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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:
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
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
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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
Accrual Accounting
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.
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
Accrued Income
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.
Accrued Interest
2. The interest that has accumulated on a bond since the last interest payment up to, but not
including, the settlement date.
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
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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.
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.
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 paid
r = gross interest rate
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.
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
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".
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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
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
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 - AP
Accounts 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.
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.
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
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assets.
Calculated by:
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
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What Does Clean Balance Sheet Mean?
Refers to a company whose balance sheet has very little or no debt.
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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).
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%)).
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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.
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).
Liquidity
There is no specific liquidity formula, however liquidity is often calculated by using liquidity ratios.
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)
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 Ratio
By 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.
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 Company
--
ABC XYZ
Current
$600 $300
Assets
Current
$300 $300
Liabilities
Working
$300 $0
Capital
Current
2.0 1.0
Ratio
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 Ratio
By 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:
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.
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 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.
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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
Current Ratio
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Also known as "liquidity ratio", "cash asset ratio" and "cash ratio".
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
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".
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Investopedia explains Inventory Turnover
Although 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
Formula:
Asset
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Investopedia explains Asset
1. 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
Tangible Asset
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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
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
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.
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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.
Revenue
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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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.
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
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.
Imagine a company has a net income of $10 million from sales of $100 million, giving it a profit
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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
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.
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.
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Investopedia explains Return On Assets - ROA
ROA 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
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.
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'
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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.
Calculated as:
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.
Also known as Profit Before Interest & Taxes (PBIT), and equals Net Income with interest and
taxes added back to it.
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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
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.
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.
Amortization can be calculated easily using most modern financial calculators, spreadsheet
software packages such as Microsoft Excel, or amortization charts and tables.
What Does Earnings Before Interest, Taxes, Depreciation, Depletion, Amortization and
Exploration Expenses - EBITDAX Mean?
An indicator of a company's financial performance calculated as:
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Investopedia explains Earnings Before Interest, Taxes, Depreciation, Depletion,
Amortization and Exploration Expenses - EBITDAX
EBITDAX 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
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.
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
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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:
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
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
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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.
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.
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
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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:
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
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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.
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
Calculated as:
Debt
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Investopedia explains Debt
Bonds, 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
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'.
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
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gives an idea to the leverage of the company along with the potential risks the company faces in
terms of its debt-load.
Long-Term Debt
Short-Term Debt
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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
Microsoft, which is always in a strong cash position, had short-term investments totaling
approximately $32 billion at the end of 2005.
Solvency
Solvency Ratio
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Investopedia explains Solvency Ratio
Acceptable 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
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).
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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.
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
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.
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Investopedia explains Earnings Per Share - EPS
Earnings 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
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
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Investopedia explains Coverage Ratio
A 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
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.
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,
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
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Also known as the Net Gearing Ratio.
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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