Quick and Dirty Interpretation of the Financial Ratios

Liquidity Ratios

1. Current Ratio = Current Assets/Current Liabilities

Example: A current ratio of 3.0: For every dollar of current liabilities, the company has
$3 of current assets.

General Rule: The greater the current ratio, the better—financially stronger.

2. Quick or Acid-test Ratio – (Current Assets – Inventory)/Current Liabilities

Example: A current ratio of 2.0: For every dollar of current liabilities, the company has
$2 of current assets excluding inventory. The quick ratio is a more conservative measure
of liquidity. That is, the quick ratio assumes inventory is not very liquid; therefore, it
should not be counted.

Profitability Ratios

1. Gross Profit Margin = Gross Profit/Sales

Example: A Gross Profit Margin of 35%: For every dollar of sales, the company has
gross profit of 35 cents.

General Rule: The greater the gross profit margin, the better.

2. Profit Margin or Net Profit Margin = Net Profit/Sales or Net Profit After Taxes/Sales
Net Income = Net Profit = Net Earnings = Net Profit after Taxes

Example: A net profit margin of 10%: For every dollar of sales, the company has net
income of 10 cents.

General Rule: The greater the net profit margin, the better.

3. Return on Assets (ROA) = Net Income/Total Assets

Example: ROA of 7 percent: For every dollar of assets, the company generates 7 cents
of net income

General Rule: The greater the ROA, the better.

4. Return on Equity (ROE) = Net Income/Stockholder Equity

Stockholder equity = owner’s equity = equity

Example: ROE of 15 percent: For every dollar of stockholder equity, the company
generates 15 cents of net income.

General Rule: The greater the ROE, the better.

5. EPS or Earnings Per Share = Net Income/Shares Outstanding

Example: EPS of $3.50: For every share of common stock, the company earns $3.50

General Rule: None—EPS is not comparable. It is driven by the number of shares

outstanding.

Solvency Ratios (aka Debt or Leverage Ratios)

1. Debt Ratio = Total Liabilities/Total Assets

Example: Debt Ratio = 65%: For every dollar of assets, the company is financed with 65
cents of debt and 35 (1-.65) cents of equity. Total financing must equal 100% (65% +
35%)

General Rule: The greater the debt ratio, the riskier the company.

2. Times Interest Earned = Earnings Before Interest & Taxes/Interest Expense

EBIT = Earnings Before Interest & Taxes = roughly equals operating income

Example: Times interest earned = 4.0: For every dollar of interest expense, the
company’s operating income equals $4.

General Rule: The lower the times interest earned, the riskier the company. It may imply
that the company has too much debt.

Asset Utilization Ratios (aka Activity or Asset-Management Ratios)

1. Inventory Turnover = Cost of Goods Sold/Inventory

Example: Inventory Turnover of Apples = 180: Say, you have one apple in inventory.
You pay $1 per apple. Every time you sell an apple, your order and receive another
apple. Therefore, your inventory will equal $1. You sell an apple every other day. Using
360 (not 365—finance oftentimes uses 360 days in a year) days in a year, you would sell
180 apples per year. Multiplying 180 X 1 = COGS of $180.

Inventory Turnover interpretation: You turn your inventory over 180 times a year.

General rule: The greater your inventory turnover, the better. It implies the product is
“moving off the shelf”.
2. Average Age of Inventory (days) = 365/Inventory Turnover

Example: If inventory turnover of apples = 180, then the average age of inventory equals
2.0 days (365/180). That is, inventory is approximately two days old.

Inventory Turnover and Average Age of Inventory are the “opposite side of the same
coin.” That is, you arrive at the same conclusions. You only need to analyze one ratio.

3. Accounts Receivable Turnover = Sales/Accounts Receivable--

Accounts Receivable Turnover—this leads us to average collection period

4. Average Collection Period (days) = 365/Accounts Receivable Turnover

Example: Average Collection Period = 30: This means that on average, it takes 30 days
to collect your receivables.

General Rule: The longer the collection period, the longer your money is tied up. If your
collection period exceeds your terms (e.g., 2/10 net 30), this may be a sign that you have
credit risk . . . that you have some receivables that may never be collected.

5. Operating Cycle (days): Average Age of Inventory + Average Collection Period

Example: Let’s say inventory is on the shelf for an average of 100 days. Once you sell
the product, you give the customer 30 days to pay. Assuming you pay cash when you
receive the inventory, it will take 130 day to convert the inventory back into cash.

General Rule: The shorter the operating cycle, the better.

6. Average Payment Period (days)—do not worry about the calculation

Example: Average Payment Period = 15. This means that on average, the company pays
its bills related to accounts payable in 15 days.

General Rule: The shorter the payment period, the more quickly cash “goes out the
door”. If the terms provided from the company’s suppliers are typically 30 days, the
average payment period should be under 30 days. Otherwise, this may communicate a
problem.

7. Total Asset Turnover = Sales/Total Assets

Example: Total Asset Turnover = 10. This implies that for every $1 of assets, the
company generates $10 in sales. Keep in mind this is not profit, but this is a measure of
efficiency.

General Rule: The higher the number, the better.

Market Value Ratios

1. EPS or Earnings Per Share = Net Income/Shares Outstanding

Example: EPS = $2.33. For every share outstanding, the company generates $2.33. So,
if the company had 100 shares outstanding, the company would have net income of $233.

If company A has EPS of $2.33 and company B has EPS of $4.34, it is not meaningful
because the number of shares are likely to be the same.

General Rule: The EPS number is not that meaningful by itself and is not comparable
between companies. However, the trend is very important. Companies prefer to increase
this number each year. The greater the percentage increase, the better.

Note: All ratios assume no preferred stock