Quick Ratio Quick Ratio = (Current Assets - Inventory) / Current Liabilities

The quick ratio is a variant of the current ratio. It takes into account the fact that inventory, while it is a current asset, is not as liquid as cash or accounts receivable. Cash is completely liquid; accounts receivable can normally be converted to cash fairly quickly, by pressing for collection from the customer. But inventory cannot be converted to cash except by selling it. The quick ratio determines the relationship between quickly accessible current assets and current liabilities: The quick ratio shows whether a company can meet its liabilities from quickly-accessible assets. In practice, a quick ratio of 1.0 is normally considered adequate, with this caveat: the credit periods that the company offers its customers and those granted to the company by its creditor must be roughly equal. If revenues will stay in accounts receivable for as long as 90 days, but accounts payable are due within 30 days, a quick ratio of 1.0 will mean that accounts receivable cannot be converted to cash quickly enough to meet accounts payable. It is possible for a company to manipulate the values of its current and quick ratios by taking certain actions toward the end of an accounting period such as a fiscal year. It might wait until the start of the next period to make purchases to its inventory, for example. Or, if its business is seasonal, it might choose a fiscal year that ends after its busy season, when inventories are usually low. As a potential creditor, you might want to examine the company s current and quick ratios on, for example, a quarterly basis. Both a current and a quick ratio can also mislead you if the inventory figure does not represent the current replacement cost of the materials in inventory. There are various methods of valuing inventory. The LIFO method, in particular, can result in an inventory valuation that is much different from the inventory's current replacement value; this is because it assumes that the most recently acquired inventory is also the most recently sold. If your actual costs to purchase materials are falling, for example, the LIFO method could result in an over-valuation of the existing inventory. This would tend to inflate the value of the current ratio, and to underestimate the value of the quick ratio if you calculate it by subtracting inventory from current assets, rather than summing cash and cash equivalents.

Current Ratio The current ratio compares a company's current assets (those that can be converted to cash during the current accounting period) to its current liabilities (those liabilities coming due during the same period). The usual formula is: Current Ratio = Current Assets / Current Liabilities The current ratio measures the company's ability to repay the principal amounts of its liabilities. The current ratio is closely related to the concept of working capital. Working capital is the difference between current assets and current liabilities. Is a high current ratio good or bad? Certainly, from the creditor's standpoint, a high current ratio means that the company is well-placed to pay back its loans. Consider, though, the nature of the current assets: they consist mainly of cash and cash equivalents. Funds invested in these types of assets do not contribute strongly and actively to the creation of income. Therefore, from the standpoint of stockholders and management, a current ratio that is very high means that the company's assets are not being used to best advantage.

Return on Assets One of management's most important responsibilities is to bring about a profit by effective use of the resources it has at hand. One ratio that speaks to this question is return on assets. There are several ways to measure this return; one useful method is: Return on Assets = (Gross Profit - Operating Expense) / Total Assets This formula will return the percentage earnings for a company in terms of its total assets. The better the job that management does in managing its assets-the resources available to it-to bring about profits, the greater this percentage will be. It's normal to calculate the return on total assets on an annual basis, rather than on a quarterly basis.

Return on Equity Another related profitability measure to Return on Assets is the Return on Equity. Again, there are several ways to calculate this ratio; here, it is measured according to this formula: Return on Equity = Net Income / Stockholder's Equity You can compare return on equity with return on assets to infer how a company obtains the funds used to acquire assets. The principal difference between the formula for return on assets and for return on equity is the use of equity rather than total assets in the denominator, and it is here that the technique of comparing ratios comes into play. By examining the difference between Return on Assets and Return on Equity, you can largely determine how the company is funding its operations. Assets are acquired through two major sources: creditors (through borrowing) and stockholders (through retained earnings and capital contributions). Collectively, the retained earnings and capital contributions constitute the company's equity. When the value of the company's assets exceeds the value of its equity, you can expect that some form of financial leverage makes up the difference: i.e., debt financing. Therefore, if the Return on Equity ratio is much larger than the Return on Assets ratio, you can infer that the company has funded some portion of its operations through borrowing.

Net Profit Margin The net profit margin narrows the focus on profitability, and highlights not just the company's sales efforts, but also its ability to keep operating costs down, relative to sales. The formula generally used to determine the net profit margin is: Net Profit Margin = Earnings After Taxes / Sales When net profit margin falls dramatically from the first to the fourth quarters, a principal culprit is cost of sales. Another place to look when you see a discrepancy between gross profit margin and net profit margin is operating expenses. When the two margins covary closely, it suggests that management is doing a good job of reducing expenses when sales fall, and increasing expenses when necessary to support production and sales in better times.

Gross Profit Margin The gross profit margin is a basic ratio that measures the added value that the market places on a company's non-manufacturing activities. Its formula is: Gross profit margin = (Sales - Cost of Goods Sold) / Sales The cost of goods sold is, clearly, an important component of the gross profit margin. It is usually calculated as the sum of the cost of materials the company purchases plus any labor involved in the manufacture of finished goods, plus associated overhead. The gross profit margin depends heavily on the type of business in which a company is engaged. A service business, such as a financial services institution or a laundry, typically has little or no cost of goods sold. A manufacturing, wholesaling, or retailing company typically has a large cost of goods sold, with a gross profit margin that varies from 20 percent to 40 percent. The gross profit margin measures the amount that customers are willing to pay for a company's product, over and above the company's cost for that product. As mentioned previously, this is the value that the company adds to that of the products it obtains from its suppliers. This margin can depend on the attractiveness of additional services, such as warranties, that the company provides. The gross profit margin also depends heavily on the ability of the sales force to persuade its customers of the value added by the company. This added value is, of course, created by other costs such as operating expenses. In turn, these costs must be met largely by the gross profit on sales. If customers do not place sufficient value on whatever the company adds to its products, there will not be enough gross profit to pay for the associated costs. Therefore, the calculation of the gross profit margin helps to highlight the effectiveness of the company's sales strategies and sales management.

Earnings Per Share (EPS) Depending on your financial objectives, you might consider investing in a company to obtain a steady return on your investment in the form of regular dividend payments, or to obtain a profit by owning the stock as the market value of its shares increases. These two objectives might both be met, but in practice they often are not. Companies frequently face a choice of distributing income in the form of dividends, or retaining that income to invest in research, new products, and expanded operations. The hope, of course, is that the retention of income to invest in the company will subsequently increase its income, thus making the company more profitable and increasing the market value of its stock. In either case, Earnings Per Share (EPS) is an important measure of the company's income. Its basic formula is: EPS = Income Available for Common Stock / Shares of Common Stock Outstanding EPS is usually a poor candidate for vertical analysis, because different companies always have different numbers of shares of stock outstanding. It may be a good candidate for horizontal analysis, if you have access both to information about the company's income and shares outstanding. With both these items, you can control for major fluctuations over time in shares outstanding. This sort of control is important: it is not unusual for a company to purchase its own stock on the open market to reduce the number of outstanding shares. So doing increases the value of the EPS ratio, perhaps making the stock appear a more attractive investment. Note that the EPS can decline steadily throughout the year. Because, the number of shares outstanding is constant throughout the year, the EPS changes are due solely to changes in net income. Many companies issue at least two different kinds of stock: common and preferred. Preferred stock is issued under different conditions than common stock. Preferred stock is often callable at the company's discretion, it pays dividends at a different (usually, higher) rate per share, it might not carry voting privileges, and often has a higher priority than common stock as to the distribution of liquidated assets if the company goes out of business. Calculating EPS for a company that has issued preferred stock introduces a slight complication. Because the company pays dividends on preferred stock before any distribution to shareholders of common stock, it is necessary to subtract these dividends from net income: EPS (Net Income - Preferred Dividends) / Shares of Common Stock Outstanding

Average Collection Period You can obtain a general estimate of the length of time it takes to receive payment for goods or services by calculating the Average Collection Period. One formula for this ratio is: Average Collection Period = Accounts Receivable / (Credit Sales / Days) Where Days is the number of days in the period for which Accounts Receivable and Credit Sales accumulate. You should interpret the average collection period in terms of the company's credit policies. If, for example, the company's policy as stated to its customers is that payment is to be received within two weeks, then an average collection period of 30 days indicates that collections are lagging. It may be that collection procedures need to be reviewed, or it is possible that one particularly large account is responsible for most of the collections in arrears. It is also possible that the qualifying procedures used by the sales force are not stringent enough. The calculation of the Average Collection Period assumes that credit sales are distributed roughly evenly during any given period. To the degree that the credit sales cluster at the end of the period, the Average Collection Period will return an inflated figure. If you obtain a result that appears too long (or too short), be sure to check whether the sales dates occur evenly throughout the period in question. Regardless of the cause, if the average collection period is over-long, it means that the company is losing profit. The company is not converting cash due from customers into new assets that can, in turn, be used to generate new income.

Inventory Turnover Ratio No company wants to have too large an inventory (the sales force excepted: salespeople prefer to be able to tell their customers that they can obtain their purchase this afternoon). Goods that remain in inventory too long tie up the company's assets in idle stock, often incur carrying charges for the storage of the goods, and can become obsolete while awaiting sale. Just-in-Time inventory procedures attempt to ensure that the company obtains its inventory no sooner than absolutely required in order to support its sales efforts. That is, of course, an unrealistic ideal, but by calculating the inventory turnover rate you can estimate how well a company is approaching the ideal. The formula for the Inventory Turnover Ratio is: Inventory Turnover = Cost of Goods Sold / Average Inventory where the Average Inventory figure refers to the value of the inventory on any given day during the period during which the Cost of Goods Sold is calculated. The higher an inventory turnover rate, the more closely a company conforms to just-in-time procedures. The figures for cost of goods sold and average inventory are taken directly from the Income Statement's cost of sales and the Balance Sheet's inventory levels. In a situation where you know only the beginning and ending inventory-for example, at the beginning and the ending of a period-you would use the average of the two levels: hence the term "average inventory." An acceptable inventory turnover rate can be determined only by knowledge of a company's business sector. If you are in the business of wholesaling fresh produce, for example, you would probably require an annual turnover rate in the 50s: a much lower rate would mean that you were losing too much inventory to spoilage. But if you sell computing equipment, you could probably afford an annual turnover rate of around 3 or 4, because hardware does not spoil, nor does it become technologically obsolete more frequently than every few months.

Debt Ratio The debt ratio is defined by this formula: Debt ratio = Total debt / Total assets It is a healthy sign when a company's debt ratio is falls, although both stockholders and potential creditors would prefer to see the rate of decline in the debt ratio more closely match the decline in return on assets. As the return on assets falls, the net income available to make payments on debt also falls. This company should probably take action to retire some of its short-term debt, and the current portion of its long-term debt, as soon as possible.

Equity Ratio The equity ratio is the opposite of the debt ratio. It is that portion of the company's assets financed by stockholders: Equity Ratio = Total Equity / Total assets It is usually easier to acquire assets through debt than to acquire them through equity. There are certain obvious considerations: for example, you might need to acquire investment capital from many investors; whereas you might be able to borrow the required funds from just one creditor. Less obvious is the issue of priority. By law, if a firm ceases operations, its creditors have the first claim on its assets to help repay the borrowed funds. Therefore, an investor's risk is somewhat higher than that of a creditor, and the effect is that stockholders tend to demand a greater return on their investment than a creditor does on its loan. The stockholder's demand for a return can take the form of dividend requirements or return on assets, each of which tend to increase the market value of their stock. But there is no "always" in financial planning. Because investors usually require a higher return on their investment than do creditors, it might seem that debt is the preferred method of raising funds to acquire assets. Potential creditors, though, look at ratios such as the return on assets and the debt ratio. A high debt ratio (or, conversely, a low equity ratio) means that existing creditors have supplied a large portion of the company's assets, and that there is relatively little stockholder's equity to help absorb the risk.

Times interest Earned Ratio One measure frequently used by creditors to evaluate the risk involved in loaning money to a firm is the Times Interest Earned ratio. This is the number of times in a given period that a company earns enough income to cover its interest payments. A ratio of 5, for example, would mean that the amount of interest payments is earned 5 times over during that period. The usual formula is: Times Interest Earned = *EBIT / Total Interest Payments *EBIT stands for Earnings Before Interest and Taxes. The Times Interest Earned ratio, in reality, seldom exceeds 10. A value of 44.1 is very high, although certainly not unheard of during a particularly good quarter. A value of 5.1 would usually be considered strong but within the normal range. Notice that this is a measure of how deeply interest charges cut into a company's income. A ratio of 1, for example, would mean that the company earns enough income (after covering such costs as operating expenses and costs of sales) to cover only its interest charges. There would be no income remaining to pay income taxes (of course, in this case it's likely that there would be no income tax liability), to meet dividend requirements or to retain earnings for future investments.