**Liquidity Ratios**

**Working Capital**

Working capital compares current assets to current liabilities, and serves as the liquid reserve available to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in determining if a firm can pay its current liabilities when due.

- Formula

Current Assets

__– Current Liabilities__

**Acid Test or Quick Ratio**

A measurement of the liquidity position of the business. The quick ratio compares the cash plus cash equivalents and accounts receivable to the current liabilities. The primary difference between the current ratio and the quick ratio is the quick ratio does **not include** **inventory and prepaid expenses** in the calculation. Consequently, a business’s quick ratio will be lower than its current ratio. It is a stringent test of liquidity.

- Formula

__Cash + Marketable Securities + Accounts Receivable__

Current Liabilities

**Current Ratio**

Provides an indication of the liquidity of the business by comparing the amount of current assets to current liabilities. A business’s current assets generally consist of cash, marketable securities, accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In general, businesses prefer to have at least one dollar of current assets for every dollar of current liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio significantly higher than the industry average could indicate the existence of redundant assets. Conversely, a current ratio significantly lower than the industry average could indicate a lack of liquidity.

- Formula

__Current Assets__

Current Liabilities

**Cash Ratio**

Indicates a conservative view of liquidity such as when a company has pledged its receivables and its inventory, or the analyst suspects severe liquidity problems with inventory and receivables.

- Formula

__Cash Equivalents + Marketable Securities__

Current Liabilities

**Profitability Ratios**

**Net Profit Margin (Return on Sales)**

A measure of net income dollars generated by each dollar of sales.

- Formula

__Net Income *__

Net Sales

* Refinements to the net income figure can make it more accurate than this ratio computation. They could include removal of equity earnings from investments, “other income” and “other expense” items as well as minority share of earnings and nonrecuring items.

**Return on Assets**

Measures the company’s ability to utilize its assets to create profits.

- Formula

__Net Income *__

(Beginning + Ending Total Assets) / 2

**Operating Income Margin**

A measure of the operating income generated by each dollar of sales.

- Formula

__Operating Income__

Net Sales

**Return on Investment**

Measures the income earned on the invested capital.

- Formula

__Net Income *__

Long-term Liabilities + Equity

**Return on Equity**

Measures the income earned on the shareholder’s investment in the business.

- Formula

__Net Income *__

Equity

**Du Pont Return on Assets**

A combination of financial ratios in a series to evaluate investment return. The benefit of the method is that it provides an understanding of how the company generates its return.

- Formula

Net Income *Sales | x | SalesAssets | x | AssetsEquity |

**Gross Profit Margin**

Indicates the relationship between net sales revenue and the cost of goods sold. This ratio should be compared with industry data as it may indicate insufficient volume and excessive purchasing or labor costs.

- Formula

__Gross Profit__

Net Sales

**Financial Leverage Ratio**

**Total Debts to Assets**

Provides information about the company’s ability to absorb asset reductions arising from losses without jeopardizing the interest of creditors.

- Formula

__Total Liabilities__

Total Assets

**Capitalization Ratio**

Indicates long-term debt usage.

- Formula

__Long-Term Debt__

Long-Term Debt + Owners’ Equity

**Debt to Equity**

Indicates how well creditors are protected in case of the company’s insolvency.

- Formula

__Total Debt__

Total Equity

**Interest Coverage Ratio (Times Interest Earned)**

Indicates a company’s capacity to meet interest payments. Uses EBIT (Earnings Before Interest and Taxes)

- Formula

__EBIT__

Interest Expense

**Long-term Debt to Net Working Capital**

Provides insight into the ability to pay long term debt from current assets after paying current liabilities.

- Formula

__Long-term Debt__

Current Assets – Current Liabilities

**Efficiency Ratios**

**Cash Turnover**

Measures how effective a company is utilizing its cash.

- Formula

__Net Sales__

Cash

**Sales to Working Capital (Net Working Capital Turnover)**

Indicates the turnover in working capital per year. A low ratio indicates inefficiency, while a high level implies that the company’s working capital is working too hard.

- Formula

__Net Sales__

Average Working Capital

**Total Asset Turnover**

Measures the activity of the assets and the ability of the business to generate sales through the use of the assets.

- Formula

__Net Sales__

Average Total Assets

**Fixed Asset Turnover**

Measures the capacity utilization and the quality of fixed assets.

- Formula

__Net Sales__

Net Fixed Assets

**Days’ Sales in Receivables**

Indicates the average time in days, that receivables are outstanding (DSO). It helps determine if a change in receivables is due to a change in sales, or to another factor such as a change in selling terms. An analyst might compare the days’ sales in receivables with the company’s credit terms as an indication of how efficiently the company manages its receivables.

- Formula

__Gross Receivables__

Annual Net Sales / 365

**Accounts Receivable Turnover**

Indicates the liquidity of the company’s receivables.

- Formula

__Net Sales__

Average Gross Receivables

**Accounts Receivable Turnover in Days**

Indicates the liquidity of the company’s receivables in days.

- Formula

__Average Gross Receivables__

Annual Net Sales / 365

**Days’ Sales in Inventory**

Indicates the length of time that it will take to use up the inventory through sales.

- Formula

__Ending Inventory__

Cost of Goods Sold / 365

**Inventory Turnover**

Indicates the liquidity of the inventory.

- Formula

__Cost of Goods Sold__

Average Inventory

**Inventory Turnover in Days**

Indicates the liquidity of the inventory in days.

- Formula

__Average Inventory__

Cost of Goods Sold / 365

**Operating Cycle**

Indicates the time between the acquisition of inventory and the realization of cash from sales of inventory. For most companies the operating cycle is less than one year, but in some industries it is longer.

- Formula

Accounts Receivable Turnover in Days

__+ Inventory Turnover in Day__

**Days’ Payables Outstanding**

Indicates how the firm handles obligations of its suppliers.

- Formula

__Ending Accounts Payable__

Purchases / 365

**Payables Turnover**

Indicates the liquidity of the firm’s payables.

- Formula

__Purchases__

Average Accounts Payable

**Payables Turnover in Days**

Indicates the liquidity of the firm’s payables in days.

- Formula

__Average Accounts Payable__

Purchases / 365

**Additional Ratios**

**Altman Z-Score**

The Z-score model is a quantitative model developed in 1968 by Edward Altman to predict bankruptcy (financial distress) of a business, using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis.

The Z-score is known to be about 90% accurate in forecasting business failure one year into the future and about 80% accurate in forecasting it two years into the future.

- Formula

Z = | 1.2 +1.4 +0.6 +0.999 +3.3 | x x x x x | (Working Capital / Total Assets) (Retained Earnings / Total Assets) (Market Value of Equity / Book Value of Debt) (Sales / Total Assets) (EBIT / Total Assets) |

Z-score | Probability of Failure |

less than 1.8 greater than 1.81 but less than 2.99 greater than 3.0 | Very High Not Sure Unlikely |

**Bad-Debt to Accounts Receivable Ratio**

Bad-debt to Accounts Receivable ratio measures expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.

- Formula

__Bad Debts__

Accounts Receivable

**Bad-Debt to Sales Ratio**

Bad-debt ratios measure expected uncollectibility on credit sales. An increase in bad debts is a negative sign, since it indicates greater realization risk in accounts receivable and possible future write-offs.

- Formula

__Bad Debts__

Sales

**Book Value per Common Share**

Book value per common share is the net assets available to common stockholders divided by the shares outstanding, where net assets represent stockholders’ equity less preferred stock. Book value per share tells what each share is worth per the books based on historical cost.

- Formula

__(Total Stockholders’ Equity – Liquidation Value of Preferred Stocks – Preferred Dividends in Arrears)__

Common Shares Outstanding

**Common Size Analysis**

In vertical analysis of financial statements, an item is used as a base value and all other accounts in the financial statement are compared to this base value.

On the balance sheet, total assets equal 100% and each asset is stated as a percentage of total assets. Similarly, total liabilities and stockholder’s equity are assigned 100%, with a given liability or equity account stated as a percentage of total liabilities and stockholder’s equity.

On the income statement, 100% is assigned to net sales, with all revenue and expense accounts then related to it.

**Cost of Credit**

The cost of credit is the cost of not taking credit terms extended for a business transaction. Credit terms usually express the amount of the cash discount, the date of its expiration, and the due date. A typical credit term is 2 / 10, net / 30. If payment is made within 10 days, a 2 percent cash discount is allowed: otherwise, the entire amount is due in 30 days. The cost of not taking the cash discount can be substantial.

- Formula

% Discount100 – % Discount | x | 360Credit Period – Discount Period |

*Example*

On a $1,000 invoice with terms of 2 /10 net 30, the customer can either pay at the end of the 10 day discount period or wait for the full 30 days and pay the full amount. By waiting the full 30 days, the customer effectively borrows the discounted amount for 20 days.

$1,000 x (1 – .02) = $980

This gives the amount paid in interest as:

$1,000 – 980 = $20

This information can be used to compute the credit cost of borrowing this money.

% Discount100 – % Discount | x | 360Credit Period – Discount Period | |

= 298 | x | 36020 | = .3673 |

As this example illustrates, the annual percentage cost of offering a 2/10, net/30 trade discount is almost 37%.

**Current-Liability Ratios**

Current-liability ratios indicate the degree to which current debt payments will be required within the year. Understanding a company’s liability is critical, since if it is unable to meet current debt, a liquidity crisis looms. The following ratios are compared to industry norms.

- Formulas

Current to Non-current | = | Current LiabilitiesNon-current Liabilities |

Current to Total | = | Current LiabilitiesTotal Liabilities |