Notes For Ratios

When computing financial ratios and when doing other financial statement analysis always keep
in mind that the financial statements reflect the accounting principles. This means assets are
generally not reported at their current value. It is also likely that many brand names and unique
product lines will not be included among the assets reported on the balance sheet, even though
they may be the most valuable of all the items owned by a company.

These examples are signals that financial ratios and financial statement analysis have limitations.
It is also important to realize that an impressive financial ratio in one industry might be viewed as
less than impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:
← Balance Sheet
← General discussion
← Common-size balance sheet
← Financial ratios based on the balance sheet
← Income Statement
← General discussion
← Common-size income statement
← Financial ratios based on the income statement

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific
date, such as December 31, 2009, September 28, 2009, etc.

The accountants' cost principle and the monetary unit assumption will limit the assets
reported on the balance sheet. Assets will be reported

   (1) only if they were acquired in a transaction, and

   (2) generally at an amount that is not greater than the asset's cost at the time of the transaction.

This means that a company's creative and effective management team will not be listed as an
asset. Similarly, a company's outstanding reputation, its unique product lines, and brand names
developed within the company will not be reported on the balance sheet. As you may surmise,
these items are often the most valuable of all the things owned by the company. (Brand names
purchased from another company will be recorded in the company's accounting records at their
cost.)

The accountants' matching principle will result in assets such as buildings, equipment,
furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these
assets are depreciated. Depreciation reduces an asset's book value each year and the amount
of the reduction is reported as Depreciation Expense on the income statement.

While depreciation is reducing the book value of certain assets over their useful lives, the current
value (or fair market value) of these assets may actually be increasing. (It is also possible that the
current value of some assets–such as computers–may be decreasing faster than the book
value.)

Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc.
usually have current values that are close to the amounts reported on the balance sheet.
Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages
Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that
are close to the amounts reported on the balance sheet.

Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not
maturing within one year) will often have current values that differ from the amounts reported on
the balance sheet.

Stockholders' equity is the book value of the company. It is the difference between the
reported amount of assets and the reported amount of liabilities. For the reasons mentioned
above, the reported amount of stockholders' equity will therefore be different from the current or
market value of the company.

By definition the current assets and current liabilities are "turning over" at least once per year. As
a result, the reported amounts are likely to be similar to their current value. The long-term assets
and long-term liabilities are not "turning over" often. Therefore, the amounts reported for long-
term assets and long-term liabilities will likely be different from the current value of those items.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following balance sheet:

Example Company
Balance Sheet
31-Dec-09
       
LIABILITIES   ASSETS  
Current Liabilities   Current Assets  
Notes Payable $   5,000  Cash $   2,100 
Accounts Payable 35,900  Petty Cash 100 
Wages Payable 8,500  Temporary Investments 10,000 
Interest Payable 2,900  Accounts Receivable - net 40,500 
Taxes Payable 6,100  Inventory 31,000 
Warranty Liability 1,100  Supplies 3,800 
Unearned Revenues      1,500  Prepaid Insurance      1,500 
Total Current Liabilities    61,000  Total Current Assets    89,000 
       
Long-term Liabilities   Investments    36,000 
Notes Payable 20,000     
Bonds Payable   400,000  Property, Plant & Equipment  
Total Long-term Liabilities   420,000  Land 5,500 
    Land Improvements  6,500 
    Buildings 180,000 
Total Liabilities   481,000  Equipment 201,000 

    Less: Accum Depreciation    (56,000)

    Prop, Plant & Equip - net   337,000 

STOCKHOLDERS' EQUITY   Intangible Assets  
Common Stock 110,000  Goodwill 105,000 
Retained Earnings 229,000  Trade Names   200,000 
   (50,000
Less: Treasury Stock ) Total Intangible Assets   305,000 
Total Stockholders' Equity   289,000     
    Other Assets      3,000 
       
Total Liab. & Stockholders'
Equity $770,000  Total Assets $770,000 
Common–Size Balance Sheet
One technique in financial statement analysis is known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size balance sheet is a balance sheet
where every dollar amount has been restated to be a percentage of total assets. We will illustrate
this by taking Example Company's balance sheet (shown above) and divide each item by the total
asset amount $770,000. The result is the following common-size balance sheet for Example
Company:

Example Company
Balance Sheet
31-Dec-09
LIABILITIES   ASSETS  
Current Liabilities   Current Assets  
Notes Payable 0.60% Cash 0.30%
Accounts Payable 4.70% Petty Cash 0.00%

Wages Payable 1.10% Temporary Investments 1.30%

Interest Payable 0.40% Accounts Receivable - net 5.30%

Taxes Payable 0.80% Inventory 4.00%
Warranty Liability 0.10% Supplies 0.50%
Unearned Revenues     0.2% Prepaid Insurance     0.2%
Total Current Liabilities     7.9% Total Current Assets   11.6%
       
Long-term Liabilities   Investments     4.7%
Notes Payable 2.60%    
Property, Plant &
Bonds Payable   52.0% Equipment  
Total Long-term Liabilities   54.6% Land 0.70%
    Land Improvements  0.80%
    Buildings 23.40%
Total Liabilities   62.5% Equipment 26.10%

    Less: Accum Depreciation   (7.3%)

    Prop, Plant & Equip - net   43.7%
STOCKHOLDERS'
EQUITY   Intangible Assets  
Common Stock 14.30% Goodwill 13.60%
Retained Earnings 29.70% Trade Names   26.0%
Less: Treasury Stock   (6.5%) Total Intangible Assets   39.6%
Total Stockholders' Equity   37.5%    
    Other Assets     0.4%
        
Total Liab. &
Stockholders' Equity 100.00% Total Assets 100.00%

The benefit of a common-size balance sheet is that an item can be compared to a similar item of
another company regardless of the size of the companies. A company can also compare its
percentages to the industry's average percentages. For example, a company with Inventory at
4.0% of total assets can look to its industry statistics to see if its percentage is reasonable.
(Industry percentages might be available from an industry association, library reference desks,
and from bankers. Generally banks have memberships in Robert Morris Associates, an
organization that collects and distributes statistics by industry.) A common-size balance sheet
also allows two businesspersons to compare the magnitude of a balance sheet item without
either one revealing the actual dollar amounts.
Financial statement analysis includes financial ratios. Here are three financial ratios that are
based solely on current asset and current liability amounts appearing on a company's balance
sheet:

Financial Ratio How to Calculate It What It Tells You

Working = Current Assets – Current Liabilities An indicator of whether the company

Capital will be able to meet its current
= $89,000 – $61,000 obligations (pay its bills, meet its
payroll, make a loan payment, etc.) If a
= $28,000 company has current assets exactly
equal to current liabilities, it has no
working capital. The greater the
amount of working capital the more
likely it will be able to make its
payments on time.

Current Ratio = Current Assets ÷ Current Liabilities This tells you the relationship of
current assets to current liabilities. A
= $89,000 ÷ $61,000 ratio of 3:1 is better than 2:1. A 1:1
ratio means there is no working capital.
= 1.46
Quick Ratio = [(Cash + Temp. Investments + This ratio is similar to the current ratio
(Acid Test Marketable securities+ Accounts except that Inventory, Supplies, and
Ratio) Receivable) ÷ Current Liabilities] : 1 Prepaid Expenses are excluded. This
indicates the relationship between the
= (Current Asset – Inventories - Prepaid amount of assets that can quickly be
Expenses)/Current Liabilities turned into cash versus the amount of
current liabilities.
= [($2,100 + $100 + $10,000 + $40,500)
÷ $61,000] : 1
=
[$52,700 ÷ $61,000] : 1

0.86 : 1

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to
income statement amounts. To illustrate these financial ratios we will use the following income
statement information:

Example Corporation
Income Statement
For the year ended December 31, 2009
Sales (all on credit)
$500,000

Cost of Goods Sold   380,000

Gross Profit   120,000

Operating Expenses
Selling Expenses 35,000
Administrative Expenses    45,000
Total Operating Expenses    80,000

Operating Income 40,000

Interest Expense    12,000

Income before Taxes 28,000

Income Tax Expense     5,000

Net Income after Taxes $ 23,000

Financial Ratio How to Calculate It What It Tells You

Accounts = Net Credit Sales for the Year ÷ The number of times per year that the
Receivable Average Accounts Receivable (Drs) accounts receivables turn over. Keep
Turnover for the Year in mind that the result is an average,
since credit sales and accounts
= $500,000 ÷ $42,000 (a computed receivable are likely to fluctuate during
average) the year. It is important to use the
average balance of accounts
= 11.90 receivable during the year.

Days' Sales in = 365 days in Year ÷ Accounts The average number of days that it
Accounts Receivable Turnover in Year took to collect the average amount of
Receivable accounts receivable during the year.
= 365 days ÷ 11.90 This statistic is only as good as the
Accounts Receivable Turnover figure.
= 30.67 days

Inventory = Cost of Goods Sold for the Year ÷ The number of times per year that
Turnover Average Inventory for the Year Inventory turns over. Keep in mind that
the result is an average, since sales
= $380,000 ÷ $30,000 (a computed and inventory levels are likely to
average) fluctuate during the year. Since
inventory is at cost (not sales value), it
= 12.67 is important to use the Cost of Goods
Sold. Also be sure to use the average
balance of inventory during the year.

Days' Sales in = 365 days in Year ÷ Inventory Turnover The average number of days that it
Inventory in Year took to sell the average inventory
during the year. This statistic is only as
= 365 days ÷ 12.67 good as the Inventory Turnover figure.

= 28.81

Days' Sales in = 365 days in Year ÷ Inventory Turnover The average number of days that it
Inventory in Year took to sell the average inventory
during the year. This statistic is only as
= 365 days ÷ 12.67 good as the Inventory Turnover figure.

= 28.81

Fixed Asset = Net Sales/Fixed Asset (Net of The fixed-asset turnover ratio
Turnover Ratio depriciation) measures a company's ability to
= generate net sales from fixed-asset
500000/337000 investments - specifically property,
= plant and equipment (PP&E) - net of
1.48 depreciation. A higher fixed-asset
turnover ratio shows that the company
has been more effective in using the
investment in fixed assets to generate
 revenues. This ratio is often used as a
measure in manufacturing industries,
where major purchases are made for
PP&E to help increase output

The next financial ratio involves the relationship between two amounts from the balance sheet:
total liabilities and total stockholders' equity:

Financial Ratio How to Calculate It What It Tells You

Debt to Debt/(Debt + Equity)

Total Fund
Long Term Debt / (Long Term Debt +
Equities)

Debt to Equity = (Total long term liabilities ÷ Total The proportion of a company's assets
Stockholders' Equity) : 1 supplied by the company's creditors
versus the amount supplied the owner
= ( $420,000 ÷ $289,000) : 1 or stockholders. In this example the
creditors have supplied $1.45 for each
= 1.45 : 1 $1.00 supplied by the stockholders. It is
important to realize that if the ratio is
greater than 1, the majority of assets
are financed through debt. If it is
smaller than 1, assets are primarily
financed through equity.

The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in
its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use
information from the following income statement:

Example Corporation
Income Statement
For the year ended December 31, 2009
Sales (all on credit)
$500,000

Cost of Goods Sold   380,000

 Gross Profit   120,000

Operating Expenses
Selling Expenses 35,000
Administrative Expenses    45,000
Total Operating Expenses    80,000

Operating Income 40,000

Interest Expense    12,000

Income before Taxes 28,000

Income Tax Expense     5,000
Net Income after Taxes $ 23,000

Earnings per Share $     0.23

(based on 100,000 shares outstanding)

Common–Size Income Statement

Financial statement analysis includes a technique known as vertical analysis. Vertical analysis
results in common-size financial statements. A common-size income statement presents all of the
income statement amounts as a percentage of net sales. Below is Example Corporation's
common-size income statement after each item from the income statement above was divided by
the net sales of $500,000:

Example Corporation
Income Statement
For the year ended December 31, 2009
Sales (all on credit)
100.0%

Cost of Goods Sold   76.0%

Gross Profit   24.0%

Operating Expenses
Selling Expenses 7.0%
Administrative Expenses    9.0%
Total Operating Expenses  16.0%

Operating Income 8.0%

Interest Expense    2.4%

Income before Taxes 5.6%

Income Tax Expense    1.0%
Net Income after Taxes    4.6%

The percentages shown for Example Corporation can be compared to other companies and to
the industry averages. Industry averages can be obtained from trade associations, bankers, and
library reference desks. If a company competes with a company whose stock is publicly traded,
another source of information is that company's "Management's Discussion and Analysis of
Financial Condition and Results of Operations" contained in its annual report to the Securities and
 Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible
under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income Statement

Financial Ratio How to Calculate It What It Tells You

Gross Profit = Gross Profit ÷ Net Sales Indicates the percentage of sales
Ratio dollars available for expenses and
= $120,000 ÷ $500,000 profit after the cost of merchandise is
deducted from sales. The gross margin
= 24.0% varies between industries and often
varies between companies within the
same industry.

Net Profit = Net Income after Tax (EAT)÷ Net Tells you the profit per sales dollar
Margin Sales( Revenue) after all expenses are deducted from
(after tax) sales. This margin will vary between
Net Income + Minority Interest + industries as well as between
= Tax-Adjusted Interest / Net Sales companies in the same industry.
= EBIT/ Net Sales

$23,000 ÷ $500,000

4.6%

Operating = Operating Profit/ Net Sales This ratio tries to measure efficiency of
Profit Ratio management decisions as
= Gross Profit – SG&A Expenses /Net management has more control over
Sales operating expenses than cost of sales
outlays. Increase in this ratio may be
= $80,000 / $50,000 attributed to reduction in operating cost
of the company
1.6%

Operating = Operating Costs ÷ Net Sales Tells you the profit per sales dollar
Ratio after all expenses are deducted from
(after tax) = (COGS+ Operating Expenses) sales. This margin will vary between
/ Net Sales industries as well as between
= $23,000 ÷ $500,000 companies in the same industry.

4.6%

Earnings Per = Net Income after Tax after preference Expresses the corporation's net
Share (EPS) dividend (EAT – Pref Dividend) ÷ income after taxes on a per share of
Weighted Average Number of common stock basis. The computation
Common Shares Outstanding requires the deduction of preferred
 = dividends from the net income if a
$23,000 ÷ 100,000 corporation has preferred stock. Also
= requires the weighted average number
$0.23 of shares of common stock during the
period of the net income.

Times Interest = Earnings for the Year before Interest Indicates a company's ability to meet
Earned and Income Tax Expense ÷ Interest the interest payments on its debt. In
Expense for the Year the example the company is earning
3.3 times the amount it is required to
= $40,000 ÷ $12,000 pay its lenders for interest. If the ratio
is 1.5 % or below companies ability to
= 3.3 meet interest expenses may be
questioned

Return on = Net Income for the Year after Reveals the percentage of profit after
Stockholders' Taxes(EAT) ÷ Average Stockholders' income taxes that the corporation
Equity (after Equity during the Year earned on its average common
tax) stockholders' balances during the year.
= $23,000 ÷ $278,000 (a computed If a corporation has preferred stock,
average) the preferred dividends must be
deducted from the net income.
= 8.3%

Return on = EBIT/ Capital Employed ROCE should always be higher than

Capital the rate at which the company
Employed EBIT/(Total Assets –Current Liabilities) borrows, otherwise any increase in
(ROCE) borrowing will reduce shareholders'
EBIT/(Shareholders Equity + Reserves earnings.
& Surplus + Preference Share + Debt
Liabilities)

EBIT/ Fixed Asset + Working Capital

The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in
its business. The resulting depreciation expense may not be a good indicator of the economic
value of the asset being used up. To illustrate this point let's assume that a company's buildings
and equipment have been fully depreciated and therefore there will be no depreciation expense
for those buildings and equipment on its income statement. Is zero expense a good indicator of
the cost of using those buildings and equipment? Compare that situation to a company with new
buildings and equipment where there will be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income
statement or the balance sheet. This may explain why there are not as many well-established
financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited
financial statement analysis:
 Example Corporation
Statement of Cash Flows
For the Year Ended December 31, 2009

Cash Flow from Operating Activities:

Net Income $23,000 
Add: Depreciation Expense 4,000 
Increase in Accounts Receivable (6,000)
Decrease in Inventory 9,000 
Decrease in Accounts Payable    (5,000)
Cash Provided (Used) in Operating Activities   25,000 

Cash Flow from Investing Activities

Capital Expenditures (28,000)
Proceeds from Sale of Property     7,000 
Cash Provided (Used) by Investing Activities  (21,000)

Cash Flow from Financing Activities:

Borrowings of Long-term Debt 10,000 
Cash Dividends (5,000)
Purchase of Treasury Stock    (8,000)
Cash Provided (Used) by Financing Activities    (3,000)

Net Increase in Cash 1,000 

Cash at the beginning of the year     1,200 
Cash at the end of the year $  2,200 

Financial Ratio How to Calculate It What It Tells You

Free Cash = Cash Flow Provided by Operating This statistic tells you how much cash
Flow Activities – Capital Expenditures is left over from operations after a
company pays for its capital
= $25,000 – $28,000 expenditures (additions to property,
plant and equipment). There can be
= ( $3,000) variations of this calculation. For
example, some would only deduct
capital expenditures to keep the
present level of capacity. Others would
also deduct dividends that are paid to
stockholders, since they are assumed
to be a requirement.
The cash flow from operating activities section of the statement of cash flows is also used by
some analysts to assess the quality of a company's earnings. For a company's earnings to be of
"quality" the amount of cash flow from operating activities must be consistently greater than the
company's net income. The reason is that under accrual accounting, various estimates and
assumptions are made regarding both revenues and expenses. When it comes to cash, however,
the money is either in the bank or it isn't.

Earnings Before Interest & Tax (EBIT)

EBIT = Profit Before Tax + Net Interest Expenses

Note: The profit before tax in the consolidated reports includes the profit or loss of the
minority participation.

Return On Assets (ROA)

ROA = (Net Income After Tax + Interest )/ (Total Assets – Fictious Assets )
ROA = PAT/ Net Worth

Net Worth = Total Assets – External Liabilities

= equity share capital + preference share capital + reserve and surplus + profits -
fictitious assets like preliminary expense – losses
= Share Capital + Reserves & Surplus - Miscellaneous expenditure to the extent not
written off

ROA tells you what earnings were generated from invested capital (assets). ROA for public
companies can vary substantially and will be highly dependent on the industry. This is why when
using ROA as a comparative measure, it is best to compare it against a company's previous ROA
numbers or the ROA of a similar company. 

The assets of the company are comprised of both debt and equity. Both of these types of
financing are used to fund the operations of the company. The ROA figure gives investors an
idea of how effectively the company is converting the money it has to invest into net income. The
higher the ROA number, the better, because the company is earning more money on less
investment. For example, if one company has a net income of $1 million and total assets of $5
million, its ROA is 20%; however, if another company earns the same amount but has total assets
of $10 million, it has an ROA of 10%. Based on this example, the first company is better at
converting its investment into profit.

Return On Equity (ROE)

ROE = Net Income/ Equity
ROE = (Net Income after tax, interest and preference dividend ÷ (Equity Shareholders Fund)
Due to the unique nature of each industry and variances in accounting methodologies among
them, ROE should normally be used for comparisons within the same industry. For example: The
ROE for service-oriented industries, such as the software industry, is significantly higher than that
of capital-intensive industries such as the construction industry.
Comparisons of ROE within the same industry can also be misleading as ROE ignores the effect
of debt. If a company can issue debt at a lower interest rate than the rate of return on its
investments, it could increase its ROE. However, higher debt also increases the risk of failure for
the company. Generally, companies with higher debt, as measured by the debt to equity ratio, will
have better ROE. An investor could get a better sense of the investment by considering the
Return on Assets, which mitigates the influence of debt, alongwith ROE.

Earnings before interest and taxes ( EBIT ) or operating income

Earnings before interest and taxes ( EBIT ) or operating income is a investment formula to
measure of a corporation's profitability excluding interest and income tax expenses. 
EBIT = Operating Revenue – Operating Expenses (OPEX) + Non-operating Income

Earnings before interest and taxes ( EBIT ) is an indicator of corporation's profitability, which is
calculated as revenue minus operating expenses, excluding tax and interest. Normally, investors
will see earnings before interest and taxes ( EBIT ) in income statement.
Some investors might confuse earnings before interest and taxes  ( EBIT ) with gross profit or
gross income. For gross profit or gross income, revenue was deducted with COGS only to obtain
the gross profit, while for EBIT, revenue was deducted with operating expenses ( OPEX ). Note
that cost of goods sold is only part of operating expenses ( OPEX ). Operating expenses includes
COGS ,administrative expenses, depreciation, amortization  and other expenses.
For companies with minimal depreciation and amortization activities, earnings before interest and
taxes ( EBIT ) is monitored closely by the creditors since it represents the amount of cash that the
companies can earn to pay off creditors. For companies with high depreciation and amortization
activities, earnings before interest, taxes, depreciation and amortization ( EBITDA ) is used rather
than earnings before interest and taxes ( EBIT ).
Besides, investors can obtain earnings before interest and taxes ( EBIT ) from net income or net
profit by adding back interest and taxes. Hence, earnings before interest and taxes ( EBIT )
sometimes is referred as profit before interest and taxes ( PBIT ).

Statement of Income — Example

(figures in millions)
Operating Revenue
     Sales Revenue $20,438
Operating Expenses
     Cost of goods sold $7,943
     Selling, general and administrative expenses $8,172
     Depreciation and amortization $960
     Other expenses $138
         Total operating expenses $17,213
Operating income $3,225
     Non-operating income $130
Earnings before Interest and Taxes (EBIT) $3,355
     Net interest expense/income $145
Earnings before income taxes $3,210
     Income taxes $1,027
Net Income (Earnings after Taxes) $2,183
Preference Dividend
Dividend Declared(Equity Shares)
Retained Earning
Investment Formula
Earnings before interest and taxes ( EBIT ) or operating income = Revenue - Operating Expenses
( OPEX )
Investment Formula Example
Corporation A has $100,000 revenue  for this financial year with $50,000 cost of goods sold ( COGS ),
$10,000 administrative expenses, $20,000 depreciation and amortization and $500 other expenses. The
earnings before interest and taxes  ( EBIT ) calculation is as following.
Earnings before interest and taxes ( EBIT ) or operating income = Revenue - Operating Expenses
( OPEX ) = 100,000 - ( 50,000 + 10,000 + 20,000 + 500 ) = $15,000
The earnings before interest and taxes ( EBIT ) of corporation A for this financial year is $15,000.

Please refer articles for description of following ratios :

Price – Earning Ratio = Market price per share/ Earning Per Share (EPS)
Market Value to Book Value Ratio or Price to book = Market Price Per Share/ Book Value Per Share
Book Value Per Share = Value of Common Equity / Number of Outstanding Shares
= Total Assets – Intangible Assets (Patent, G/w)– Total Liabilities/ No. of share
outstanding