Ratio Analysis

Liquidity ratios

Liquidity ratios measure the ability of a company to repay its short-term debts and meet unexpected cash needs.

Current ratio. The current ratio is also called the working capital ratio, as working capital is the difference between current assets and current liabilities. This ratio measures the ability of a company to pay its current obligations using current assets. The current ratio is calculated by dividing current assets by current liabilities.

This ratio indicates the company has more current assets than current liabilities. Different industries have different levels of expected liquidity. Whether the ratio is considered adequate coverage depends on the type of business, the components of its current assets, and the ability of the company to generate cash from its receivables and by selling inventory.

Acid-test ratio. The acid-test ratio is also called the quick ratio. Quick assets are defined as cash, marketable (or short-term) securities, and accounts receivable and notes receivable, net of the allowances for doubtful accounts. These assets are considered to be very liquid (easy to obtain cash from the assets) and therefore, available for immediate use to pay obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities.

The traditional rule of thumb for this ratio has been 1:1. Anything below this level requires further analysis of receivables to understand how often the company turns them into cash. It may also indicate the company needs to establish a line of credit with a financial institution to ensure the company has access to cash when it needs to pay its obligations.

Receivables turnover. The receivable turnover ratio calculates the number of times in an operating cycle (normally one year) the company collects its receivable balance. It is calculated by dividing net credit sales by the average net receivables. Net credit sales is net sales less cash sales. If cash sales are unknown, use net sales. Average net receivables is usually the balance of net receivables at the beginning of the year plus the balance of net receivables at the end of the year divided by two. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.

Average collection period. The average collection period (also known as day's sales outstanding) is a variation of receivables turnover. It calculates the number of days it will take to collect the average receivables balance. It is often used to evaluate the effectiveness of a company's credit and collection policies. A rule of thumb is the average collection period should not be significantly greater than a company's credit term period. The average collection period is calculated by dividing 365 by the receivables turnover ratio.

The decrease in the average collection period is favorable. If the credit period is 60 days, the 20X1 average is very good. However, if the credit period is 30 days, the company needs to review its collection efforts.

Inventory turnover. The inventory turnover ratio measures the number of times the company sells its inventory during the period. It is calculated by dividing the cost of goods sold by average inventory. Average inventory is calculated by adding beginning inventory and ending inventory and dividing by 2. If the company is cyclical, an average calculated on a reasonable basis for the company's operations should be used such as monthly or quarterly.

Day's sales on hand. Day's sales on hand is a variation of the inventory turnover. It calculates the number of day's sales being carried in inventory. It is calculated by dividing 365 days by the inventory turnover ratio.

Profitability ratios

Profitability ratios measure a company's operating efficiency, including its ability to generate income and therefore, cash flow. Cash flow affects the company's ability to obtain debt and equity financing.

Profit margin. The profit margin ratio, also known as the operating performance ratio, measures the company's ability to turn its sales into net income. To evaluate the profit margin, it must be compared to competitors and industry statistics. It is calculated by dividing net income by net sales.

Asset turnover. The asset turnover ratio measures how efficiently a company is using its assets. The turnover value varies by industry. It is calculated by dividing net sales by average total assets.

Return on assets. The return on assets ratio (ROA) is considered an overall measure of profitability. It measures how much net income was generated for each $1 of assets the company has. ROA is a combination of the profit margin ratio and the asset turnover ratio. It can be calculated separately by dividing net income by average total assets or by multiplying the profit margin ratio times the asset turnover ratio.

The information shown in equation format can also be shown as follows:

Return on common stockholders' equity. The return on common stockholders' equity (ROE) measures how much net income was earned relative to each dollar of common stockholders' equity. It is calculated by dividing net income by average common stockholders' equity. In a simple capital structure (only common stock outstanding), average common stockholders' equity is the average of the beginning and ending stockholders' equity.

In a complex capital structure, net income is adjusted by subtracting the preferred dividend requirement, and common stockholders' equity is calculated by subtracting the par value (or call price, if applicable) of the preferred stock from total stockholders' equity.

Earnings per share. Earnings per share (EPS) represents the net income earned for each share of outstanding common stock. In a simple capital structure, it is calculated by dividing net income by the number of weighted average common shares outstanding.

Assuming The Home Project Company has 50,000,000 shares of common stock outstanding, EPS is calculated as follows: