A.

  Analyzing Liquidity 

Liquid assets are those that can be converted into cash quickly. The short-term liquidity
ratios show the firm’s ability to meet its short-term obligations. Thus a higher ratio (#1 and
#2) would indicate a greater liquidity and lower risk for short-term lenders. The Rules of
Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1).

While high liquidity means that the company will not default on its short-term obligations,
one should keep in mind that by retaining assets as cash, valuable investment opportunities
may be lost. Obviously, cash by itself does not generate any return.  Only if it is invested
will we get future return.

1.  Current Ratio = Total Current Assets / Total Current  Liabilities 

2.  Quick Ratio = (Total Current Assets - Inventories) / Total Current Liabilities

In the quick ratio, we subtract inventories from total current assets, since they are
the least liquid among the current assets

B.  Analyzing Debt

Debt ratios show the extent to which a firm is relying on debt to finance its investments and
operations, and how well it can manage the debt obligation, i.e. repayment of principal and
periodic interest. If the company is unable to pay its debt, it will be forced into bankruptcy.
On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and
allows it to exploit business opportunities and grow.

Note that total debt includes short-term debt (bank advances + the current portion of long-
term debt) and long-term debt (bonds, leases, notes payable).

1. Leverage Ratios

1a.   Debt to Equity Ratio = Total Debt / Total Equity

This shows the firm’s degree of leverage, or its reliance on external debt for financing.

1b.  Debt to Assets Ratio = Total Debt  /  Total assets

Some analysts prefer to use this ratio, which also shows the company’s reliance on external
sources for financing its assets. 

In general, with either of the above ratios, the lower the ratio, the more conservative (and
probably safer) the company is.  However, if a company is not using debt, it may be
foregoing investment and growth opportunities.  This is a question that can be answered
only by further company and industry research.

A frequently cited rule of thumb for manufacturing and other non-financial industries is that
companies not finance more than 50% of their capital through external debt.
2.  Interest Coverage (or Times Interest Earned) Ratio = Earnings Before Interest and
Taxes / Annual Interest Expense 

This shows the firm’s ability to cover fixed interest charges (on both short-term and long-
term debt) with current earnings. The margin of safety that is acceptable varies within and
across industries, and also depends on the earnings history of a firm (especially the
consistency of earnings from period to period and year to year).

3.  Cash Flow Coverage = Net Cash Flow / Annual Interest Expense

Net cash flow = Net Income +/- non-cash items (e.g. -equity income + minority interest
in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization
expenses)

Since depreciation is usually the largest non-cash item in most companies, analysts often
approximate Net cash flow as being equivalent to Net Income + Depreciation.

Cash flow is a “critical variable” in assessing a company. If a company is showing strong

profits but has poor cash flow, you should investigate further before passing a favorable
opinion on the company. nalysts prefer ratio #3 to ratio #2.

C.  Analyzing Profitability 

Profitability is a relative term.  It is hard to say what percentage of profits represents a

profitable firm, as profits depend on such factors as the position of the company and its
products on the competitive life cycle (for example profits will be lower in the initial years
when investment is high), on competitive conditions in the industry, and on borrowing
costs.

For decision-making, we are concerned only with the present value of expected future
profits. Past or current profits are important only as they help us to identify likely future
profits, by identifying historical and forecasted trends of profits and sales.  

We want to know whether profits are generally on the rise; whether sales stable or rising;
how the profits compare to the industry average;  whether the market share of the
company is rising, stable or falling; and other things that indicate the likely future
profitability of the firm.

1.  Net Profit Margin = Profit after taxes / Sales  

2.  Return on Assets (ROA) = Profit after taxes  / Total Assets

3.  Return on Equity (ROE) = Profit after taxes / Shareholders’ Equity (book

value)

4.  Earnings per Common share (EPS) = (Profits after taxes - Preferred Dividend)
/ (# of common shares outstanding)

5.  Payout Ratio = Cash Dividends / Net  Income

Note:  The terms profits, earnings and net income are often used interchangeably in
financial statements.  Be sure to review the statements to understand their components.

 D.  Analyzing Efficiency

These ratios reflect how well the firm’s assets are being managed.

The inventory ratios shows how fast the inventory is being produced and sold.

1.  Inventory Turnover = Cost of Goods Sold / Average Inventory  

This ratio shows how quickly the inventory is  being turned over (or sold) to generate sales. 
A higher ratio implies the firm is more efficient in managing inventories by minimizing the
investment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12
times, or the average inventory is sold in a month.

2.  Total Assets Turnover = Sales / Average Total Assets  

This ratio shows how much sales the firm is generating for every dollar of investment
in assets.  The higher the ratio, the better the firm is performing.

3.  Accounts Receivable Turnover = Annual Credit Sales / Average Receivables

4.  Average Collection period = Average Accounts Receivable / (Total Sales /

365)

Ratios #3 and #4 show the firm’s efficiency in collecting cash from its credit sales.
While a low ratio is good, it could also mean that the firm is being very strict in
its credit policy, which may not attract customers.

5.  Days in Inventory = Days in a year / Inventory turnover

Ratio #5 is referred to as the “shelf-life” i.e. how quickly the manufactured product
is sold off the shelf. Thus #5 and #1 are related.

E.  Value Ratios

Value ratios show the “embedded value” in stocks, and are used by investors as a screening
device before making investments.

For example, a high P/E ratio may be regarded by some as being a sign of “over pricing”.
When the markets are bullish (optimistic) or if investor sentiment is optimistic about a
particular stock, the P/E ratio will tend to be high.  For example, in the late 1990s Internet
stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting
investors' optimism about the future prospects of these companies.  Of course, the burst of
the bubble showed that such confidence was misplaced.

On the other hand, a low P/E ratio may show that the company has a poor track record.  On
the other hand, it may simply be priced too low based on its potential earnings.  Further
investigation is required to determine whether the company would then provide a good
investment opportunity.

1.  Price To Earnings Ratio (P/E) = Current Market Price Per Share / After-tax
Earnings Per Share

2.  Dividend Yield= Annual Dividends Per Share /Current Market Price Per Share