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financial Ratio TutorialPrinter friendly version (PDF format) By Richard Loth (Contact | Biography ) When it comes to investing, analyzing financial statement information (also known as quantitative analysis), is one of, if not the most important element in the fundamental analysis process. At the same time, the massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, you will be able to work with these numbers in an organized fashion. The objective of this tutorial is to provide you with a guide to sources of financial statement data, to highlight and define the most relevant ratios, to show you how to compute them and to explain their meaning as investment evaluators. In this regard, we draw your attention to the complete set of financials for Zimmer Holdings, Inc. (ZMH), a publicly listed company on the NYSE that designs, manufactures and markets orthopedic and related surgical products, and fracture-management devices worldwide. We've provided these statements in order to be able to make specific reference to the account captions and numbers in Zimmer's financials in order to illustrate how to compute all the ratios. Among the dozens of financial ratios available, we've chosen 30 measurements that are the most relevant to the investing process and organized them into six main categories as per the following list: 1) Liquidity Measurement Ratios - Current Ratio - Quick Ratio - Cash Ratio - Cash Conversion Cycle 2) Profitability Indicator Ratios - Profit Margin Analysis - Effective Tax Rate - Return On Assets - Return On Equity - Return On Capital Employed 3) Debt Ratios - Overview Of Debt - Debt Ratio 4) Operating Performance Ratios - Fixed-Asset Turnover - Sales/Revenue Per Employee - Operating Cycle 5) Cash Flow Indicator Ratios - Operating Cash Flow/Sales Ratio - Free Cash Flow/Operating Cash Ratio - Cash Flow Coverage Ratio - Dividend Payout Ratio 6) Investment Valuation Ratios - Per Share Data - Price/Book Value Ratio - Price/Cash Flow Ratio - Price/Earnings Ratio - Price/Earnings To Growth Ratio 1

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financial Ratio TutorialPrinter friendly version (PDF format)

By Richard Loth (Contact | Biography)

When it comes to investing, analyzing financial statement information (also known as quantitative analysis), is one of, if not the most important element in the fundamental analysis process. At the same time, the massive amount of numbers in a company's financial statements can be bewildering and intimidating to many investors. However, through financial ratio analysis, you will be able to work with these numbers in an organized fashion.

The objective of this tutorial is to provide you with a guide to sources of financial statement data, to highlight and define the most relevant ratios, to show you how to compute them and to explain their meaning as investment evaluators.

In this regard, we draw your attention to the complete set of financials for Zimmer Holdings, Inc. (ZMH), a publicly listed company on the NYSE that designs, manufactures and markets orthopedic and related surgical products, and fracture-management devices worldwide. We've provided these statements in order to be able to make specific reference to the account captions and numbers in Zimmer's financials in order to illustrate how to compute all the ratios.

Among the dozens of financial ratios available, we've chosen 30 measurements that are the most relevant to the investing process and organized them into six main categories as per the following list:

1) Liquidity Measurement Ratios- Current Ratio- Quick Ratio- Cash Ratio- Cash Conversion Cycle2) Profitability Indicator Ratios- Profit Margin Analysis- Effective Tax Rate- Return On Assets- Return On Equity- Return On Capital Employed3) Debt Ratios- Overview Of Debt- Debt Ratio- Debt-Equity Ratio- Capitalization Ratio- Interest Coverage Ratio- Cash Flow To Debt Ratio

4) Operating Performance Ratios- Fixed-Asset Turnover- Sales/Revenue Per Employee- Operating Cycle5) Cash Flow Indicator Ratios- Operating Cash Flow/Sales Ratio- Free Cash Flow/Operating Cash Ratio- Cash Flow Coverage Ratio- Dividend Payout Ratio6) Investment Valuation Ratios- Per Share Data- Price/Book Value Ratio- Price/Cash Flow Ratio- Price/Earnings Ratio- Price/Earnings To Growth Ratio- Price/Sales Ratio- Dividend Yield- Enterprise Value Multiple

Liquidity Measurement Ratios: IntroductionBy Richard Loth (Contact | Biography)The first ratios we'll take a look at in this tutorial are theliquidity ratios. Liquidity ratios attempt to measure a company's ability to pay off its short-term debt obligations. This is done by comparing a company's most liquid assets(or, those that can be easily converted to cash), its short-term liabilities.

In general, the greater the coverage of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting its obligations.

The biggest difference between each ratio is the type of assets used in the calculation. While each ratio

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includescurrent assets, the more conservative ratios will exclude some current assets as they aren't as easily converted to cash.

The ratios that we'll look at are the current, quick and cash ratios and we will also go over the cash conversion cycle, which goes into how the company turns its inventory into cash.

To find the data used in the examples in this section, please see the Securities and Exchange Commission's website to view the 2005 Annual Statement of Zimmer Holdings.

Liquidity Ratios

What Does Liquidity Ratios Mean?A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.   

Investopedia explains Liquidity RatiosCommon liquidity ratios include the current ratio, the quick ratio and the operating cash flow ratio. Different analysts consider different assets to be relevant in calculating liquidity. Some analysts will calculate only the sum of cash and equivalents divided by current liabilities because they feel that they are the most liquid assets, and would be the most likely to be used to cover short-term debts in an emergency.

A company's ability to turn short-term assets into cash to cover debts is of the utmost importance when creditors are seeking payment. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern.

Liquid Asset

What Does Liquid Asset Mean?An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally regarded in the same light as cash because their prices are relatively stable when they are sold on the open market.

Investopedia explains Liquid AssetFor an asset to be liquid it needs an established market with enough participants to absorb the

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selling without materially impacting the price of the asset. There also needs to be a relative ease in the transfer of ownership and the movement of the asset. Liquid assets include most stocks, money market instruments and government bonds. The foreign exchange market is deemed to be the most liquid market in the world because trillions of dollars exchange hands each day, making it impossible for any one individual to influence the exchange rate.

Accounting

What Does Accounting Mean?To provide a record such as funds paid or received for a person or business. Accounting summarizes and submits this information in reports and statements. The reports are intended both for the firm itself and for outside parties.

Investopedia explains AccountingConcise accounting helps management make accurate decisions.

Accrual Accounting

What Does Accrual Accounting Mean?An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur. The general idea is that economic events are recognized by matching revenues to expenses (the matching principle) at the time in which the transaction occurs rather than when payment is made (or received). This method allows the current cash inflows/outflows to be combined with future expected cash inflows/outflows to give a more accurate picture of a company's current financial condition. 

Accrual accounting is considered to be the standard accounting practice for most companies, with the exception of very small operations. This method provides a more accurate picture of the company's current condition, but its relative complexity makes it more expensive to implement. This is the opposite of cash accounting, which recognizes transactions only when there is an exchange of cash.

Investopedia explains Accrual AccountingThe need for this method arose out of the increasing complexity of business transactions and a desire for more accurate financial information. Selling on credit and projects that provide revenue streams over a long period of time affect the company's financial condition at the point of the transaction. Therefore, it makes sense that such events should also be reflected on the financial statements during the same reporting period that these transactions occur.

For example, when a company sells a TV to a customer who uses a credit card, cash and accrual methods will view the event differently. The revenue generated by the sale of the TV

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will only be recognized by the cash method when the money is received by the company. If the TV is purchased on credit, this revenue might not be recognized until next month or next year. 

Accrual accounting, however, says that the cash method isn't accurate because it is likely, if not certain, that the company will receive the cash at some point in the future because the sale has been made. Therefore, the accrual accounting method instead recognizes the TV sale at the point at which the customer takes ownership of the TV. Even though cash isn't yet in the bank, the sale is booked to an account known in accounting lingo as "accounts receivable," increasing the seller's revenue.

Accrued Expense

What Does Accrued Expense Mean?An accounting expense recognized in the books before it is paid for. It is a liability, ans is usually current. These expenses are typically periodic and documented on a company's balance sheet due to the high probability that they will be collected.

Investopedia explains Accrued ExpenseAccrued expenses are the opposite of prepaid expenses. Firms will typically incur periodic expenses such as wages, interest and taxes. Even though they are to be paid at some future date, they are indicated on the firm's balance sheet from when the firm can reasonably expect their payment, until the time they are paid. 

Accrued Income

What Does Accrued Income Mean?Income that is earned in a fund or by company by providing a service or selling a product, but has yet to be received. Mutual funds or other pooled assets that accumulate income over a period of time but only pay it out to shareholders once a year are, by definition, accruing their income. Individual companies can also accrue income without actually receiving it, which is the basis of the accrual accounting system.

Investopedia explains Accrued IncomeFor example, assume that a company is expected to complete services for another company once per month for six consecutive months, but that under the terms of the contract, it will not receive monetary payment for these services until the end of the six-month period. The company performing the services can accrue a percentage of the income earned after each month, even though physical payment will not take place until after the six-month period.

Accrual rate

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What Does Accrual Rate Mean?The rate of interest that is added to the principal of a financial instrument between cash payments of that interest. For example, a six-month bond with interest payable semiannually will accrue daily interest during the six-month term until it is paid in full on the date it becomes due.

Investopedia explains Accrual RateAccrual rates are also used in nonfinancial contexts, such as for vacation or pension accrual rates. As well, they are often used in accrual accounting, which is used by most businesses; cash-basis accounting is most commonly used by individuals.

Accrued Interest

What Does Accrued Interest Mean?1. A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, but not yet paid or received. Accrued interest occurs as a result of the difference in timing of cash flows and the measurement of these cash flows. 

2. The interest that has accumulated on a bond since the last interest payment up to, but not including, the settlement date. 

Investopedia explains Accrued Interest1. For example, accrued interest receivable occurs when interest on an outstanding receivable has been earned by the company, but has not yet been received. A loan to a customer for goods sold would result in interest being charged on the loan. If the loan is extended on October 1 and the lending company's year ends on December 31, there will be two months of accrued interest receivable recorded as interest revenue in the company's financial statements for the year. 

2. Accrued interest is added to the contract price of a bond transaction. Accrued interest is that which has been earned since the last coupon payment. Because the bond hasn't expired or the next payment is not yet due, the owner of the bond hasn't officially received the money. If he or she sells the bond, accrued interest is added to the sale price. 

Accrued Interest

What Does Accrued Interest Mean?1. A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, but not yet paid or received. Accrued interest occurs as a result of the difference in timing of cash flows and the measurement of these cash flows. 

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2. The interest that has accumulated on a bond since the last interest payment up to, but not including, the settlement date. 

Investopedia explains Accrued Interest1. For example, accrued interest receivable occurs when interest on an outstanding receivable has been earned by the company, but has not yet been received. A loan to a customer for goods sold would result in interest being charged on the loan. If the loan is extended on October 1 and the lending company's year ends on December 31, there will be two months of accrued interest receivable recorded as interest revenue in the company's financial statements for the year. 

2. Accrued interest is added to the contract price of a bond transaction. Accrued interest is that which has been earned since the last coupon payment. Because the bond hasn't expired or the next payment is not yet due, the owner of the bond hasn't officially received the money. If he or she sells the bond, accrued interest is added to the sale price. 

Annual Equivalent Rate - AER

What Does Annual Equivalent Rate - AER Mean?Interest that is calculated under the assumption that any interest paid is combined with the original balance and the next interest payment will be based on the slightly higher account balance. Overall, this means that interest can be compounded several times in a year depending on the number of times that interest payments are made. 

In the United Kingdom, the amount of interest received from savings accounts is listed in AER form.

Calculated as:

Where:n = number of times a year that interest is paidr = gross interest rate

Investopedia explains Annual Equivalent Rate - AERFor example, a savings account with a quoted interest rate of 10% that pays interest quarterly would have an annual equivalent rate of 10.38%. Investors should be aware that the annual equivalent rate will typically be higher than the actual annual rate calculated without compounding

Annuity

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What Does Annuity Mean?A financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time. Annuities are primarily used as a means of securing a steady cash flow for an individual during their retirement years.

Investopedia explains AnnuityAnnuities can be structured according to a wide array of details and factors, such as the duration of time that payments from the annuity can be guaranteed to continue. Annuities can be created so that, upon annuitization, payments will continue so long as either the annuitant or their spouse is alive. Alternatively, annuities can be structured to pay out funds for a fixed amount of time, such as 20 years, regardless of how long the annuitant lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or variable payments. The intent of variable annuities is to allow the annuitant to receive greater payments if investments of the annuity fund do well and smaller payments if its investments do poorly. This provides for a less stable cash flow than a fixed annuity, but allows the annuitant to reap the  benefits of strong returns from their fund's investments.

The different ways in which annuities can be structured provide individuals seeking annuities the flexibility to construct an annuity contract that will best meet their needs.

Current Assets

What Does Current Assets Mean?1. A balance sheet account that represents the value of all assets that are reasonably expected to be converted into cash within one year in the normal course of business. Current assets include cash, accounts receivable, inventory, marketable securities, prepaid expenses and other liquid assets that can be readily converted to cash.   

2. In personal finance, current assets are all assets that a person can readily convert to cash to pay outstanding debts and cover liabilities without having to sell fixed assets. 

In the United Kingdom, current assets are also known as "current accounts".

Investopedia explains Current Assets1. Current assets are important to businesses because they are the assets that are used to fund day-to-day operations and pay ongoing expenses. Depending on the nature of the business, current assets can range from barrels of crude oil, to baked goods, to foreign currency. 

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2. In personal finance, current assets include cash on hand and in the bank, and marketable securities that are not tied up in long-term investments. In other words, current assets are anything of value that is highly liquid. 

Accounts Receivable - AR

What Does Accounts Receivable - AR Mean?Money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or used, but not yet paid for. Receivables usually come in the form of operating lines of credit and are usually due within a relatively short time period, ranging from a few days to a year. 

On a public company's balance sheet,  accounts receivable is often recorded as an asset because this represents a legal obligation for the customer to remit cash for its short-term debts

Investopedia explains Accounts Receivable - ARIf a company has receivables, this means it has made a sale but has yet to collect the money from the purchaser. Most companies operate by allowing some portion of their sales to be on credit. These type of sales are usually made to frequent or special customers who are invoiced periodically, and allows them to avoid the hassle of physically making payments as each transaction occurs. In other words, this is when a customer gives a company an IOU for goods or services already received or rendered.

Accounts receivable are not limited to businesses - individuals have them as well. People get receivables from their employers in the form of a monthly or bi-weekly paycheck. They are legally owed this money for services (work) already provided. 

When a company owes debts to its suppliers or other parties, these are known as accounts payable. 

Accounts Payable - AP

What Does Accounts Payable - AP Mean?An accounting entry that represents an entity's obligation to pay off a short-term debt to its creditors. The accounts payable entry is found on a balance sheet under the heading current liabilities. 

Accounts payable are often referred to as "payables". 

Another common usage of AP refers to a business department or division that is responsible for making payments owed by the company to suppliers and other creditors.

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Investopedia explains Accounts Payable - APAccounts payable are debts that must be paid off within a given period of time in order to avoid default. For example, at the corporate level, AP refers to short-term debt payments to suppliers and banks. 

Payables are not limited to corporations. At the household level, people are also subject to bill payment for goods or services provided to them by creditors. For example, the phone company, the gas company and the cable company are types of creditors. Each one of these creditors provide a service first and then bills the customer after the fact. The payable is  essentially a short-term IOU from a customer to the creditor.  

Each demands payment for goods or services rendered and must be paid accordingly. If people or companies don't pay their bills, they are considered to be in default.What Does Balance Sheet Mean?A financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time. These three balance sheet segments give investors an idea as to what the company owns and owes, as well as the amount invested by the shareholders.

The balance sheet must follow the following formula:

        Assets = Liabilities + Shareholders' Equity 

Each of the three segments of the balance sheet will have many accounts within it that document the value of each. Accounts such as cash, inventory and property are on the asset side of the balance sheet, while on the liability side there are accounts such as accounts payable or long-term debt. The exact accounts on a balance sheet will differ by company and by industry, as there is no one set template that accurately accommodates for the differences between different types of businesses.

Investopedia explains Balance SheetIt's called a balance sheet because the two sides balance out. This makes sense: a company has to pay for all the things it has (assets) by either borrowing money (liabilities) or getting it from shareholders (shareholders' equity). 

The balance sheet is one of the most important pieces of financial information issued by a company. It is a snapshot of what a company owns and owes at that point in time. The income statement, on the other hand, shows how much revenue and profit a company has generated over a certain period. The cash flow statement describes the inflow and outflow of cash throughout the period. The financial statements are built to be used together to present a complete picture of a company's finances.

Acid-Test Ratio

What Does Acid-Test Ratio Mean?A stringent test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory

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assets.

Calculated by:

Investopedia explains Acid-Test RatioCompanies with ratios of less than 1 cannot pay their current liabilities and should be looked at with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory. Retail stores are examples of this type of business. 

The term comes from the way gold miners would test whether their findings were real gold nuggets. Unlike other metals, gold does not corrode in acid; if the nugget didn't dissolve when submerged in acid, it was said to have passed the acid test. If a company's financial statements pass the figurative acid test, this indicates its financial integrity.

Cash Ratio

What Does Cash Ratio Mean?The ratio of a company's total cash and cash equivalents to its current liabilities. The cash ratio is most commonly used as a measure of company liquidity. It can therefore determine if, and how quickly, the company can repay its short-term debt. A strong cash ratio is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party.

Investopedia explains Cash RatioThe cash ratio is generally a more conservative look at a company's ability to cover its liabilities than many other liquidity ratios. This is due to the fact that inventory and accounts receivable are left out of the equation. Since these two accounts are a large part of many companies, this ratio should not be used in determining company value, but simply as one factor in determining liquidity.

Clean Balance Sheet

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What Does Clean Balance Sheet Mean?Refers to a company whose balance sheet has very little or no debt.

Investopedia explains Clean Balance SheetA company is told to "clean up" its balance sheet if they are exposed to large amounts of debt

certified Financial Statement

What Does Certified Financial Statement Mean?A financial statement, such as an income statement, cash flow statement or balance sheet, that has been audited and signed off on by an accountant. Once an auditor has fully reviewed the details of a financial statement following GAAP guidelines and is confident the numbers reported within it are accurate, they certify the documents.

Investopedia explains Certified Financial StatementCertified financial statements play an important role in the financial markets. Investors demand assurance that the documents they rely upon to make investment decisions are accurate and have not been subject to any material errors or omissions by the company that compiled them.

Cash Flow Statement

What Does Cash Flow Statement Mean?One of the quarterly financial reports any publicly traded company is required to disclose to the SEC and the public. The document provides aggregate data regarding all cash inflows a company receives from both its ongoing operations and external investment sources, as well as all cash outflows that pay for business activities and investments during a given quarter.

Investopedia explains Cash Flow StatementBecause public companies tend to use accrual accounting, the income statements they release each quarter may not necessarily reflect changes in their cash positions. For example, if a company lands a major contract, this contract would be recognized as revenue (and therefore income), but the company may not yet actually receive the cash from the contract until a later date. While the company may be earning a profit in the eyes of accountants (and paying income taxes on it), the company may, during the quarter, actually end up with less cash than when it started the quarter. Even profitable companies can fail to adequately manage their cash flow, which is why the cash flow statement is important: it helps investors see if a company is having trouble with cash.

Capital Asset Pricing Model - CAPM

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What Does Capital Asset Pricing Model - CAPM Mean?A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

 

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model - CAPMThe CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Generally Accepted Accounting Principles - GAAP

What Does Generally Accepted Accounting Principles - GAAP Mean?The common set of accounting principles, standards and procedures that companies use to compile their financial statements. GAAP are a combination of authoritative standards (set by policy boards) and simply the commonly accepted ways of recording and reporting accounting information.

Investopedia explains Generally Accepted Accounting Principles - GAAPGAAP are imposed on companies so that investors have a minimum level of consistency in the financial statements they use when analyzing companies for investment purposes. GAAP cover

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such things as revenue recognition, balance sheet item classification and outstanding share measurements. Companies are expected to follow GAAP rules when reporting their financial data via financial statements. If a financial statement is not prepared using GAAP principles, be very wary!

That said, keep in mind that GAAP is only a set of standards. There is plenty of room within GAAP for unscrupulous accountants to distort figures. So, even when a company uses GAAP, you still need to scrutinize its financial statements.

International Accounting Standards - IAS

What Does International Accounting Standards - IAS Mean?An older set of standards stating how particular types of transactions and other events should be reflected in financial statements. In the past, international accounting standards (IAS) were issued by the Board of the International Accounting Standards Committee (IASC). 

Since 2001, the new set of standards has been known as the international financial reporting standards (IFRS) and has been issued by the International Accounting Standards Board (IASB).

Investopedia explains International Accounting Standards - IASIASC has no authority to require compliance with its accounting standards. However, many countries require the financial statements of publicly-traded companies to be prepared in accordance with IAS.

Liquidity

What Does Liquidity Mean?1. The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. Assets that can by easily bought or sold, are known as liquid assets.

2. The ability to convert an asset to cash quickly. Also known as "marketability".

There is no specific liquidity formula, however liquidity is often calculated by using liquidity ratios.

Investopedia explains Liquidity1. It is safer to invest in liquid assets than illiquid ones because it is easier for an investor to get his/her money out of the investment.

2. Examples of assets that are easily converted into cash include blue chip and money market securities.

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Time Value of Money (TVM)

What Does Time Value of Money (TVM) Mean?The idea that money available at the present time is worth more than the same amount in the future, due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received. Also referred to as "present discounted value".

Investopedia explains Time Value of Money (TVM)Everyone knows that money deposited in a savings account will earn interest. Because of this universal fact, we would prefer to receive money today rather than the same amount in the future.

For example, assuming a 5% interest rate, $100 invested today will be worth $105 in one year ($100 multiplied by 1.05).  Conversely, $100 received one year from now is only worth $95.24 today ($100 divided by 1.05), assuming a 5% interest rate.

Liquidity Measurement Ratios: Current RatioBy Richard Loth (Contact | Biography)

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current or working capital position) by deriving the proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents, marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities (notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the current ratio, the better.

Formula:

Components: 

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' current assets amounted to $1,575.60 (balance sheet), which is the numerator; while current liabilities amounted to $606.90 (balance sheet), which is the denominator. By dividing, the equation gives us a current ratio of 2.6.

Variations: None

Commentary:The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad (see chart below).

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Here's why: Contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is flawed because it's conceptually based on the liquidation of all of a company's current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio can be "misleading."

A simplistic, but accurate, comparison of two companies' current position will illustrate the weakness of relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole indicator of liquidity:

 

--Company ABC

Company XYZ

Current Assets

$600 $300

Current Liabilities

$300 $300

Working Capital

$300 $0

Current Ratio

2.0 1.0

Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies' current liabilities have an average payment period of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its inventory turns over 24 times a year (every 15 days).

In this contrived example, Company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company's XYZ's seemingly tight current position is, in effect, much more liquid because of its quicker cash conversion.

When looking at the current ratio, it is important that a company's current assets can cover its current liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to understand the types of current assets the company has and how quickly these can be converted into cash to meet current liabilities. This important perspective can be seen through the cash conversion cycle (read the chapter on CCC now). By digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity.

Liquidity Measurement Ratios: Quick RatioBy Richard Loth (Contact | Biography)

The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines the current ratio by measuring the amount of the most liquid current assets there are to cover current liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid current position.

Formula:

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Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' quick assets amounted to $756.40 (balance sheet); while current liabilities amounted to $606.90 (balance sheet). By dividing, the equation gives us a quick ratio of 1.3.

Variations:Some presentations of the quick ratio calculate quick assets (the formula's numerator) by simply subtracting the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety. Generally, this is close to the truth, but not always.

Zimmer Holdings is a good example of what can happen if you take the aforementioned "inventory shortcut" to calculating the quick ratio:

Standard Approach: $233.2 plus $524.2 = $756 ÷ $606.9 =1.3

Shortcut Approach: $1,575.6 minus $583.7 = $991.9 ÷ $606.9 = 1.6

Restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shortcut approach artificially overstates Zimmer Holdings' more liquid assets and inflates its quick ratio.

Commentary:As previously mentioned, the quick ratio is a more conservative measure of liquidity than the current ratio as it removes inventory from the current assets used in the ratio's formula. By excluding inventory, the quick ratio focuses on the more-liquid assets of a company.

The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory.

While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable component, suffers from the same deficiencies as the current ratio - albeit somewhat less. To understand these "deficiencies", readers should refer to the commentary section of the Current Ratio chapter. In brief, both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis for measuring liquidity.

While theoretically feasible, as a going concern a company must focus on the time it takes to convert its working capital assets to cash - that is the true measure of liquidity. Thus, if accounts

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receivable, as a component of the quick ratio, have, let's say, a conversion time of several months rather than several days, the "quickness" attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as indicators of a company's liquidity can be misleading.

Next: Liquidity Measurement Ratios: Cash Ratio

Table of Contents

1) Liquidity Measurement Ratios: Introduction

2) Liquidity Measurement Ratios: Current Ratio

3) Liquidity Measurement Ratios: Quick Ratio

4) Liquidity

Quick Ratio

What Does Quick Ratio Mean?An indicator of a company's short-term liquidity. The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company.

The quick ratio is calculated as:

 

Also known as the "acid-test ratio" or the "quick assets ratio". 

Investopedia explains Quick RatioThe quick ratio is more conservative than the current ratio, a more well-known liquidity measure, because it excludes inventory from current assets. Inventory is excluded because some companies have difficulty turning their inventory into cash. In the event that short-term obligations need to be paid off immediately, there are situations in which the current ratio would overestimate a company's short-term financial strength

Current Ratio

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What Does Current Ratio Mean?A liquidity ratio that measures a company's ability to pay short-term obligations.

The Current Ratio formula is:

 

Also known as "liquidity ratio", "cash asset ratio" and "cash ratio".

Investopedia explains Current RatioThe ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.

The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry.

This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and prepaids as assets that can be liquidated. The components of current ratio (current assets and current liabilities) can be used to derive working capital (difference between current assets and current liabilities). Working capital is frequently used to derive the working capital ratio, which is working capital as a ratio of sales

Inventory Turnover

What Does Inventory Turnover Mean?A ratio showing how many times a company's inventory is sold and replaced over a period. the

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The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days".

Investopedia explains Inventory TurnoverAlthough the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors.

This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying.

High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.

Asset Turnover

What Does Asset Turnover Mean?The amount of sales generated for every dollar's worth of assets. It is calculated by dividing sales in dollars by assets in dollars.

Formula:

 

Also known as the Asset Turnover Ratio.

Investopedia explains Asset TurnoverAsset turnover measures a firm's efficiency at using its assets in generating sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit

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margins tend to have high asset turnover, while those with high profit margins have low asset turnover

Asset

What Does Asset Mean?1. A resource with economic value that an individual, corporation or country owns or controls with the expectation that it will provide future benefit.

2. A balance sheet item representing what a firm owns.

Investopedia explains Asset1. Assets are bought to increase the value of a firm or benefit the firm's operations. You can think of an asset as something that can generate cash flow, regardless of whether it's a company's manufacturing equipment or an individual's rental apartment.

2. In the context of accounting, assets are either current or fixed (non-current). Current means that the asset will be consumed within one year. Generally, this includes things like cash, accounts receivable and inventory. Fixed assets are those that are expected to keep providing benefit for more than one year, such as equipment, buildings and real estate.

Intangible Asset

What Does Intangible Asset Mean?An asset that is not physical in nature. Corporate intellectual property (items such as patents, trademarks, copyrights, business methodologies), goodwill and brand recognition are all common intangible assets in today's marketplace. An intangible asset can be classified as either indefinite or definite depending on the specifics of that asset. A company brand name is considered to be an indefinite asset, as it stays with the company as long as the company continues operations. However, if a company enters a legal agreement to operate under another company's patent, with no plans of extending the agreement, it would have a limited life and would be classified as a definite asset.

Investopedia explains Intangible AssetWhile intangible assets don't have the obvious physical value of a factory or equipment, they can prove very valuable for a firm and can be critical to its long-term success or failure. For example, a company such as Coca-Cola wouldn't be nearly as successful were it not for the high value obtained through its brand-name recognition. Although brand recognition is not a physical asset you can see or touch, its positive effects on bottom-line profits can prove extremely valuable to firms such as Coca-Cola, whose brand strength drives global sales year after year.

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Tangible Asset

What Does Tangible Asset Mean?An asset that has a physical form such as machinery, buildings and land.

Investopedia explains Tangible AssetThis is the opposite of an intangible asset such as a patent or trademark. Whether an asset is tangible or intangible isn't inherently good or bad. For example, a well-known brand name can be very valuable to a company. On the other hand, if you produce a product solely for a trademark, at some point you need to have "real" physical assets to produce it.

Fixed Asset

What Does Fixed Asset Mean?A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be consumed or converted into cash any sooner than at least one year's time.

Fixed assets are sometimes collectively referred to as "plant".

Investopedia explains Fixed AssetBuildings, real estate, equipment and furniture are good examples of fixed assets. 

Generally, intangible long-term assets such as trademarks and patents are not categorized as fixed assets but are more specifically referred to as "fixed intangible assets".

Depreciation

What Does Depreciation Mean?1. In accounting, an expense recorded to allocate a tangible asset's cost over its useful life. Because depreciation is a non-cash expense, it increases free cash flow while decreasing reported earnings.

2. A decrease in the value of a particular currency relative to other currencies.

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Investopedia explains Depreciation1. Depreciation is used in accounting to try to match the expense of an asset to the income that the asset helps the company earn. For example, if a company buys a piece of equipment for $1 million and expects it to have a useful life of 10 years, it will be depreciated over 10 years. Every accounting year, the company will expense $100,000 (assuming straight-line depreciation), which will be matched with the money that the equipment helps to make each year.

2. Examples of currency depreciation are the infamous Russian ruble crisis in 1998, which saw the ruble lose 25% of its value in one day.

Fixed-Asset Turnover Ratio

What Does Fixed-Asset Turnover Ratio Mean?A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company's ability to generate net sales from fixed-asset investments - specifically property, plant and equipment (PP&E) - net of depreciation. A higher fixed-asset turnover ratio shows that the company has been more effective in using the investment in fixed assets to generate revenues.

The fixed-asset turnover ratio is calculated as:

Investopedia explains Fixed-Asset Turnover RatioThis ratio is often used as a measure in manufacturing industries, where major purchases are made for PP&E to help increase output. When companies make these large purchases, prudent investors watch this ratio in following years to see how effective the investment in the fixed assets was.

Revenue

What Does Revenue Mean?The amount of money that a company actually receives during a specific period, including discounts and deductions for returned merchandise. It is the "top line" or "gross income" figure from which costs are subtracted to determine net income.

Revenue is calculated by multiplying the price at which goods or services are sold by the number of units or amount sold.

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Revenue is also known as "REVs".

Investopedia explains RevenueRevenue is the amount of money that is brought into a company by its business activities. In the case of government, revenue is the money received from taxation, fees, fines, inter-governmental grants or transfers, securities sales, mineral rights and resource rights, as well as any sales that are made.

Cost Of Goods Sold - COGS

What Does Cost Of Goods Sold - COGS Mean?The direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appears on the income statement and can be deducted from revenue to calculate a company's gross margin.

Also referred to as "cost of sales".

Investopedia explains Cost Of Goods Sold - COGSCOGS is the costs that go into creating the products that a company sells; therefore, the only costs included in the measure are those that are directly tied to the production of the products. For example, the COGS for an automaker would include the material costs for the parts that go into making the car along with the labor costs used to put the car together. The cost of sending the cars to dealerships and the cost of the labor used to sell the car would be excluded.

The exact costs included in the COGS calculation will differ from one type of business to another.

The cost of goods attributed to a company's products are expensed as the company sells these goods. There are several ways to calculate COGS but one of the more basic ways is to start with the beginning inventory for the period and add the total amount of purchases made during the period then deducting the ending inventory. This calculation gives the total amount of inventory or, more specifically, the cost of this inventory, sold by the company during the period. Therefore, if a company starts with $10 million in inventory, makes $2 million in purchases and ends the period with $9 million in inventory, the company's cost of goods for the period would be $3 million ($10 million + $2 million - $9 million). 

Profit Margin

What Does Profit Margin Mean?A ratio of profitability calculated as net income divided by revenues, or net profits divided by

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sales. It measures how much out of every dollar of sales a company actually keeps in earnings.

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.

Also known as Net Profit Margin.

Investopedia explains Profit MarginLooking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Imagine a company has a net income of $10 million from sales of $100 million, giving it a profit margin of 10% ($10 million/$100 million). If in the next year net income rises to $15 million on sales of $200 million, the company's profit margin would fall to 7.5%. So while the company increased its net income, it has done so with diminishing profit margins.

Profitability Ratios

What Does Profitability Ratios Mean?A class of financial metrics that are used to assess a business's ability to generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time. For most of these ratios, having a higher value relative to a competitor's ratio or the same ratio from a previous period is indicative that the company is doing well.

Investopedia explains Profitability RatiosSome examples of profitability ratios are profit margin, return on assets and return on equity. It is important to note that a little bit of background knowledge is necessary in order to make relevant comparisons when analyzing these ratios.

For instances, some industries experience seasonality in their operations. The retail industry, for example, typically experiences higher revenues and earnings for the Christmas season. Therefore, it would not be too useful to compare a retailer's fourth-quarter profit margin with its first-quarter profit margin. On the other hand, comparing a retailer's fourth-quarter profit margin with the profit margin from the same period a year before would be far more informative.

Return On Assets - ROA

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What Does Return On Assets - ROA Mean?An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment".

The formula for return on assets is:

Note: Some investors add interest expense back into net income when performing this calculation because they'd like to use operating returns before cost of borrowing.

Investopedia explains Return On Assets - ROAROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous ROA numbers or the ROA of a similar company. 

The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management's most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.

Return On Equity - ROE

What Does Return On Equity - ROE Mean?The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.  

ROE is expressed as a percentage and calculated as:

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Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.

Also known as "return on net worth" (RONW).

Investopedia explains Return On Equity - ROEThe ROE is useful for comparing the profitability of a company to that of other firms in the same industry.

There are several variations on the formula that investors may use:

1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders' equity, giving the following: return on common equity (ROCE) = net income - preferred dividends / common equity.

2. Return on equity may also be calculated by dividing net income by average shareholders' equity. Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at period's end and dividing the result by two.

3. Investors may also calculate the change in ROE for a period by first using the shareholders' equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders' equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.

Return On Capital Employed - ROCE

What Does Return On Capital Employed - ROCE Mean?A ratio that indicates the efficiency and profitability of a company's capital investments.

Calculated as:

Investopedia explains Return On Capital Employed - ROCEROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders' earnings.

A variation of this ratio is return on average capital employed (ROACE), which takes the average of opening and closing capital employed for the time period.

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Earnings Before Interest & Tax - EBIT

What Does Earnings Before Interest & Tax - EBIT Mean?An indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and interest. EBIT is also referred to as "operating earnings", "operating profit" and "operating income", as you can re-arrange the formula to be calculated as follows:

EBIT =  Revenue - Operating  Expenses

Also known as Profit Before Interest & Taxes (PBIT), and equals Net Income with interest and taxes added back to it. 

Investopedia explains Earnings Before Interest & Tax - EBITIn other words, EBIT is all profits before taking into account interest payments and income taxes. An important factor contributing to the widespread use of EBIT is the way in which it nulls the effects of the different capital structures and tax rates used by different companies. By excluding both taxes and interest expenses, the figure hones in on the company's ability to profit and thus makes for easier cross-company comparisons. 

EBIT was the precursor to the EBITDA calculation, which takes the process further by removing two non-cash items from the equation (depreciation and amortization).

Amortization

What Does Amortization Mean?1. The paying off of debt in regular installments over a period of time.

2. The deduction of capital expenses over a specific period of time (usually over the asset's life). More specifically, this method measures the consumption of the value of intangible assets, such as a patent or a copyright.

Investopedia explains AmortizationSuppose XYZ Biotech spent $30 million dollars on a piece of medical equipment and that the patent on the equipment lasts 15 years, this would mean that $2 million would be recorded each year as an amortization expense.

While amortization and depreciation are often used interchangeably, technically this is an incorrect practice because amortization refers to intangible assets and depreciation refers to tangible assets.

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Amortization can be calculated easily using most modern financial calculators, spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.

Earnings Before Interest, Taxes, Depreciation, Depletion, Amortization and Exploration Expenses - EBITDAX

What Does Earnings Before Interest, Taxes, Depreciation, Depletion, Amortization and Exploration Expenses - EBITDAX Mean?An indicator of a company's financial performance calculated as:

= Revenue - Expenses (excluding tax, interest, depreciation, depletion, amortization and exploration expenses)

Investopedia explains Earnings Before Interest, Taxes, Depreciation, Depletion, Amortization and Exploration Expenses - EBITDAXEBITDAX is used when reporting earnings for oil and mineral exploration companies. It excludes costly exploration expenses and gives the true EBITDA of the firm.

This is especially useful when a company wants to acquire another company. The EBITDAX would cover any loan payments needed to finance the takeover

Earnings Before Interest, Tax and Depreciation - EBITD

What Does Earnings Before Interest, Tax and Depreciation - EBITD Mean?An indicator of a company's financial performance, which is calculated as:

 

This measure attempts to gauge a firm's profitability before any legally required payments, such as taxes and interest on debt, are paid. Depreciation is removed because this is an expense the firm records, but does not necessarily have to pay in cash.

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Investopedia explains Earnings Before Interest, Tax and Depreciation - EBITDEBITD is very similar to earnings before interest, taxes, depreciation and amortization (EBITDA), but excludes amortization.

The difference between amortization and depreciation is subtle, but worth noting. Depreciation relates to the expensing of the original cost of a tangible assets over its useful life, while amortization is the expense of an intangible asset's cost over its useful life. Intangible assets include, but are not limited to, goodwill and patents, and are unlikely to represent a large expense for most firms.

Using either the EBITD or EBITDA measures should yield similar results

Return On Total Assets - ROTA

What Does Return On Total Assets - ROTA Mean?A ratio that measures a company's earnings before interest and taxes (EBIT) against its total net assets. The ratio is considered an indicator of how effectively a company is using its assets to generate earnings before contractual obligations must be paid.

To calculate ROTA:

 

Investopedia explains Return On Total Assets - ROTAThe greater a company's earnings in proportion to its assets (and the greater the coefficient from this calculation), the more effectively that company is said to be using its assets.

To calculate ROTA, you must obtain the net income figure from a company's income statement, and then add back interest and/or taxes that were paid during the year. The resulting number will reveal the company's EBIT. The EBIT number should then be divided by the company's total net assets (total assets less depreciation and any allowances for bad debts) to reveal the earnings that company has generated for each dollar of assets on its books.

Inventory

What Does Inventory Mean?The raw materials, work-in-process goods and completely finished goods that are considered to be the portion of a business's assets that are ready or will be ready for sale. Inventory represents

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one of the most important assets that most businesses possess, because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders/owners.

Investopedia explains InventoryPossessing a high amount of inventory for long periods of time is not usually good for a business because of inventory storage, obsolescence and spoilage costs. However, possessing too little inventory isn't good either, because the business runs the risk of losing out on potential sales and potential market share as well.

Inventory management forecasts and strategies, such as a just-in-time inventory system, can help minimize inventory costs because goods are created or received as inventory only when needed

Turnover

What Does Turnover Mean?1. In accounting, the number of times an asset is replaced during a financial period.

2. The number of shares traded for a period as a percentage of the total shares in a portfolio or of an exchange.

Investopedia explains Turnover1. In accounting, turnover often refers to inventory or accounts receivable. A quick turnover is desired because it means that inventory is not sitting on the shelves for too long.

2. In a portfolio, a small turnover is desired because it means the investor is paying less in commissions to the broker. It is called "churning" when a broker unethically generates numerous trades solely in order to increase commissions.

Working Capital Turnover

What Does Working Capital Turnover Mean?A measurement comparing the depletion of working capital to the generation of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales.

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Investopedia explains Working Capital TurnoverA company uses working capital (current assets - current liabilities) to fund operations and purchase inventory. These operations and inventory are then converted into sales revenue for the company. The working capital turnover ratio is used to analyze the relationship between the money used to fund operations and the sales generated from these operations. In a general sense, the higher the working capital turnover, the better because it means that the company is generating a lot of sales compared to the money it uses to fund the sales.

For example, if a company has current assets of $10 million and current liabilities of $9 million, its working capital is $1 million. When compared to sales of $15 million, the working capital turnover ratio for the period is 15 ($15M/$1M). When used in fundamental analysis, this ratio can be compared to that of similar companies or to the company's own historical working capital turnovers.

Working Ratio

What Does Working Ratio Mean?A ratio used to measure a company's ability to recover operating costs from annual revenue. This ratio is calculated by taking the company's total annual expenses (excluding depreciation and debt-related expenses) and dividing it by the annual gross income:

Investopedia explains Working RatioA working ratio below 1 implies that the company is able to recover operating costs, whereas a ratio above 1 reflects the company's inability to do so.

Income TaxWorking Capital Management

What Does Working Capital Management Mean?A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

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Investopedia explains Working Capital ManagementImplementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.

A few key performance ratios of a working capital management system are the working capital ratio, inventory turnover and the collection ratio. Ratio analysis will lead management to identify areas of focus such as inventory management, cash management, accounts receivable and payable management

What Does Income Tax Mean?A tax that governments impose on financial income generated by all entities within their jurisdiction. By law, businesses and individuals must file an income tax return every year to determine whether they owe any taxes or are eligible for a tax refund. Income tax is a key source of funds that the government uses to fund its activities and serve the public.

Investopedia explains Income TaxMost countries employ a progressive income tax system in which higher income earners pay a higher tax rate compared to their lower earning counterparts. 

The first income tax imposed in America was during the War of 1812. Its original purpose was to fund the repayment of a $100 million debt that was incurred through war-related expenses. After the war, the tax was repealed, but income tax became permanent during the early 20th century

Net Debt

What Does Net Debt Mean?A metric that shows a company's overall debt situation by netting the value of a company's liabilities and debts with its cash and other similar liquid assets.

Calculated as:

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Investopedia explains Net DebtWhen investing in a company, one of the most important factors you need to consider is how much debt the company is carrying. Here are some questions to ask yourself when analyzing a company's debt: How much debt really exists? What kind of debt is it (long/short-term maturities)? What is the debt for (repay or refinance old debts)? Can the company afford the debt if it runs into financial trouble? And, finally, how does it compare to the debt levels of competing companies?

Debt

What Does Debt Mean?An amount of money borrowed by one party from another. Many corporations/individuals use debt as a method for making large purchases that they could not afford under normal circumstances. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.

Investopedia explains DebtBonds, loans and commercial paper are all examples of debt. For example, a company may look to borrow $1 million so they can buy a certain piece of equipment. In this case, the debt of $1 million will need to be paid back (with interest owing) to the creditor at a later date

Debt/Equity Ratio

What Does Debt/Equity Ratio Mean?A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

 

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as companies'.

Investopedia explains Debt/Equity RatioA high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

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If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

Debt Ratio

What Does Debt Ratio Mean?A ratio that indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load.

Investopedia explains Debt RatioA debt ratio of greater than 1 indicates that a company has more debt than assets, meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's level of risk.

Long-Term Debt

What Does Long-Term Debt Mean?Loans and financial obligations lasting over one year.

In the U.K., long-term debts are known as "long-term loans."

Investopedia explains Long-Term DebtFor example, debts obligations such as bonds and notes, which have maturities greater than one year, would be considered long-term debt. Other securities such as T-bills and commercial papers would not be long-term debt because their maturities are typically shorter than one year.

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Short-Term Debt

What Does Short-Term Debt Mean?An account shown in the current liabilities portion of a company's balance sheet. This account is comprised of any debt incurred by a company that is due within one year. The debt in this account is usually made up of short-term bank loans taken out by a company.

Investopedia explains Short-Term DebtThe value of this account is very important when determining a company's financial health. If the account is larger than the company's cash and cash equivalents, this suggests that the company may be in poor financial health and does not have enough cash to pay off its short-term debts. Although short-term debts are due within a year, there may be a portion of the long-term debt included in this account. This portion pertains to payments that must be made on any long-term debt throughout the year.

Short-Term Investments

What Does Short-Term Investments Mean?An account in the current assets section of a company's balance sheet. This account contains any investments that a company has made that will expire within one year. For the most part, these accounts contain stocks and bonds that can be liquidated fairly quickly.       

Investopedia explains Short-Term InvestmentsMost companies in a strong cash position have a short-term investments account on the balance sheet. This means that a company can afford to invest excess cash in stocks and bonds to earn higher interest than what would be earned from a normal savings account.

Microsoft, which is always in a strong cash position, had short-term investments totaling approximately $32 billion at the end of 2005.

Solvency

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What Does Solvency Mean?The ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth.

Investopedia explains SolvencyThe better a company's solvency, the better it is financially. When a company is insolvent, it means that it can no longer operate and is undergoing bankruptcy

Solvency Ratio

What Does Solvency Ratio Mean?One of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations.

The measure is usually calculated as follows:

Investopedia explains Solvency RatioAcceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

Texas Ratio

What Does Texas Ratio Mean?A ratio developed by Gerald Cassidy and other analysts at RDC Capital Markets to measure the credit problems of particular banks or regions of banks. The Texas ratio takes the amount of a bank's non-performing assets and loans, as well as loans delinquent for more than 90 days, and divides this number by the firm's tangible capital equity plus its loan loss reserve.  A ratio of more than 100 (or 1:1) is considered a warning sign.

Investopedia explains Texas RatioThe Texas ratio was developed as an early warning system to identify potential problem banks. It

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was originally applied to banks in Texas in the 1980s and proved useful for New England banks in the early 1990s. This ratio can be useful when an asset held on a bank's balance sheet is falling in value, such as with oil reserves or mortgage assets.

Price-Earnings Ratio - P/E Ratio

What Does Price-Earnings Ratio - P/E Ratio Mean?A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

 

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters. Also sometimes known as "price multiple" or "earnings multiple". 

Investopedia explains Price-Earnings Ratio - P/E RatioIn general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.  The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of  current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number

Earnings Per Share - EPS

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What Does Earnings Per Share - EPS Mean?The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.

Calculated as:

When calculating, it is more accurate to use a weighted average number of shares outstanding over the reporting term, because the number of shares outstanding can change over time. However, data sources sometimes simplify the calculation by using the number of shares outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants outstanding in the outstanding shares number.

Investopedia explains Earnings Per Share - EPSEarnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the price-to-earnings valuation ratio. 

For example, assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Proprietary Technology

What Does Proprietary Technology Mean?A process, tool, system or similar item that is the property of a business or an individual and provides some sort of benefit or advantage to the owner. Companies that are able to develop useful proprietary technologies in-house are rewarded with a valuable asset: they can either use it exclusively or profit from the sale of licensing of their technology to other parties.

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Investopedia explains Proprietary TechnologyFor example, let's say a biotech company successfully develops a new drug to treat a major disease. By patenting the process, method and end result of the drug, the company is able to reap substantial rewards from its efforts to develop its proprietary technology.

In some industries, proprietary technologies are a key determinant of success. As a result, they are guarded closely within a corporation and are protected legally by patents and copyrights.

Coverage Ratio

What Does Coverage Ratio Mean?An accounting ratio that helps measure a company's ability to meet its obligations satisfactorily.

Investopedia explains Coverage RatioA coverage ratio encompasses many different types of financial ratios. Typically, these kinds of ratios involve a comparison of assets and liabilities. The better the assets "cover" the liabilities, the better off the company is.

Leverage

What Does Leverage Mean?1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

2. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.

Leverage is most commonly used in real estate transactions through the use of mortgages to purchase a home.

Investopedia explains Leverage1. Leverage can be created through options, futures, margin and other financial instruments. For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.

2. Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest in business operations without increasing its equity. For example,

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if a company formed with an investment of $5 million from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and more opportunity to increase value for shareholders.

Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it would've been if the investment had not been leveraged - leverage magnifies both gains and losses. In the business world, a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit risk of default destroys shareholder value

Gearing Ratio

What Does Gearing Ratio Mean?A general term describing a financial ratio that compares some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.

Also known as the Net Gearing Ratio.

Investopedia explains Gearing RatioThe higher a company's degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).

A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is

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