All-Time Favourite Financial Ratios There are hundreds of financial ratios, many of which provide basically the same information. Therefore you should limit the calculation of ratios to a reasonable number. Its the analysis of the ratios, their trends and comparison to the industry that matter. Notes about names/definitions: Sales and Revenues are the same thing. Income, Earnings, and Profit are the same thing. Therefore Operating Profit = Operating Earnings; Net Income = Net Profit. Shareholders equity (Canadian) = Stockholders equity (American) Shareholders equity includes Share Capital, Contributed Surplus, Retained Earnings, Accumulated Comprehensive Income (Loss) and other things that a company may jam there. Plant, Property & Equipment (PP&E) = Fixed Assets Liquidity Ratios Liquidity ratios give you the sense of a companys short term prospects. Does it have enough cash to pay its bills, and in some instances debt coming due. Banks like to look at liquidity ratios when considering loan requests. Days receivable, etc. can also be considered Activity / Efficiency ratios. Generally, a low days receivable or days inventory is better. But not too low. For example, too low inventory days may mean that you have interruptions in production because the company doesnt have enough parts on hand. The good level will vary by industry. Retailing will have a very low (2 5 days) receivables figure because the credit and debit card companies pay very quickly. 1. Current Ratio = Current Assets Current Liabilities (times) A company is in a good position to meet its current obligations if current assets exceed current liabilities by a comfortable margin. 2. Quick Ratio (Acid Test) = Current AssetsInventory Current Liabilities (times) Acid Test removes inventory as it can be slow moving and not so readily realisable into cash. 1

3. Average Collection Period ACR (aka Days Receivable) = Accounts Receivable Average Daily Sales (days) Average Daily Sales = Sales 365 The ratio represents the average length of time that a company must wait after making a sale before receiving payment. 4. Days Inventory Held (DIH) = Inventory Average Daily Costs of Sales(COGS) (days) Average Daily Cost of Sales = COGS 365 The ratio measures average number of days the company holds its inventory before selling it. 5. Days Payable Outstanding (DPO) = Accounts Payable Average DailyCost of Sales ( COGS ) (days) Average Daily Cost of Sales = COGS 365 The ratio measures average number of days it takes for a company to pay off to their supplier. 6. Net Trade Cycle (Cash Conversion Cycle) = Days Receivable + Days Inventory Days Payable (days) The ratio measures days it takes to convert inventory into cash flow from sales. Activity / Efficiency Ratios Activity / Efficiency ratios give investors and lenders a sense of how well a company is using its assets in order to generate cash and net income. They look at short-term assets: days payable/ payables turnover, etc., as well as fixed assets. Note: you dont really need the first three turnover ratios if youve done days inventory, etc. These ratios tell you the same thing in a different manner. A low number of days receivable will mean a high accounts receivable turnover. 1. Accounts Receivable Turnover = Net Sales Accounts Receivable (times) 2

2. Inventory Turnover = Cost of Goods Sold Inventory (times) 3. Accounts Payable Turnover = Cost of Goods Sold Accounts Payable (times) 4. Fixed Assets Turnover = Net Sales Net Assests (times) Net Fixed Assets = Net plant, Property & Equipment The ratio measures how investment in fixed assets contributes to growth in sales. 5. Total Assets Turnover = Net Sales Total Assets (times) The ratio measures how total companys assets contribute to growth in sales. Leverage Ratios Leverage ratios are another favourite of the banks. These give lenders a sense of the debt load a company has. Banks will also look closely at when a companys loans are due (disclosed in a note to the financial statements) to see if there are any warning signals (eg lots of debt coming due in the next two years). Equity investors keep an eye on these too, as they are aware that financial leverage can increase profits, as well as add risk to a companys profile. 1. Debt = Total Debt Total Assets (%) The debt ratio measures the proportion of assets that are financed by debt. Note: I dont usually use this ratio, but left it in because all the books have it. Remember, not all liabilities are debt. 2. Debt to Total Capitalisation = Total Debt Shareholders Equity+Total Debt (%) Total Debt = Short term+Current portion of long term+ Long term debt All else equal, the higher the debt-to-capital ratio, the riskier the company. 3. Long Term Debt to Total Capitalisation = Long Term Debt LongTerm Debt + Share holders Equity (%) 3

This ratio was used more when companies financed their fixed assets with long-term debt and only used short-term debt for occasional operating shortfalls in cash. Today, many (most?) companies use short-term debt as part of their permanent financing. 4. Debt to Equity = Total Debt Shareholders Equity (%) Total Debt = Short term+Current portion of long term+ Long term This ratio can be used to evaluate how much leverage a company is using. Higher leverage usually indicates higher risk. The following three ratios indicate the ability of a company to service its debt (ie pay the interest). Banks are really, really interested in this. In general, the higher the better. A standard rule of thumb suggests that a two times interest coverage ratio is about as low as a company would want to go. 5. Times Interest Earned (Interest Coverage Ratio) = Operating Profit Interest Expense (times) It measures the extent to which earnings can decline without the company finding itself unable to meet the annual interest costs. 6. Fixed Charge Coverage = Operating Profit + Rent / Lease Expense Interest Expense + Rent / Lease Expense (times) Fixed charge coverage is more comprehensive because it covers lease payments which are essentially debt, and can be substantial in some industries (airlines) and companies. Think about leasing a car you get all the benefits of owning it by making monthly payments. There is very little difference between borrowing to buy a car and leasing it, until the lease expires. Therefore, its best to use fixed charge coverage which includes the lease payments if the company has significant lease obligations (usually disclosed in the notes to the financial statements). 7. Cash Flow Adequacy = Cash Flow Operations Capital Expenditures+ Debt Repayments+ Dividend Paid (times) This ratio determines whether the cash flows generated by the operations of a business are sufficient to pay for its other ongoing expenses. All these numbers can be found in the Cash Flow Statement. 4

Profitability and Return Ratios Profit margins will vary by industry, so you must compare companies in the same industry. Generally, a higher profit margin, at any level, makes you happy. High and increasing over time will make you very happy. 1. Gross Profit Margin = Gross Profit Net Sales (%) Gross Profit = Net Sales COGS The higher the percentage, the more the company retains on each dollar of sales to service its other costs and obligations. 2. Operating Profit Margin = Operating Profit Net Sales (%) This ratio measures how well company is managed and how risky it is as it shows proportion of revenue available to cover non-operating costs like interest. 3. Net Profit Margin = Net Earnings Net Sales (%) This ratio measures the percentage of revenue left after all expenses have been deducted from sales. High ratio indicates that costs are managed effectively and products are priced correctly. 4. Cash Flow Margin = Cash Flow Operations Net Sales (%) This ratio indicates how well company converts sales into cash. Cash flow margin is infrequently used. Return Ratios Return ratios help an investor or banker determine how well the company turns its assets or equity into profits. They are hybrids which look at both the income statement (net or operating profit) and the balance sheet (assets and shareholders equity). Industries will differ in the level of these return ratios. For example a technology company would be expected to have a better ROA and ROE than a heavy manufacturing industry. As always, you need to compare a companys ratios to other companys in the same industry. It doesnt make sense to compare the ROE of Apple to the ROE of Ford. In general, the higher the better. And as always, high and growing is better still. 5

1. Return on Assets (ROA) = Operating Earnings (EBIT ) Total Average Assets (%) This ratio gives a sense of the return a company is earning, while eliminating the potential effects of financial leverage. 2. Return on Equity = Net Earnings Average Shareholde r ' s Equity (%) This ratio tells you how effectively management is using equity to grow business. Market Ratios Market ratios, or valuation ratios are the most fun and generally attract the most attention of investors. Once you determine from other financial ratios, that a company appears to be well managed and on a solid footing, you need to determine whether it is worth purchasing or not. Market ratios can help you in your assessment. 1. Price Earnings Ratio (P/E) = Share Price Today Earnings Per Share for a specified 12 month period (times) A high P/E ratio could mean that a company's stock is overvalued, or that investors are expecting high eps growth rates in the future. P/E ratios can be for a trailing period, eg todays share price divided by 2019 actual EPS or for a forward looking period, eg todays share price divided by 2021 estimated EPS. You cannot compare the two. For comparisons, you must always use the same time frame for the EPS. Every company has a trailing EPS and if there are accurate estimates available it will have several estimated EPSs (2020, 2021, and possibly 2022). The following is also the P/E ratio, but it multiplies the share price by number of shares outstanding and it multiplies the EPS by the number of shares outstanding. Its a quick way to determine the total equity value of a company. 6

2. Price Earnings Ratio (P/E) (2) = Market Capitalisation Today Net Income for a Specified 12month Period (times) 3. Earnings Per Share (EPS) = Net Income Weighted Average Number of Shares Outstanding ($) This ratio shows how much money company makes for each share of its stock. EPS is not comparable across companies. Therefore an EPS of $10.00 is not inherently better than earnings of $1.00 per share. The difference could simply be the result of a difference in the number of shares outstanding. 4. Dividend Payout Ratio = Total Dividend Paid Net Income or Dividend per Share Earnings per Share (%) This ratio measures proportion of earnings paid out as dividends to shareholders. 5. Market Capitalisation (Market Cap) = Share Price x Total number of Common Shares Outstanding ($) This ration is used to determine companys size. Advanced Valuation Ratios Sophisticated investors use other financial ratios to compare the valuation of companies because of the various shortcomings of using net income as a denominator in a valuation ratio. There are far too many accounting decisions that can affect the calculation of net income or EPS to make it the most useful ratio for valuation. Having said that, the P/E ratio is still the most widely talked about valuation ratio by non-financial professionals. 1. Enterprise Value EBITDA = Market Value of all Debt + Market Capitalisation Earnings before Interest Tax DepriciationAmortisation (times) The lower the ratio, the cheaper the valuation for a company. 7

2. Enterprise Value EBIT = Market Value of all Debt + Market Capitalisation Earningsbefore Interest Tax (times) 3. Price Book Value= Market Capitalisation Shareholders Equity ( book value ) or Share Price Shareholders Equity per Share (times) The ratio measures the markets valuation of a company relative to its book value. Today it is not frequently used, except in the financial services industry

National Fabricators

Review the exhibits above and discuss the companys financial performance during the past four years. Tell me what happened AND WHY it happened.