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Understanding Financial Ratios
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How are Financial Ratios Compiled ?
The financial ratios are calculated using standardized financial methods to determine company and industry performance. USBR provides you with complete and accurate financial figures.
Current ratio = current assets / current liabilities
Current assets includes cash , marketable securities, inventory, and prepaid expenses. Current liabilities includes accounts payable ( 1 year or less) , current portions of long-term debt, and salaries payable. The current ratio measures the ability of the firm to pay is current bills while still allowing for a safety margin above their required amount needed to pay current obligations.
The quick ratio is similar to the current ratio but eliminates the inventory figure in the current assets section of the balance sheet. The inventory figure is thought to be the least liquid figure and should thus, be eliminated. USBR calculates the quick ratio as follows:
Quick ratio = (Current Assets - Inventory) / Current Liabilities
Generally, the quick ratio should be lower than the current ratio because it eliminates the inventory figure from the calculation.
The Net Working Capital figure simply deducts the current assets from the current liabilities on the balance sheet. USBR calculates the Net Working capital as follows:
NWC = Current Assets - Current Liabilities
Days Sales Outstanding
USBR calculates the average collection period by the following formula:
DSO = Accounts Receivable / (Sales / 360 days)
Total accounts receivable includes all outstanding credit obligations from customers. The sales figure includes sales for the prior four quarters of financial performance. The figure may also include amounts on a quarterly basis only. The accounts receivable period is a measure of a companys ability to collect accounts receivable within a timely and reasonable period. The accounts collection period varies from industry to industry. The smaller the accounts receivable period, the more effectively a company is in managing and collecting money from customers.
The inventory turnover ratio measures the number of times during a year that a company replaces its inventory. Differences in turnover rates result from differing operating characteristics within an industry. USBR calculates the inventory turnover rate as follows:
Inventory Turnover = Cost of Goods / Total Inventory
The higher the inventory turnover rate means the more efficiently a company is able to grow sales volume. USBR compiles inventory turnover by using the cost of goods figure in the numerator since inventories are usually carried at cost. Many other compilers of financial data use sales in the numerator. However, this is usually an inaccurate barometer of financial performance to determine the inventory turnover rate.
Fixed Asset Turnover
The fixed assets turnover is a measure of how efficiently a company uses its fixed assets to generate sales. The higher the fixed asset ratio the better. USBR calculates the fixed assets turnover by adding all sales of the company and dividing the amount by net fixed assets for the latest four quarters of financial performance. The basic formula is as follows:
FAT = ( Sales / Net Fixed Assets )
The fixed asset turnover can vary substantially from industry to industry.
Total Asset Turnover
The total asset turnover is a measure of how efficiently and effectively a company uses its assets to generate sales. The figure is similar to the fixed assets turnover but includes all assets . The higher the total asset turnover ratio, the more efficiently a firms assets have been used. USBR calculates the total asset turnover ratio as follows:
Total Asset Turnover = Sales / Total Assets
Debt ratios measure the total amount and proportion of debt within the liabilities section of a firms balance sheet. These figures are normally appropriate for comparing a company performance from one period to another.
USBR measures the proportion of total assets provided by a company's creditors. The debt ratio is calculated by dividing the total liabilities by total assets. The higher this ratio, the greater the degree of outside financing by creditors. It indicates that the firm is more highly leveraged (debt) and highly risky for creditors. The basic formula is as follows:
Debt Ratio = Total Liabilities / Total Assets
Higher ratios indicate high financial leverage to the firm. USBR ignores short term obligations (e.g. current liabilities) in calculating debt ratios based on the prior four quarters of financial performance.
Deb to Equity
This ratio indicates the ratio of debt on a firms balance sheet to the amount of funds provided by owners. USBR measures performance by using only long term debt divided by total equity. The basic formula is calculated as follows:
Debt to Equity = Long Term Debt / Total Equity
The more capital intensive the firm, the higher the debt to equity ratio. It measures the percentage of debt tied up in the owners equity.
Times Interest Earned
Times interest earned measures the ability of the firm to service all debts. The figure will indicate how many times a company can cover its fixed contractual obligations to its creditors. The higher the times interest earned , the more likely the firm can meet its obligations. USBR uses this basic formula as follows:
Times Interest Earned = EBIT / Interest
The figure is determined from the income statement by finding the operating profit margin. The operating profit margin (discussed below) is the profits of the firm before interest and taxes are subtracted. The interest figure is the interest obligations for the prior four quarters of financial performance from the use of long term debt funds.
Return on Investment
USBR uses the DuPont formula to determine the return on investment. The ROI is determined by multiplying the Total Asset turnover by the Net Profit Margin. The figure is meaningful because it shows how well a company uses its assets to generate profits,. The basic formula is as follows:
ROI = Total Asset Turnover x Net Profit Margin
The DuPont method allows the firm to break down its return on investment into a profit on sales component and an asset efficiency component. Typically, a firm with a low net profit margin would have a total asset turnover. The relationship between the net profit margin and Total Asset turnover is largely dependent on the industry the firm operates.
Return on Equity
The return on equity measures the return earned on the owners equity in the firm. The higher the rate the better the firm has increased wealth to shareholders. The basic formula is as follows:
ROE = Net Profits / Stockholders Equity
USBR measures the ROE figure by adjusting for new equity infusion from the prior four quarters of a company.
Return on Capital
Return on Capital is a measure of economic performance within a business firm. This ratio is used to measure how much capital (e.g. debt and equity) was needed to produce a firm's earnings. This ratio is also an indication of how well a company uses its capital to generate returns to shareholders. This could also provide a clue to how a company will perform in the future with its capital. The basic formula is as follows:
Return on Capital = Return on Equity (ROE) / (1 + Debt to Equity Ratio)
Return on Capital = ROE x ( 1 - Debt to Capital )
This ratio is similar to return on equity. Return on capital has a tendency to be more meaningful from heavily leveraged (debt-laden) companies.
Gross Profit Margin
The profitability figures measure the ability of the business firm to earn a profit from its operations through assets, sales, and equity.
The gross profit margin indicates the percentage of each sales dollar remaining after a firm has paid for its goods. The basic formula is calculated as follows:
GPM = ( Sales - Cost of Goods Sold )/ Sales
The higher the GPM the better pricing flexibility and cost management controls a firm has in its operations.
Operatign Profit Margin
The operating profit margin indicates the profits of the company before interest and taxes are deducted from a firms operations. The higher the operating profit margin, the greater pricing flexibility a firm has in its operations. However, it could also indicate the degree of cost control management a firm possesses. The figure is calculated as follows:
Operating Profits = Operating Profits / Sales
Net Profit Margin
Similar to the operating profit margin, the net profit margin measures the amount of profits available to shareholders after interest and taxes have been deducted on the income statement. The higher the profit margin, the more pricing flexibility a firm may have in its operations or the greater cost control initiated by management. The figure is determined as follows:
NPM = Net Profits /Sales
Earnings Per Share
The earnings per share measures the per share dollar return to owners of a company. The figure is calculated as follows:
EPS = Total Earnings / No. of shares outstanding
USBR sums the prior year earnings and divides the amount by the weighted average of shares outstanding. This assumes the most accurate information if a company distributes new shares outstanding during the period which could substantially impact (or dilute) shares to current shareholders with lower per share earnings.