Price Earnings P/E Ratio

The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market
prospect ratio that calculates the market value of a stock relative to its earnings by
comparing the market price per share by the earnings per share. In other words, the
price earnings ratio shows what the market is willing to pay for a stock based on its
current earnings.

Investors often use this ratio to evaluate what a stock's fair market value should be by
predicting future earnings per share. Companies with higher future earnings are usually
expected to issue higher dividends or have appreciating stock in the future.

Obviously, fair market value of a stock is based on more than just predicted future
earnings. Investor speculation and demand also help increase a share's price over time.
The PE ratio helps investors analyze how much they should pay for a stock based on its
current earnings. This is why the price to earnings ratio is often called a price multiple or
earnings multiple. Investors use this ratio to decide what multiple of earnings a share is
worth. In other words, how many times earnings they are willing to pay.

Formula
The price earnings ratio formula is calculated by dividing the market value price per
share by the earnings per share.

This ratio can be calculated at the end of each quarter when quarterly financial
statements are issued. It is most often calculated at the end of each year with the annual
financial statements. In either case, the fair market value equals the trading value of the
stock at the end of the current period.
The earnings per share ratio is also calculated at the end of the period for each share
outstanding. A trailing PE ratio occurs when the earnings per share is based on previous
period. A leading PE ratios occurs when the EPS calculation is based on future
predicted numbers. A justified PE ratio is calculated by using the dividend discount
analysis.

Analysis
The price to earnings ratio indicates the expected price of a share based on its earnings.
As a company's earnings per share being to rise, so does their market value per share.
A company with a high P/E ratio usually indicated positive future performance and
investors are willing to pay more for this company's shares.

A company with a lower ratio, on the other hand, is usually an indication of poor current
and future performance. This could prove to be a poor investment.

In general a higher ratio means that investors anticipate higher performance and growth
in the future. It also means that companies with losses have poor PE ratios.

An important thing to remember is that this ratio is only useful in comparing like
companies in the same industry. Since this ratio is based on the earnings per share
calculation, management can easily manipulate it with specific accounting techniques.

Example
The Island Corporation stock is currently trading at $50 a share and its earnings per
share for the year is 5 dollars. Island's P/E ratio would be calculated like this:

As you can see, the Island's ratio is 10 times. This means that investors are willing to
pay 10 dollars for every dollar of earnings. In other words, this stock is trading at a
multiple of ten.

Since the current EPS was used in this calculation, this ratio would be considered a
trailing price earnings ratio. If a future predicted EPS was used, it would be considered a
leading price to earnings ratio.

Days Sales Outstanding

The days sales outstanding calculation, also called the average collection period or
days' sales in receivables, measures the number of days it takes a company to collect
cash from its credit sales. This calculation shows the liquidity and efficiency of a
company's collections department.
In other words, it shows how well a company can collect cash from its customers. The
sooner cash can be collected, the sooner this cash can be used for other operations.
Both liquidity and cash flows increase with a lower days sales outstanding
measurement.

Formula
The ratio is calculated by dividing the ending accounts receivable by the total credit
sales for the period and multiplying it by the number of days in the period. Most often this
ratio is calculated at year-end and multiplied by 365 days.

Accounts receivable can be found on the year-end balance sheet. Credit sales, however,
are rarely reported separate from gross sales on the income statement. The credit sales
figure will most often have to be provided by the company.
This formula can also be calculated by using the accounts receivable turnover ratio

Analysis
The days sales outstanding formula shows investors and creditors how well companies'
can collect cash from their customers. Obviously, sales don't matter if cash is never
collected. This ratio measures the number of days it takes a company to convert its
sales into cash.
A lower ratio is more favorable because it means companies collect cash earlier from
customers and can use this cash for other operations. It also shows that the accounts
receivables are good and won't be written off as bad debts.
A higher ratio indicates a company with poor collection procedures and customers who
are unable or unwilling to pay for their purchases. Companies with high days sales ratios
are unable to convert sales into cash as quickly as firms with lower ratios.

Example
Devin's Long Boards is a retailer that offers credit to customers. Devin often selling
inventory to customers on account with the agreement that these customers will pay for
the merchandise within 30 days. Some customers promptly pay for their goods, while
others are delinquent. Devin's year-end financial statements list the following accounts:
 Accounts Receivable: $15,000
 Net Credit Sales: $175,000
Devin's days sales is calculated like this:

As you can see, it takes Devin approximately 31 days to collect cash from his customers
on average. This is a good ratio since Devin is aiming for a 30 day collection period.

Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company's total debt
to total equity. The debt to equity ratio shows the percentage of company financing that
comes from creditors and investors. A higher debt to equity ratio indicates that more
creditor financing (bank loans) is used than investor financing (shareholders).

Formula
The debt to equity ratio is calculated by dividing total liabilities by total equity. The debt
to equity ratio is considered a balance sheet ratio because all of the elements are
reported on the balance sheet.

Analysis
Each industry has different debt to equity ratio benchmarks, as some industries tend to
use more debt financing than others. A debt ratio of .5 means that there are half as
many liabilities than there is equity. In other words, the assets of the company are
funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of
every dollar of company assets while creditors only own 33.3 cents on the dollar.
A debt to equity ratio of 1 would mean that investors and creditors have an equal stake
in the business assets.

A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to creditors and
investors than companies with a lower ratio. Unlike equity financing, debt must be repaid
to the lender. Since debt financing also requires debt servicing or regular interest
payments, debt can be a far more expensive form of financing than equity financing.
Companies leveraging large amounts of debt might not be able to make the payments.

Creditors view a higher debt to equity ratio as risky because it shows that the investors
haven't funded the operations as much as creditors have. In other words, investors don't
have as much skin in the game as the creditors do. This could mean that investors don't
want to fund the business operations because the company isn't performing well. Lack of
performance might also be the reason why the company is seeking out extra debt
financing.

Example
Assume a company has $100,000 of bank lines of credit and a $500,000 mortgage on its
property. The shareholders of the company have invested $1.2 million. Here is how you
calculate the debt to equity ratio.

Earnings Per Share

Earning per share, also called net income per share, is a market prospect ratio that
measures the amount of net income earned per share of stock outstanding. In other
words, this is the amount of money each share of stock would receive if all of the profits
were distributed to the outstanding shares at the end of the year.
Earnings per share is also a calculation that shows how profitable a company is on a
shareholder basis. So a larger company's profits per share can be compared to smaller
company's profits per share. Obviously, this calculation is heavily influenced on how
many shares are outstanding. Thus, a larger company will have to split its earning
amongst many more shares of stock compared to a smaller company.

Formula
Earnings per share or basic earnings per share is calculated by subtracting preferred
dividends from net income and dividing by the weighted average common shares
outstanding. The earnings per share formula looks like this.

You'll notice that the preferred dividends are removed from net income in the earnings
per share calculation. This is because EPS only measures the income available to
common stockholders. Preferred dividends are set-aside for the preferred shareholders
and can't belong to the common shareholders.
Most of the time earning per share is calculated for year-end financial statements. Since
companies often issue new stock and buy back treasury stock throughout the year, the
weighted average common shares are used in the calculation. The weighted average
common shares outstanding is can be simplified by adding the beginning and ending
outstanding shares and dividing by two.

Analysis
Earning per share is the same as any profitability or market prospect ratio. Higher
earnings per share is always better than a lower ratio because this means the company
is more profitable and the company has more profits to distribute to its shareholders.

Although many investors don't pay much attention to the EPS, a higher earnings per
share ratio often makes the stock price of a company rise. Since so many things can
manipulate this ratio, investors tend to look at it but don't let it influence their decisions
drastically.

Example
Quality Co. has net income during the year of $50,000. Since it is a small company,
there are no preferred shares outstanding. Quality Co. had 5,000 weighted average
shares outstanding during the year. Quality's EPS is calculated like this.
As you can see, Quality's EPS for the year is $10. This means that if Quality distributed
every dollar of income to its shareholders, each share would receive 10 dollars.

Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is
managed by comparing cost of goods sold with average inventory for a period. This
measures how many times average inventory is "turned" or sold during a period. In other
words, it measures how many times a company sold its total average inventory dollar
amount during the year. A company with $1,000 of average inventory and sales of
$10,000 effectively sold its 10 times over.

This ratio is important because total turnover depends on two main components of
performance. The first component is stock purchasing. If larger amounts of inventory are
purchased during the year, the company will have to sell greater amounts of inventory to
improve its turnover. If the company can't sell these greater amounts of inventory, it will
incur storage costs and otherholding costs.
The second component is sales. Sales have to match inventory purchases otherwise the
inventory will not turn effectively. That's why the purchasing and sales departments must
be in tune with each other.

Formula
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period
by the average inventory for that period.

Average inventory is used instead of ending inventory because many companies'

merchandise fluctuates greatly throughout the year. For instance, a company might
purchase a large quantity of merchandise January 1 and sell that for the rest of the year.
By December almost the entire inventory is sold and the ending balance does not
accurately reflect the company's actual inventory during the year. Average inventory is
usually calculated by adding the beginning and ending inventory and dividing by two.

The cost of goods sold is reported on the income statement.

Analysis
Inventory turnover is a measure of how efficiently a company can control its
merchandise, so it is important to have a high turn. This shows the company does not
overspend by buying too much inventory and wastes resources by storing non-salable
inventory. It also shows that the company can effectively sell the inventory it buys.

This measurement also shows investors how liquid a company's inventory is. Think
about it. Inventory is one of the biggest assets a retailer reports on its balance sheet. If
this inventory can't be sold, it is worthless to the company. This measurement shows
how easily a company can turn its inventory into cash.
Creditors are particularly interested in this because inventory is often put up as collateral
for loans. Banks want to know that this inventory will be easy to sell.
Inventory turns vary with industry. For instance, the apparel industry will have higher
turns than the exotic car industry.

Example
Donny's Furniture Company sells industrial furniture for office buildings. During the
current year, Donny reported cost of goods sold on its income statement of $1,000,000.
Donny's beginning inventory was $3,000,000 and its ending inventory was $4,000,000.
Donny's turnover is calculated like this:

As you can see, Donny's turnover is .29. This means that Donny only sold roughly a
third of its inventory during the year. It also implies that it would take Donny
approximately 3 years to sell his entire inventory or complete one turn. In other words,
Danny does not have very good inventory control.
Liquidity Ratios
Liquidity ratios analyze the ability of a company to pay off both its current liabilities as
they become due as well as their long-term liabilities as they become current. In other
words, these ratios show the cash levels of a company and the ability to turn other
assets into cash to pay off liabilities and other current obligations.

Liquidity is not only a measure of how much cash a business has. It is also a measure of
how easy it will be for the company to raise enough cash or convert assets into cash.
Assets like accounts receivable, trading securities, and inventory are relatively easy for
many companies to convert into cash in the short term. Thus, all of these assets go into
the liquidity calculation of a company.

Here are the most common liquidity ratios.

Solvency Ratios
Solvency ratios, also called leverage ratios, measure a company's ability to sustain
operations indefinitely by comparing debt levels with equity, assets, and earnings. In
other words, solvency ratios identify going concern issues and a firm's ability to pay its
bills in the long term. Many people confuse solvency ratios with liquidity ratios. Although
they both measure the ability of a company to pay off its obligations, solvency ratios
focus more on the long-term sustainability of a company instead of the current liability
payments.

Solvency ratios show a company's ability to make payments and pay off its long-term
obligations to creditors, bondholders, and banks. Better solvency ratios indicate a more
creditworthy and financially sound company in the long-term.

The most common solvency ratios include:

Efficiency Ratios
Efficiency ratios also called activity ratios measure how well companies utilize their
assets to generate income. Efficiency ratios often look at the time it takes companies to
collect cash from customer or the time it takes companies to convert inventory into cash
—in other words, make sales. These ratios are used by management to help improve
the company as well as outside investors and creditors looking at the operations of
profitability of the company.

Efficiency ratios go hand in hand with profitability ratios. Most often when companies are
efficient with their resources, they become profitable. Wal-Mart is a good example. Wal-
Mart is extremely good at selling low margin products at high volumes. In other words,
they are efficient at turning their assets. Even though they don't make much profit per
sale, they make a ton of sales. Each little sale adds up.

Here are the most common efficiency ratios include:

Accounts Receivable
Turnover Ratio
What is accounts receivable? It's anefficiency ratio or activity ratio that measures how
many times a business can turn its accounts receivable into cash during a period. In
other words, the accounts receivable turnover ratio measures how many times a
business can collect its average accounts receivable during the year.
A turn refers to each time a company collects its average receivables. If a company had
$20,000 of average receivables during the year and collected $40,000 of receivables
during the year, the company would have turned its accounts receivable twice because it
collected twice the amount of average receivables.

This ratio shows how efficient a company is at collecting its credit sales from customers.
Some companies collect their receivables from customers in 90 days while other take up
to 6 months to collect from customers.

In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well.
Companies are more liquid the faster they can covert their receivables into cash.

Formula
Accounts receivable turnover is calculated by dividing net credit sales by the average
accounts receivable for that period.
The reason net credit sales are used instead of net sales is that cash sales don't create
receivables. Only credit sales establish a receivable, so the cash sales are left out of the
calculation. Net sales simply refers to sales minus returns and refunded sales.

The net credit sales can usually be found on the company's income statement for the
year although not all companies report cash and credit sales separately. Average
receivables is calculated by adding the beginning and ending receivables for the year
and dividing by two. In a sense, this is a rough calculation of the average receivables for
the year.

Analysis
Since the receivables turnover ratio measures a business' ability to efficiently collect
itsreceivables, it only makes sense that a higher ratio would be more favorable. Higher
ratios mean that companies are collecting their receivables more frequently throughout
the year. For instance, a ratio of 2 means that the company collected its average
receivables twice during the year. In other words, this company is collecting is money
from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can
collect cash from customers sooner, it will be able to use that cash to pay bills and other
obligations sooner.

Accounts receivable turnover also is and indication of the quality of credit sales and
receivables. A company with a higher ratio shows that credit sales are more likely to be
collected than a company with a lower ratio. Since accounts receivable are often posted
as collateral for loans, quality of receivables is important.

Example
Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to
all of his main customers. At the end of the year, Bill's balance sheet shows $20,000 in
accounts receivable, $75,000 of gross credit sales, and $25,000 of returns. Last year's
balance sheet showed $10,000 of accounts receivable.

The first thing we need to do in order to calculate Bill's turnover is to calculate net credit
sales and average accounts receivable. Net credit sales equals gross credit sales minus
returns (75,000 – 25,000 = 50,000). Average accounts receivable can be calculated by
averaging beginning and ending accounts receivable balances ((10,000 + 20,000) / 2 =
15,000).
Finally, Bill's accounts receivable turnover ratio for the year can be like this.

As you can see, Bill's turnover is 3.33. This means that Bill collects his receivables about
3.3 times a year or once every 110 days. In other words, when Bill makes a credit sale, it
will take him 110 days to collect the cash from that sale.

Asset Turnover Ratio

The asset turnover ratio is an efficiency ratio that measures a company's ability to
generate sales from its assets by comparing net sales with average total assets. In other
words, this ratio shows how efficiently a company can use its assets to generate sales.

The total asset turnover ratio calculates net sales as a percentage of assets to show
how many sales are generated from each dollar of company assets. For instance, a ratio
of .5 means that each dollar of assets generates 50 cents of sales.

Formula
The asset turnover ratio is calculated by dividing net sales by average total assets.

Net sales, found on the income statement, are used to calculate this ratio returns and
refunds must be backed out of total sales to measure the truly measure the firm's assets'
ability to generate sales.

Average total assets are usually calculated by adding the beginning and ending total
asset balances together and dividing by two. This is just a simple average based on a
two-yearbalance sheet. A more in-depth, weighted average calculation can be used, but
it is not necessary.
 Analysis
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher
ratio is always more favorable. Higher turnover ratios mean the company is using its
assets more efficiently. Lower ratios mean that the company isn't using its assets
efficiently and most likely have management or production problems.

For instance, a ratio of 1 means that the net sales of a company equals the average total
assets for the year. In other words, the company is generating 1 dollar of sales for every
dollar invested in assets.

Like with most ratios, the asset turnover ratio is based on industry standards. Some
industries use assets more efficiently than others. To get a true sense of how well a
company's assets are being used, it must be compared to other companies in its
industry.

The total asset turnover ratio is a general efficiency ratio that measures how efficiently a
company uses all of its assets. This gives investors and creditors an idea of how a
company is managed and uses its assets to produce products and sales.

Sometimes investors also want to see how companies use more specific assets like
fixed assets and current assets. The fixed asset turnover ratio and the working capital
ratio are turnover ratios similar to the asset turnover ratio that are often used to calculate
the efficiency of these asset classes.

Example
Sally's Tech Company is a tech start up company that manufactures a new tablet
computer. Sally is currently looking for new investors and has a meeting with an angel
investor. The investor wants to know how well Sally uses her assets to produce sales, so
he asks for her financial statements.

Here is what the financial statements reported:

 Beginning Assets: $50,000

 Ending Assets: $100,000
 Net Sales: $25,000
The total asset turnover ratio is calculated like this:
As you can see, Sally's ratio is only .33. This means that for every dollar in assets, Sally
only generates 33 cents. In other words, Sally's start up in not very efficient with its use
of assets.

Times Interest Earned Ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a
coverage ratio that measures the proportionate amount of income that can be used to
cover interest expenses in the future.

In some respects the times interest ratio is considered a solvency ratio because it
measures a firm's ability to make interest and debt service payments. Since these
interest payments are usually made on a long-term basis, they are often treated as an
ongoing, fixed expense. As with most fixed expenses, if the company can't make the
payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a
solvency ratio.

Formula
The times interest earned ratio is calculated by dividing income before interest and
income taxes by the interest expense.

Both of these figures can be found on the income statement. Interest expense and
income taxes are often reported separately from the normal operating expenses for
solvency analysis purposes. This also makes it easier to find the earnings before interest
and taxes or EBIT.
Analysis
The times interest ratio is stated in numbers as opposed to a percentage. The ratio
indicates how many times a company could pay the interest with its before tax income,
so obviously the larger ratios are considered more favorable than smaller ratios.

In other words, a ratio of 4 means that a company makes enough income to pay for its
totalinterest expense 4 times over. Said another way, this company's income is 4 times
higher than its interest expense for the year.
As you can see, creditors would favor a company with a much higher times interest ratio
because it shows the company can afford to pay its interest payments when they come
due. Higher ratios are less risky while lower ratios indicate credit risk.

Example
Tim's Tile Service is a construction company that is currently applying for a new loan to
buy equipment. The bank asks Tim for his financial statements before they will consider
his loan. Tim's income statement shows that he made $500,000 of income before
interest expense and income taxes. Tim's overall interest expense for the year was only
$50,000. Tim's time interest earned ratio would be calculated like this:

As you can see, Tim has a ratio of ten. This means that Tim's income is 10 times greater
than his annual interest expense. In other words, Tim can afford to pay additional
interest expenses. In this respect, Tim's business is less risky and the bank shouldn't
have a problem accepting his loan.

Return on Equity Ratio

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm
to generate profits from its shareholders investments in the company. In other words, the
return on equity ratio shows how much profit each dollar of common stockholders' equity
generates.
So a return on 1 means that every dollar of common stockholders' equity generates 1
dollar of net income. This is an important measurement for potential investors because
they want to see how efficiently a company will use their money to generate net income.

ROE is also and indicator of how effective management is at using equity financing to
fund operations and grow the company.

Formula
The return on equity ratio formula is calculated by dividing net income by shareholder's
equity.

Most of the time, ROE is computed for common shareholders. In this case, preferred
dividends are not included in the calculation because these profits are not available to
common stockholders. Preferred dividends are then taken out of net income for the
calculation.

Also, average common stockholder's equity is usually used, so an average of beginning

and ending equity is calculated.

Analysis
Return on equity measures how efficiently a firm can use the money from shareholders
to generate profits and grow the company. Unlike other return on investment ratios, ROE
is a profitability ratio from the investor's point of view—not the company. In other words,
this ratio calculates how much money is made based on the investors' investment in the
company, not the company's investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this
indicates that the company is using its investors' funds effectively. Higher ratios are
almost always better than lower ratios, but have to be compared to other companies'
ratios in the industry. Since every industry has different levels of investors and income,
ROE can't be used to compare companies outside of their industries very effectively.
Many investors also choose to calculate the return on equity at the beginning of a period
and the end of a period to see the change in return. This helps track a company's
progress and ability to maintain a positive earnings trend.

Example
Tammy's Tool Company is a retail store that sells tools to construction companies
across the country. Tammy reported net income of $100,000 and issued preferred
dividends of $10,000 during the year. Tammy also had 10,000, $5 par common shares
outstanding during the year. Tammy would calculate her return on common equity like
this:

As you can see, after preferred dividends are removed from net income Tammy's ROE
is 1.8. This means that every dollar of common shareholder's equity earned about $1.80
this year. In other words, shareholders saw a 180 percent return on their investment.
Tammy's ratio is most likely considered high for her industry. This could indicate that
Tammy's is a growing company.
An average of 5 to 10 years of ROE ratios will give investors a better picture of the
growth of this company.

Company growth or a higher ROE doesn't necessarily get passed onto the investors
however. If the company retains these profits, the common shareholders will only realize
this gain by having an appreciated stock.

Profit Margin Ratio

The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a
profitability ratio that measures the amount of net income earned with each dollar of
sales generated by comparing the net income and net sales of a company. In other
words, the profit margin ratio shows what percentage of sales are left over after all
expenses are paid by the business.

Creditors and investors use this ratio to measure how effectively a company can convert
sales into net income. Investors want to make sure profits are high enough to distribute
dividends while creditors want to make sure the company has enough profits to pay back
its loans. In other words, outside users want to know that the company is running
efficiently. An extremely low profit margin would indicate the expenses are too high and
the management needs to budget and cut expenses.

The return on sales ratio is often used by internal management to set performance goals
for the future.

Formula
The profit margin ratio formula can be calculated by dividing net income by net sales.

Net sales is calculated by subtracting any returns or refunds from gross sales. Net
incomeequals total revenues minus total expenses and is usually the last number
reported on theincome statement.

Analysis
The profit margin ratio directly measures what percentage of sales is made up of net
income. In other words, it measures how much profits are produced at a certain level of
sales.

This ratio also indirectly measures how well a company manages its expenses relative to
its net sales. That is why companies strive to achieve higher ratios. They can do this by
either generating more revenues why keeping expenses constant or keep revenues
constant and lower expenses.

Since most of the time generating additional revenues is much more difficult than cutting
expenses, managers generally tend to reduce spending budgets to improve their profit
ratio.
Like most profitability ratios, this ratio is best used to compare like sized companies in
the same industry. This ratio is also effective for measuring past performance of a
company.
Example
Trisha's Tackle Shop is an outdoor fishing store that selling lures and other fishing gear
to the public. Last year Trisha had the best year in sales she has ever had since she
opened the business 10 years ago. Last year Trisha's net sales were $1,000,000 and
her net income was $100,000.

Here is Trisha's return on sales ratio.

As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that
with this year's numbers of $800,000 of net sales and $200,000 of net income.

This year Trisha may have made less sales, but she cut expenses and was able to
convert more of these sales into profits with a ratio of 25 percent.

Accounts Payable Turnover

Ratio
The accounts payable turnover ratio is a liquidity ratio that shows a company's ability to
pay off its accounts payable by comparing net credit purchases to the average accounts
payable during a period. In other words, the accounts payable turnover ratio is how
many times a company can pay off its average accounts payable balance during the
course of a year.

This ratio helps creditors analyze the liquidity of a company by gauging how easily a
company can pay off its current suppliers and vendors. Companies that can pay off
supplies frequently throughout the year indicate to creditor that they will be able to make
regular interest and principle payments as well.

Vendors also use this ratio when they consider establishing a new line of credit or floor
plan for a new customer. For instance, car dealerships and music stores often pay for
their inventory with floor plan financing from their vendors. Vendors want to make sure
they will be paid on time, so they often analyze the company's payable turnover ratio.
Formula
The accounts payable turnover formula is calculated by dividing the total purchases by
the average accounts payable for the year.

The total purchases number is usually not readily available on any general purpose
financial statement. Instead, total purchases will have to be calculated by adding the
ending inventory to the cost of goods sold and subtracting the beginning inventory. Most
companies will have a record of supplier purchases, so this calculation may not need to
be made.
The average payables is used because accounts payable can vary throughout the year.
The ending balance might be representative of the total year, so an average is used. To
find the average accounts payable, simply add the beginning and ending accounts
payable together and divide by two.

Analysis
Since the accounts payable turnover ratio indicates how quickly a company pays off its
vendors, it is used by supplies and creditors to help decide whether or not to grant credit
to a business. As with most liquidity ratios, a higher ratio is almost always more
favorable than a lower ratio.

A higher ratio shows suppliers and creditors that the company pays its bills frequently
and regularly. It also implies that new vendors will get paid back quickly. A high turnover
ratio can be used to negotiate favorable credit terms in the future.

As with all ratios, the accounts payable turnover is specific to different industries. Every
industry has a slightly different standard. This ratio is best used to compare similar
companies in the same industry.

Example
Bob's Building Suppliers buys constructions equipment and materials from wholesalers
and resells this inventory to the general public in its retail store. During the current year
Bob purchased $1,000,000 worth of construction materials from his vendors. According
to Bob'sbalance sheet, his beginning accounts payable was $55,000 and his ending
accounts payable was $958,000.
Here is how Bob's vendors would calculate his payable turnover ratio:

As you can see, Bob's average accounts payable for the year was $506,500 (beginning
plus ending divided by 2). Based on this formula Bob's turnover ratio is 1.97. This means
that Bob pays his vendors back on average once every six months of twice a year. This
is not a high turnover ratio, but it should be compared to others in Bob's industry.

Gross Margin Ratio

Gross margin ratio is a profitability ratio that compares the gross margin of a business to
the net sales. This ratio measures how profitable a company sells its inventory or
merchandise. In other words, the gross profit ratio is essentially the percentage markup
on merchandise from its cost. This is the pure profit from the sale of inventory that can
go to paying operating expenses.
Gross margin ratio is often confused with the profit margin ratio, but the two ratios are
completely different. Gross margin ratio only considers the cost of goods sold in its
calculation because it measures the profitability of selling inventory. Profit margin ratio
on the other hand considers other expenses.

Formula
Gross margin ratio is calculated by dividing gross margin by net sales.
The gross margin of a business is calculated by subtracting cost of goods sold from net
sales. Net sales equals gross sales minus any returns or refunds. The broken down
formula looks like this:

Analysis
Gross margin ratio is a profitability ratio that measures how profitable a company can
sell its inventory. It only makes sense that higher ratios are more favorable. Higher ratios
mean the company is selling their inventory at a higher profit percentage.

High ratios can typically be achieved by two ways. One way is to buy inventory very
cheap. If retailers can get a bigpurchase discount when they buy their inventory from
the manufacturer or wholesaler, their gross margin will be higher because their costs are
down.
The second way retailers can achieve a high ratio is by marking their goods up higher.
This obviously has to be done competitively otherwise goods will be too expensive and
customers will shop elsewhere.

A company with a high gross margin ratios mean that the company will have more
money to pay operating expenses like salaries, utilities, and rent. Since this ratio
measures the profits from selling inventory, it also measures the percentage of sales that
can be used to help fund other parts of the business. Here is another great explaination.

Example
Assume Jack's Clothing Store spent $100,000 on inventory for the year. Jack was able
to sell this inventory for $500,000. Unfortunately, $50,000 of the sales were returned by
customers and refunded. Jack would calculate his gross margin ratio like this.

As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel
industry. This means that after Jack pays off his inventory costs, he still has 78 percent
of his sales revenue to cover his operating costs.

Debt Ratio
Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its
total assets. In a sense, the debt ratio shows a company's ability to pay off its liabilities
with its assets. In other words, this shows how many assets the company must sell in
order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels
of liabilities compared with assets are considered highly leveraged and more risky for
lenders.
This helps investors and creditors analysis the overall debt burden on the company as
well as the firm's ability to pay off the debt in future, uncertain economic times.

Formula
The debt ratio is calculated by dividing total liabilities by total assets. Both of these
numbers can easily be found the balance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation. The debt
ratio shows the overall debt burden of the company—not just the current debt.

Analysis
The debt ratio is shown in decimal format because it calculates total liabilities as a
percentage of total assets. As with many solvency ratios, a lower ratios is more
favorable than a higher ratio.

A lower debt ratio usually implies a more stable business with the potential of longevity
because a company with lower ratio also has lower overall debt. Each industry has its
own benchmarks for debt, but .5 is reasonable ratio.

A debt ratio of .5 is often considered to be less risky. This means that the company has
twice as many assets as liabilities. Or said a different way, this company's liabilities are
only 50 percent of its total assets. Essentially, only its creditors own half of the
company's assets and the shareholders own the remainder of the assets.

A ratio of 1 means that total liabilities equals total assets. In other words, the company
would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a
highly leverage firm. Once its assets are sold off, the business no longer can operate.
The debt ratio is a fundamental solvency ratio because creditors are always concerned
about being repaid. When companies borrow more money, their ratio increases creditors
will no longer loan them money. Companies with higher debt ratios are better off looking
to equity financing to grow their operations.

Example
Dave's Guitar Shop is thinking about building an addition onto the back of its existing
building for more storage. Dave consults with his banker about applying for a new loan.
The bank asks for Dave's balance to examine his overall debt levels.
The banker discovers that Dave has total assets of $100,000 and total liabilities of
$25,000. Dave's debt ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as
many assets as he has liabilities. This is a relatively low ratio and implies that Dave will
be able to pay back his loan. Dave shouldn't have a problem getting approved for his
loan.

Quick Ratio
The quick ratio or acid test ratio is aliquidity ratio that measures the ability of a company
to pay its current liabilities when they come due with only quick assets. Quick assets are
current assets that can be converted to cash within 90 days or in the short-term. Cash,
cash equivalents, short-term investments or marketable securities, and current accounts
receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available
for sale securities that can easily be converted into cash within the next 90 days.
Marketable securities are traded on an open market with a known price and readily
available buyers. Any stock on the New York Stock Exchange would be considered a
marketable security because they can easily be sold to any investor when the market is
open.
The quick ratio is often called the acid test ratio in reference to the historical use of acid
to test metals for gold by the early miners. If the metal passed the acid test, it was pure
gold. If metal failed the acid test by corroding from the acid, it was a base metal and of
no value.

The acid test of finance shows how well a company can quickly convert its assets into
cash in order to pay off its current liabilities. It also shows the level of quick assets to
current liabilities.

Formula
The quick ratio is calculated by adding cash, cash equivalents, short-term investments,
and current receivables together then dividing them by current liabilities.

Sometimes company financial statements don't give a breakdown of quick assets on

thebalance sheet. In this case, you can still calculate the quick ratio even if some of the
quick asset totals are unknown. Simply subtract inventory and any current prepaid
assets from the current asset total for the numerator. Here is an example.

Quick Ratio
The quick ratio or acid test ratio is aliquidity ratio that measures the ability of a company
to pay its current liabilities when they come due with only quick assets. Quick assets are
current assets that can be converted to cash within 90 days or in the short-term. Cash,
cash equivalents, short-term investments or marketable securities, and current accounts
receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available
for sale securities that can easily be converted into cash within the next 90 days.
Marketable securities are traded on an open market with a known price and readily
available buyers. Any stock on the New York Stock Exchange would be considered a
marketable security because they can easily be sold to any investor when the market is
open.

The quick ratio is often called the acid test ratio in reference to the historical use of acid
to test metals for gold by the early miners. If the metal passed the acid test, it was pure
gold. If metal failed the acid test by corroding from the acid, it was a base metal and of
no value.

The acid test of finance shows how well a company can quickly convert its assets into
cash in order to pay off its current liabilities. It also shows the level of quick assets to
current liabilities.

Formula
The quick ratio is calculated by adding cash, cash equivalents, short-term investments,
and current receivables together then dividing them by current liabilities.

Sometimes company financial statements don't give a breakdown of quick assets on

thebalance sheet. In this case, you can still calculate the quick ratio even if some of the
quick asset totals are unknown. Simply subtract inventory and any current prepaid
assets from the current asset total for the numerator. Here is an example.

Analysis

The acid test ratio measures the liquidity of a company by showing its ability to pay off its
current liabilities with quick assets. If a firm has enough quick assets to cover its total
 current liabilities, the firm will be able to pay off its obligations without having to sell off
any long-term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling off these
capital assets will not only hurt the company it will also show investors that current
operations aren't making enough profits to pay off current liabilities.

Higher quick ratios are more favorable for companies because it shows there are more
quick assets than current liabilities. A company with a quick ratio of 1 indicates that quick
assets equal current assets. This also shows that the company could pay off its current
liabilities without selling any long-term assets. An acid ratio of 2 shows that the company
has twice as many quick assets than current liabilities.

Obviously, as the ratio increases so does the liquidity of the company. More assets will
be easily converted into cash if need be. This is a good sign for investors, but an even
better sign to creditors because creditors want to know they will be paid back on time.

Example
Let's assume Carole's Clothing Store is applying for a loan to remodel the storefront.
The bank asks Carole for a detailed balance sheet, so it can compute the quick ratio.
Carole's balance sheet included the following accounts:

 Cash: $10,000
 Accounts Receivable: $5,000
 Inventory: $5,000
 Stock Investments: $1,000
 Prepaid taxes: $500
 Current Liabilities: $15,000
The bank can compute Carole's quick ratio like this.

As you can see Carole's quick ratio is 1.07. This means that Carole can pay off all of her
current liabilities with quick assets and still have some quick assets left over.

Now let's assume the same scenario except Carole did not provide the bank with a
detailed balance sheet. Instead Carole's balance sheet only included these accounts:
 Inventory: $5,000
 Prepaid taxes: $500
 Total Current Assets: $21,500
 Current Liabilities: $15,000
Since Carole's balance sheet doesn't include the breakdown of quick assets, the bank
can compute her quick ratio like this:
 DuPont Analysis
The Dupont analysis also called the Dupont model is a financial ratio based on the return
on equity ratio that is used to analyze a company's ability to increase its return on equity.
In other words, this model breaks down the return on equity ratio to explain how
companies can increase their return for investors.
The Dupont analysis looks at three main components of the ROE ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage
Based on these three performances measures the model concludes that a company can
raise its ROE by maintaining a high profit margin, increasing asset turnover, or
leveraging assets more effectively.

The Dupont Corporation developed this analysis in the 1920s. The name has stuck with
it ever since.

Formula
The Dupont Model equates ROE to profit margin, asset turnover, and financial leverage.
The basic formula looks like this.

Since each one of these factors is a calculation in and of itself, a more explanatory
formula for this analysis looks like this.

Every one of these accounts can easily be found on the financial statements. Net
income and sales appear on the income statement, while total assets and total equity
appear on the balance sheet.
Analysis
This model was developed to analyze ROE and the effects different business
performance measures have on this ratio. So investors are not looking for large or small
output numbers from this model. Instead, they are looking to analyze what is causing the
current ROE. For instance, if investors are unsatisfied with a low ROE, the management
can use this formula to pinpoint the problem area whether it is a lower profit margin,
asset turnover, or poor financial leveraging.
Once the problem area is found, management can attempt to correct it or address it with
shareholders. Some normal operations lower ROE naturally and are not a reason for
investors to be alarmed. For instance, accelerated depreciation artificially lowers ROE in
the beginning periods. This paper entry can be pointed out with the Dupont analysis and
shouldn't sway an investor's opinion of the company.

Example
Let's take a look at Sally's Retailers and Joe's Retailers. Both of these companies
operate in the same apparel industry and have the same return on equity ratio of 45
percent. This model can be used to show the strengths and weaknesses of each
company. Each company has the following ratios:

Ratio Sally Joe

Profit Margin 30% 15%
Total Asset Turnover .50 6.0
Financial Leverage 3.0 .50
As you can see, both companies have the same overall ROE, but the companies'
operations are completely different.

Sally's is generating sales while maintaining a lower cost of goods as evidenced by its
higher profit margin. Sally's is having a difficult time turning over large amounts of sales.

Joe's business, on the other hand, is selling products at a smaller margin, but it is
turning over a lot of products. You can see this from its low profit margin and extremely
high asset turnover.
This model helps investors compare similar companies like these with similar
ratios. Investorscan then apply perceived risks with each company's business model.