteriorating.
Many other factors can affect a companys asset turnover ratio in a given year, such as
whether or not an industry is cyclical. (For more, see: Cyclical Versus Non-Cyclical
Stocks.)
History
The Asset Turnover ratio is a key component of DuPont analysis, a system that
the DuPont Corporation began using during the 1920s. DuPont analysis breaks
down Return on Equity (ROE) into three parts, one of which is asset turnover, the other
two being profit margin and financial leverage. In splitting ROE into distinct components,
this form of analysis allows one to analyze the nuances of a high or low ROE, to attempt
There are several layers of profitability that analysts monitor to assess the performance
of a company, including gross profit, operating profit and net income. Each level provides
information about a company's profitability. Gross profit, the first level of profitability, tells
analysts how good a company is at creating a product or providing a service compared
to its competitors. Gross profit margin, calculated as gross profit divided by revenues,
allows analysts to compare business models with a quantifiable metric.
Net profit margin is the ratio of net profits to revenues for a company or business
segment . Typically expressed as a percentage, net profit margins show how much of
each dollar collected by a company as revenue translates into profit. The equation to
calculate net profit margin is: net margin = net profit / revenue.
To illustrate, imagine a business has $100,000 in revenue, but it also has $20,000 in
operating costs, $10,000 in COGS and $14,000 in tax liability. Its net profits are $56,000.
Profits divided by revenue equals .56 or 56%. A 56% profit margin indicates the
company earns 56 cents in profit for every dollar it collects.
The general equation for return on total capital is: (Net income - Dividends) /
(Debt + Equity)
Return on total capital is also called "return on invested capital (ROIC)" or "return on
capital."
Looking at an example, Manufacturing Company MM has $100,000 in net income,
$500,000 in total debt and $100,000 in shareholder equity. Its operations are
straightforward -- MM makes and sells widgets.
We can calculate MM's return on total capital with the given equation: (Net income Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%
Note that for some companies, net income may not be the most useful profitability
measure to use. You want to make sure that the profit metric you put in the
numerator provides a genuine measure of profitability.
Return on total capital is most useful when you're trying to determine the returns
generated by the business operation itself, not the short-lived results from one-time
events. Gains/losses from foreigncurrency fluctuations and other one-time events
are included in the net income listed on the bottom line, but they do not result from
business operations. Try to think of what your business "does" and only
consider income related to fundamental business operations.
As an example, let's say, Conglomerate CC shows $100,000 as net income,
$500,000 in total debt and $100,000 in shareholder equity. But when you look at
CC's income statement, you see a lot of extra line-items, like "gains from foreign
currency transactions" and "gains from one-time transactions."
In the case of CC, if you use the net income number, you are not using a specific
measure as to where the returns are being generated. Were they from strong
business results? Were they from fluctuations in the foreign currency markets? Did
CC sell a subsidiary?
For CC, it is better to use an income measure called net operating profits after tax
(NOPAT) as the numerator. It's not found on the income statement, but you can
calculate it yourself using the following equation:
NOPAT = Earnings before Interest & Taxes * (1 - Tax Rate)
Using NOPAT in the equation will tell you the return for both its bondholders and
stockholders the company generated with its operations.
WHY IT MATTERS:
A firm's return on total capital can be an outstanding indicator of the size and
strength of its moat. If a company is able to generate returns of 15-20% year after
year, it has a great system for converting investor capital into profits.
Return on total capital is especially useful for companies that invest lots of capital,
like oil and gas firms, computer hardware companies, and even big box stores. As an
investor, it's imperative to know that if a company uses your money, you'll get a
respectable return on your investment.
If new shares are issued then use the weighted average of the
number of shares throughout the year.
Averaging ROE over the past 5 to 10 years can give you a better
idea of the historical growth.
For more on return on equity (ROE) read Are companies with a negative return on equity
(ROE) always a bad investment? and ROA And ROE Give Clear Picture Of Corporate
Health
1. Like with most ratios, when using the debt/equity ratio it is very important to consider
the industry in which the company operates. Because different industries rely on different
amounts of capital to operate and use that capital in different ways, a relatively high D/E
ratio may be common in one industry while a relatively low D/E may be common in
another. For example,capital-intensive industries such as auto manufacturing tend to
have a debt/equity ratio above 2, while companies like personal computer manufacturers
usually are not particularly capital intensive and may often have a debt/equity ratio of
under 0.5. As such, D/E ratios should only be used to compare companies when those
companies operate within the same industry.
Another important point to consider when assessing D/E ratios is that the Total
Liabilities portion of the formula may often be determined in a variety of ways by
different companies, some of which are not actually the sum of all of the companys
liabilities. In some cases, companies will only incorporate debts (like loans and debt
securities) into the liabilities portion of the formula, while omitting other kinds of liabilities
(unearned revenue, etc.). In other cases, companies may calculate D/E in an even more
specific way, including only long-term debts and excluding short-term debts and other
liabilities. Yet, long-term debt here is not necessarily a term with a consistent meaning.
It may include all long-term debts, but it may also exclude long-term debts
nearing maturity, which are then categorized as short-term debts. Because of these
differentiations, when considering a companys D/E ratio one should try to determine
how the ratio was calculated and should be sure to consider other ratios and
performance metrics as well.
or
likely refuse to lend the company more money, as the companys risk for default is too
high.
Moreover, an interest coverage ratio below 1 indicates the company is not generating
sufficient revenues to satisfy its interest expenses. If a companys ratio is below 1, it will
likely need to spend some of its cash reserves in order to meet the difference or borrow
more, which will be difficult for reasons stated above. Otherwise, even if earnings are low
for a single month, the company risks falling into bankruptcy.
Generally, an interest coverage ratio of 2.5 is often considered to be a warning sign,
indicating that the company should be careful not to dip further.
Even though it creates debt and interest, borrowing has the potential to positively affect a
companys profitability through the development of capital assets according to the costbenefit analysis. But a company must also be smart in its borrowing. Because interest
affects a companys profitability as well, a company should only take a loan if it knows it
will have a good handle on its interest payments for years to come. A good interest
coverage ratio would serve as a good indicator of this circumstance, and potentially as
an indicator of the companys ability to pay off the debt itself as well. Large corporations,
however, may often have both high interest coverage ratios and very large borrowings.
With the ability to pay off large interest payments on a regular basis, large companies
may continue to borrow without much worry.
Businesses may often survive for a very long time while only paying off their interest
payments and not the debt itself. Yet, this is often considered a dangerous practice,
particularly if the company is relatively small and thus has low revenue compared to
larger companies. Moreover, paying off the debt helps pay off interest down the road, as
with reduced debt the interest rate may be adjusted as well.
stable. The ratio may also be used to compare the ability of different companies to pay
off their interest, which can help when making an investment decision.
Generally, stability in interest coverage ratios is one of the most important things to look
for when analyzing the interest coverage ratio in this way. A declining interest coverage
ratio is often something for investors to be wary of, as it indicates that a company may be
unable to pay its debts in the future.
Overall, interest coverage ratio is a very good assessment of a companys shortterm financial health. While making future projections by analyzing a companys interest
coverage ratio history may be a good way of assessing an investment opportunity, it is
difficult to accurately predict a companys long-term financial health with any ratio
or metric.