Which of these ratios measure the extent to which the firm uses debt or financial leverage versus equity to finance its assets?

Finance > Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial situation. Most ratios can be calculated from information provided by the financial statements. Financial ratios can be used to analyze trends and to compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future bankruptcy.

Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:

• Liquidity ratios
• Asset turnover ratios
• Financial leverage ratios
• Profitability ratios
• Dividend policy ratios

Liquidity Ratios

Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities:

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially are current assets less inventory. The quick ratio often is referred to as the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:

The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some reason immediate payment were demanded.

Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover.

Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:

The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:

The collection period also can be written as:

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:

The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:

The inventory period also can be written as:

Other asset turnover ratios include fixed asset turnover and total asset turnover.

Financial Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets:

The debt-to-equity ratio is total debt divided by total equity:

Debt ratios depend on the classification of long-term leases and on the classification of some items as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:

where  EBIT  =  Earnings Before Interest and Taxes

Profitability Ratios

Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:

Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as:

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows:

Dividend Policy Ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. Two commonly used ratios are the dividend yield and payout ratio.

The dividend yield is defined as follows:

A high dividend yield does not necessarily translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard, and is defined as follows:

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:

• A reference point is needed. To to be meaningful, most ratios must be compared to historical values of the same firm, the firm's forecasts, or ratios of similar firms.

• Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of them combined to paint a picture of the firm's situation.

• Year-end values may not be representative. Certain account balances that are used to calculate ratios may increase or decrease at the end of the accounting period because of seasonal factors. Such changes may distort the value of the ratio. Average values should be used when they are available.

• Ratios are subject to the limitations of accounting methods. Different accounting choices may result in significantly different ratio values.

Finance > Financial Ratios

Financial ratios are used to provide a quick assessment of potential financial difficulties and dangers. Ratios provide you with a unique perspective and insight into the business. If a financial ratio identifies a potential problem, further investigation is needed to determine if a problem exists and how to correct it. Although there are often specific benchmarks attached to ratios to indicate when there is cause for concern, ratios should also be thought of as a continuum from weak to strong with the stronger the ratio the better. Ratios can identify problems by the size of the ratio but also by the direction of the ratio over time.

Liquidity Ratios

Current Ratio - A firm’s total current assets are divided by its total current liabilities. It shows the ability of a firm to meets its current liabilities with current assets.

Quick Ratio - A firm’s cash or near cash current assets divided by its total current liabilities. It shows the ability of a firm to quickly meet its current liabilities.

Net Working Capital Ratio - A firm’s current assets less its current liabilities divided by its total assets. It shows the amount of additional funds available for financing operations in relationship to the size of the business.

Asset Management Ratios

Days Sales Outstanding - A firm’s accounts receivables divided by its average daily sales. It shows the average length of time a firm must wait after making a sale before it receives payment.

Fixed Asset Turnover Ratio - A firm’s total sales divided by its net fixed assets. It is a measure of how efficiently a firm uses its plant and equipment.

Inventory Turnover Ratio - A firm’s total sales divided by its inventories. It shows the number of times a firm’s inventories are sold-out and need to be restocked during the year.

Total Assets Turnover Ratio - A firm’s total sales divided by its total assets. It is a measure of how efficiently a firm uses its assets.

Debt Management Ratios

Debt to Asset Ratio - A firm’s total debt divided by its total assets. It is a measure of how much of the firm is debt financed.

Debt Coverage Ratio or Debt Service Coverage Ratio (DSCR) - A firm’s cash available for debt service divided by the cash needed for debt service. It is a measure of a firm’s ability to service its debt obligations.

Times Interest Earned Ratio (TIE) - A firm’s earnings before interest and taxes (EBIT) divided by its interest charges. It shows a firm’s ability to meet its interest payments. It is also called the interest coverage ratio.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Coverage Ratio - A firm’s cash flow available to meet fixed financial charges divided by the firm’s fixed financial charges. It shows the ability of a firm to meet its fixed financial charges.

Profitability Ratios

Profit Margin on Sales - A firm’s net income divided by its sales. It shows the ability of sales to generate net income.

Basic Earning Power (BEP) - A firm’s earnings before interest and taxes (EBIT) divided by its total assets. It shows the earning ability of a firm’s assets before the influence of taxes and interest (leverage).

Return on Total Assets (ROA) - A firm’s net income divided by its total assets (both debt and equity supported assets). It shows the ability of the firm’s assets to generate net income. Interest expense is added back to net income because interest is a form of return on debt-financed assets.

Return on Equity (ROE) - A firm’s net income divided by its equity. It shows the ability of the firm’s equity to generate profits.

Return on Investment (ROI) - A firm’s net income divided by the owner’s original investment in the firm.

Earnings per Share - A firm’s net income per share of stock.

Market Value Ratios

Price/Earnings Ratio (P/E) - The price per share of a firm is divided by its earnings per share. It shows the price investors are willing to pay per dollar of the firm’s earnings.

Price/Cash Flow Ratio - The price per share of a firm divided by its cash flow per share. It shows the price investors are willing to pay per dollar of net cash flow of the firm.

Market-to-book value (M/B) - The market value of a firm is divided by its book value.

Don Hofstrand, retired extension value added agriculture specialist,