QUICK GUIDE TO INVESTMENT ACCOUNTING RATIOSDon Gimpel’s Investopedia.com Notes

Edited by Sandra Kovach

- QUESTIONS AND GUIDE TO ANSWERS -

1. Which is the single most important metric used to measure the investment quality of a company? See Cash Flow Indicator/Free Cash Flow.

2. What is the most conservative measure of liquidity? See Liquidity/Cash Ratio.

3. What is a good measure of management’s performance? See Profitability/Operating Profit Margin, OPM or Profitability/Net Profit Margin, NPM.

4. What is the key factor in gauging profitability? See Profitability/Return on Capital Employed, ROCE.

5. What is a good measure of a company’s ability to leverage debt? See Debt/Debt-Equity Ratio, DER.

6. What is a good measure of a company’s financial fitness? See Debt/Capitalization Ratio, CR.

7. What is the most conservative measure of a company’s funding ability?See Cash Flow Indicator/CCCR or CAPEX + Cash Dividends Ratio.

8. How can you tell if a company is able to keep paying high dividends?See the Cash Flow Indicator/Dividend Payout Ratio, the DPR.|

9. What’s the best measure of a company’s profitability? See Investment Valuation/Price to Cash Flow.

10. Are there problems in using the P/E Ratio? See comments in Investment Valuation/Price-Earnings Ratio

11. What is “The King of the (Investment) Value Factors.”See comments in Investment Valuation/Price-Sales Ratio

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QUICK GUIDE TO INVESTMENT ACCOUNTING RATIOSThese notes are based in part upon material found in www.investopedia.com/university/ratios

LIQUIDITY … A measure of a company’s ability to pay its short-term debtsType/Measurement What it means The ratio CommentsCurrent Ratio, CR or

Current to WorkingCash Position

The proportion of current assets available to cover current liabilities. The higher the ratio, the better

CR = N / DN = Cash or cash equivalents + marketable securities + receivables and inventoryD = Notes payable + current ST debt payables + accrued expenses+ taxes(1+5+2+3)/(35+11+32+34)

This method is flawed because a company is a going concern and its ability to cover it’s current debts is not really significant

Quick Ratio, QR, orQuick Assets Ratio, QAR

This is a measure of the amount of the most liquid assets to cover current liabilities. The higher the ratio the better.

QR = N / DN = Cash & Equivalents + ST Inventory + Accounts ReceivableD = Current Liabilities(1+3+2)/33

The most liquid assets available to cover current liabilities. A more conservative valuation than the Current Ratio. The “quickness” of the ratio depends upon the time required to collect receivables.

Cash Ratio, CashR A refinement of the current ratio to cover current liabilities. The higher the ratio the better.

CashR = N / DN = Cash & Cash Equivalents + Invested FundsD = Current Liabilities1/33

The most conservative liquidity measure. It is not realistic to have a CR>1 because it might be considered poor asset utilization.

Cash Conversion Cycle, CCC

# Days a company’s cash is tied up in production and sales. The shorter the better.

Note: The numbers in column 3 refer to Balance Sheet or P&L line items.

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PROFITABILITY … A measure of a company’s valuationType/Measurement What it means The ratio CommentsProfit Margin, GPM

Operating Profit M., OPMPretax Profit Margin, PPMNet Profit Margin, NPM

These four ratios measure a company’s ability to make money. The higher the ratio the better.

GPM = Gross Profit / Net Sales = ( 1 – Cost of Goods Sold / Net Sales)16-COGS/16OP = Gross Profit – Operating Expenses(16-COGS)-36OPM = OP / Net Sales = (Gross Profit–Selling Exp.-GA ) / Net sales((16-COGS)-37-38)/16PPM = Pretax Profit / Net Sales 17/16NPM = Net Income / Net Sales 18/16GA = General & Administrative Expenses

GPM measures how efficiently a company uses its raw materials, labor and mfg.-related assets. Management has real control of OPM so this is a good measure of performance.PPM is similar to OPM.NPM is the bottom line and a good performance measure..

Effective Tax Rate, ETR

Provides a good understanding of a company’s tax rate.

ETR = Income Tax Expenses / Pre Tax Income20/17

Some analysts prefer to use the pretax profit instead of the net profit number for the profitability.

Return on Assets, ROA

This shows how profitable a company is compared to total assets. The higher the better.

ROA = Net Income / Average Total Assets18/19 AVG

This is best used for historical purposes because businesses vary widely in their Fixed Asset requirements.

Return on Capital Employed,. ROCE

This compliments the ROE by adding debt liabilities.

ROCE = Net Income + Capital Employed18+(11+12AVG)+8AVGCapital Employed = Avg. Debt + Average Shareholders Equity

Factoring debt liability into the total capital provides a more comprehensive measure of how well management is using debt. Focus on ROCE as the key factor to gauge profitability. ROCE should be >= a company’s borrowing rate.

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DEBT … A measure of how well a company is using outside assets in its operations.Type/Measurement What it means The ratio CommentsOverview of DebtDebt Ratio, DR This measures the total debt to

total assets, a measure of a company’s debt leverage. The lower the better.

DR = Total Liabilities / Total Assets7/6

The Debt Ratio provides a quick take on a company’s financial leverage.

Debt-Equity Ratio, DER

This is another leverage ratio. This measures how much suppliers, lenders, creditors and obligors have committed versus shareholders. The lower the ratio.

DER = Total Liabilities / Shareholders Equity7/8

An easy-to-calculate ratio provides a general indication of a company’s equity-liability relationship. DER provides a more dramatic perspective on a company’s leverage than DR.

Capitalization Ratio, CapR

This ratio provides a key insight into a company’s use of leverage. This is an excellent measure of investment quality. The lower the ratio the better.

CapR = LT Debt/(LT Debt + Shareholders Equity)12((12+8)

This measures financial fitness. One of the more meaningful debt ratios.

Interest Coverage Ratio, ICR

This determines how easily a company can pay interest on its debts. The higher the ratio the better.

EBIT – Earnings before Interest and Taxes9ICR = EBIT / Interest Expense9/10

When ICR < 1.5, the company’s ability to meet its interest expenses is questionable.

Cash Flow to Debt Ratio, CFDR, orFree Cash Flow to Debt Ratio, FCFDR

This ratio provides an indication of a company’s ability to cover its total debt with its yearly cash flow. The higher the ratio, the better.

Total Debt = ST + LT debt11+12CFDR = Operating Cash Flow / Total DebtOther = Redeemable Preferred Stock + 2/3 of principal of non-cancellable operating leases.13/(11+12)FCFDR = Operating Cash Flow/(Total Debt + Other)13/(11+12)

A high double-digit ratio is a sign of financial strength. A low ratio indicates too much debt or weak cash flow generation.

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OPERATING PERFORMANCE … A broad measures of a company’s operating healthType/Measurement What it means The ratio CommentsFixed-Asset Turnover, FAT

This is a rough estimate of the productivity of a company’s fixed asset utilization. The higher the ratio, the better.

FAT = Revenue / (Property + Plant + Equipment) 14/15

This measures a company’s efficiency in managing fixed assets. Best used with historical ratios to establish trends. This ratio is highly dependent on the company’s kind of business

Sales Revenue per Employee, SRE

This a measure of personal productivity as Net Sales per Employee

SRE = Revenue / # Employees = Net Sales / # Employees14/#Employees16/#Employees

Like others in this class, this measure is highly dependent upon the nature of the business. It is best used to determine trends among competitors.

Operating Cycle, OC A measurement of management performance similar to the CCC. The fewer the # days, the better.

THINK OF THIS AS CASH SENT OUT AND THE CASH COLLECTED. MORE IMPORTANT WITH THE RETAIL SECTOR. LOOK FOR THIS INFORMATION IN THE NOTES

OC = DIO + DSO – DPODIO = # Days Inventory outstanding =Average Inventory divided by Cost of Sales/dayAverage Inventory = (Io + Ie) / 2Cost of Sales per day = Annual Cost of Sales/365

DSO = # Days Receivable’s Outstanding = Average Accounts Receivable/Net Sales per dayAvg. Acct. Rec = (Initial + Final)Acct. Rec. / 2Net Sales / Day = Annual Net Sales / 365

DPO = # Days Payables Outstanding = Avg. Accts. Payable / Cost of Sales per dayAvg. Acct. Payable = (Init. + Final ) Payables/2Cost of Sales/Day = Annual Cost of Sales / 365

The more efficient the collection operations, the better. The slower the payables are paid, the better. The lower the inventory to sales ratio, the better. When using the OC, look for historical consistency.

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CASH FLOW INDICATOR … A measure of how efficiently a company uses its cash assetsType/Measurement What it means The ratio CommentsOperating Cash Flow to Sales Ratio, OCF/S

The Operating Cash Flow to Sales Ratio measures how the cash generated from operations varies over time. Generally, the greater the ratio, the better.

OCF/S = Operating Cash Flow / SalesOCF is taken from the Cash Flow Statement.Net Sales is taken from the Income Statement13/16

There are three sources of cash flow: (1) from operations, (2) from Investing and (3) from Financing. Use only the part derived from operations, which is usually the foremost source of cash.

Free Cash Flow to Operating Cash Flow, FCF/OCF

This is the fraction of cash flow available for expansion, acquisitions and/or financial stability to enable a company to weather difficult conditions. The higher the ratio, the better.

FCF/OCF=(1–Capital Exp./Operating Cash Flow)1-(17/13)

Many investment institutions value Free Cash Flow ahead of earnings as the single most important financial metric used to measure the investment quality of a company.

Cash Flow Coverage Ratio, CCCR

These are measures of the ability of a company’s OCF to meet its obligations. The higher the ratio the better.

STDC = OCF / ST Debt 13/11CEC = OCF / Cap. Exp. 13/17DC = OCF / Cash Dividends 13/21CAPEX + Cash Dividends Ratio = OCF / (Cash Expenditures + Cash Dividends )13/17+21

These ratios determine the company’s funding ability. The last ratio is a really stringent measure that puts cash to the ultimate test. It is “free cash flow on steroids” and indicates high investment quality

Dividend Payout Ratio, DPR

Measures the fraction of earnings allocated for cash dividends. This is a measure of how well earnings support the dividend payment. The smaller the ratio the better.

DPR = Dividends per Common Share Earnings per Share(21/24)/(18/24)

This ratio is only used for dividend paying companies. Look for consistent or steadily increasing ratios. Be skeptical of excessively high dividends because the company might not be able to keep it up triggering a sharp stock price decline.

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INVESTMENT VALUATION … A measure of how an investment is valuedType/Measurement What it means The ratio CommentsPer Share DataPrice to Book Value Ratio, PB

This ratio is how many times a company’s stock value is trading per share compared to a company’s book value per share

PB = Stock Price / Shareholder’s Equity per share23/(8/24)

When a company’s stock price is less than it’s book value then (1) the stock is undervalued and represents a buying value or (2) if that evaluation is correct, the investment will be perceived as a losing proposition or at best a stagnant investment

Price to Cash Flow Ratio, PCF

This ratio is used to evaluate an investment’s attractiveness. The lower the ratio the better.

PCF = Stock price / Operating Cash Flow per share23/(13/24)

This ratio is similar to PB but many analysts consider it more reliable for evaluating acceptability of current pricing because it is not as easily manipulated.

Price to Earnings Ratio, PE

This is the best known investment valuation indicator.

PE = Stock Price / Earnings per share23/(18/24)Substitutions for the denominator include:TTM = Trailing Twelve-month Earnings/ShareObtain from 25 Price/Sales RatioFEPS = Estimate future 12-month Earnings/Share Obtain from 22 Earnings per Share Growth – Growth is an estimate

This ratio is often optimistic during bull markets and pessimistic during bear markets. It should be looked at skeptically particularly if forward earnings estimates are used. High P/Es imply a growth company where potential investors are willing to pay extra for potential growth. This ratio is highly sensitive to changes in accounting practices.

Price to Earnings to Growth Ratio, PEG

The PEG Ratio is a refinement of the PE Ratio made by including the growth factor in the denominator into the current valuation. It measures the degree to which high PE’s and growth are correlated.

PEG = PE / G(23/(18/24))/22Here, G is the E/S Growth.

This is a variation of Graham-Dodds valuation equation P = aE*(1 + bG) rewritten to the form+ (P/E) / (a*(1 + bG ))

Graham and Dodd found that the constants a and b depend upon the company’s specific industrial classification.

If the PEG = 1. the market is currently valuing a stock in accordance with the stock’s current estimated earning per share growth. If the value is <L1, the stock is undervalued and if >1, overvalued. The PEG Ratio determines the degree of reliability of the assumption that high prices and growth are related. It is common to encounter estimates of a company’s future growth that are incorrect. See Value Line’s reports that are available free at most public libraries.

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Price to Sales Ratio, P/S

A stock valuation indicator similar to the P/E Ratio except it measures valuation against Annual Sales. The lower the ratio, the better.

P/S = Stock price per share / Net Sales per share23/(16/24)

According to James O’Shaughghnessy author of “What Works on Wall Street,” this ratio is “The King of Value Factors.” It beats all others and does so consistently.

Dividend Yield, DY A measure of valuation as the annual dividend per share divided by the stock price per share

DY = Ann. Dividend/Share / Stock Price per Share(21/24)/23

This measure depends on the nature of the company’s business, whether it’s “value” or “growth” oriented, earnings, cash-flow and dividend policies. The value of this indicator depends on whether the investor favors value or growth.

Enterprise Value Multiple, EVM, in years

This is the ratio of the “enterprise value” by EBITDA. It measures how long it would take for an acquisition to pay off its costs.

EVM = EV / EBITDAEV = Market Capitalization + Debt + Minority Interest + Preferred Stock – Cash – Cash Equivalents.EBITDA = Earnings before Interest, Taxes, Depreciation and Amortization

(23*24)/21+(11+12)+26-27

The EVM is influenced by investor sentiment and market conditions. It measures the value of a company as a going concern.

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QUICK GUIDE TO INVESTMENT ACCOUNTING RATIOS- ABBREVIATIONS -

CAPEX Capital Expenditure CoverageCapR Capitalization RatioCashR Cash RatioCCC Cash Conversion CycleCFDR Cash Flow to Debt RatioCR Current RatioDC Dividend CoverageDER Debt-Equity RatioDIO # Days Inventory OutstandingDPO # Days Payables OutstandingDPR Dividend Payout RatioDR Debt RatioDSO # Days Receivables OutstandingDY Dividend YieldEBIT Earnings Before Interest and TaxesEBITDA Earnings before Interest, Taxes,

Depreciation and AmortizationEPS Earnings (ex post) earnings per shareETR Effective Tax RateEV Enterprise ValueEVM Enterprise Value MultipleFAT Fixed-Asset TurnoverFCF Free Cash FlowFCF/OCF Free Cash Flow to OCF Ratio

FCFDR Free Cash Flow to Debt RatioFEPS Forward (ex ante) Earnings per shareG Earnings per share growthGPM Gross Profit MarginICR Interest Coverage RatioNPM Net Profit MarginOC Operating Cycle, DaysOCF Operating Cash FlowOCF/S Operating Cash Flow to SalesOPM Operating Profit MarginPB Price to Book RatioPCF Price to Cash Flow RatioPE Price to Earnings RatioPEG Price to Earnings Growth RatioPPM Pretax Profit MarginQAR Quick Assets RatioQR Quick RatioROA Return on AssetsROCE Return on Capital EmployedS Sales, NetSRE Net Sales per EmployeeSTDC Short-term Debt CoverageTTM Trailing 12-Month (Earnings per share)

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QUICK GUIDE TO INVESTING ACCOUNTING RATIOS- LOCATION OF BALANCE SHEET AND PROFIT/LOSS STATEMENT ITEMS -

ITEM LOCATIONAccounts Receivable Balance Sheet/Assets/Current AssetsAssets, Total Balance Sheet/Assets/Total AssetsBook Value Balance Sheet/EquityCapital Employed Balance Sheet/EquityCapital Expenditures Balance Sheet/Fixed Assets/PropertyCash Balance Sheet/Current Assets/CashCash, Dividends Income Statement/Footnotes/Dividends per shareCash, Equivalents Balance Sheet/Assets/Current Assets/Cash & Cash EquivalentsCash, Flow Cash Flow StatementCash, Free Cash Cash Flow StatementCash Flow, Operating Cash Flow StatementCost of Goods Sold Income Statement/Expenses/TotalDebt, Average Balance sheet/Liabilities and Equity/Long-Term Liabilities./LTDebt, Current Short-Term Balance sheet/Liabilities/Current portion of bank loansDebt, Long-Term Balance Sheet/Liabilities & Equity/LT/Bank Loans Dividend Payout Ratio Income Statement/ FootnotesDividend Yield Income Statement/FootnotesEarnings Income Statement/Net EarningsEarnings per Share Growth Income Statement/FootnotesEmployees, number Personnel Records Enterprise ValueEnterprise Value MultipleExpense, Accrued Income Statement/Total ExpensesExpense, General & Administrative (GA) Income Statement/Expenses/G&AExpense, Income Tax Income Statement/Scheduled ExpensesExpense, Interest Income Statement/Scheduled ExpensesExpense, Operating Income Statement/Variable ExpensesExpense, Selling Income Statement/Variable ExpensesIncome, Net Income Statement/Net EarningsIncome, Pre-Tax Income Statement/Net EarningsInventory Balance Sheet/Assets/Current Assets/InventoryInvested Funds Income Statement/Operating Income/Interest IncomeLiabilities, Current Balance Sheet/Liabilities & Equity/Current Liabilities/TotalLiabilities, Total Balance Sheet/Liabilities & Equity/Total LiabilitiesMinority InterestNotes payable Balance Sheet/Liabilities & Equity/Current Liabilities/Current

Portion of Bank LoansPreferred Stock, redeemable Balance Sheet/EquityPrice to Sales Ratio Income Statement/FootnoteProperty, Plant & Equipment Balance Sheet/Assets/Fixed Assets/Property, Plant and EquipmentProfit, Gross Income Statement/Gross ProfitsProfit, Pretax Income Statement/ProfitReceivables Balance Sheet/Assets & Equity/Current Assets/Acct. ReceivableSales, Net Income Statement/Revenues/Sales NetSecurities, Marketable Balance Sheet/Assets/Current Assets/Cash & Cash EquivalentsShareholders Equity, Average Balance Sheet/Equity/Per share capitalTaxes Payable Balance Sheet/Liabilities and Equity/Current and Long Term

Liabilities/Taxes Payable

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INCOME (PROFIT & LOSS) AND QUICK CASH FLOW STATEMENTS

REVENUES QUICK GUIDE REFERENCE16 Net Operating Sales Net sales

Other Income Interest Income14 TOTAL REVENUE Total revenue

9 EXPENSES36 Operating Total Expenses, operating37 Selling Selling expense38 G & A General & Administrative Expense

TOTAL EXPENSES Total expenses

EBITDA Earnings before Interest, Taxes, Depreciation & Amortization

SCHEDULED EXPENSES10 Interest

Depreciation and Amortization17 Pre-tax Profit Pre-tax Profit20 Taxes

TOTAL SCHEDULED EXPENSES

18 NET EARNINGS Net Earnings

NOTES21 Cash dividends24 Average # shares outstanding in period23 Stock price at close of period22 Earnings per share growth25 Price/Sales Ratio

CASH FLOW

CASH FLOW+ Net Earnings+ Depreciation and Amortization- Change in working capital- Funds Invested in Period

13 QUICK CASH FLOW Quick Cash Flow

BALANCE SHEET AND SHAREHOLDERS EQUITY

ASSETS QUICK GUIDE REFERENCE

CURRENT ASSETS1 Cash & Cash equivalents 27 Cash & Cash Equivalents2 Accounts Receivable Accounts Receivable, Receivables3 Inventory4 Prepaid expenses5 Securities, marketable Securities, marketable6 Other current assets

FIXED ASSETS15 Property, Plant and Equipment 17 Capital expenditures (fixed asset

purchases)GoodwillOther intangible fixed assets

6 TOTAL ASSETS 19 Total Assets

LIABILITIES AND SHAREHOLDERS EQUITY

CURRENT LIABILITIES 8 Accounts Payable9 Current Income Taxes 34 Taxes payable10 Current portion of bank loans 35 Notes payable30 Short-term provisions32 Other 33 Total Short-term Liabilities 11 Current short-term debt, Liabilities-current

LONG TERM LIABILITIES Bank loans Issued debt securities Deferred tax liability 26 Provisions – minority interest 7 Total Long-term Liabilities 12 Debt, long-term

TOTAL LIABILITIES

EQUITY Per Share capital 24 Shareholders equity per share Capital reserves Revaluation reserves Retained profits Preferred stock redeemable 15 Preferred stock redeemable

NOTES Book value Book value