Accounting Standards Boards

IASB - International Accounting Standards Board. Establishes IFRS

FASB - Financial Accounting Standards Board. Establishes U. S. GAAP.

Desirable Attributes of Accounting Standards Boards

- Responsibilities of all parties involved are clearly defined

- All parties observe high professional standards
- Organization has adequate authority, resources, and competencies
- Guided by a well-articulated framework
- Board operates independently but seeks stakeholder input
- Not compromised by special interests
- Decisions made in public interest result in adopted standards

Regulatory Autorities

IOSCO - International Organization of Securities Commissions

- Regulate 90% of world's financial capital markets
- Objectives: protect investors, ensure markets are fair, efficient, and transparent, reduce systemic risk
- Goal is uniform regulation

SEC - Securities and Exchange Commission (US)

- Primary responsibility for securities and capital markets
- Ordinary member of IOSCO

ESMA - European Securities and Market Authority

- Cross-border supervisor in the EU

SEC Filings / Forms

Form S-1 - Sale of new securities to the public

Forms 10-K, 20-F, and 40-F - Annual reports
Forms 10-Q and 6-K - Quarterly reports
Form 8-K - Material corporate events
Form DEF-14A - Proxy statement
Form 144 - Stock issues to qualified buyers without SEC registration
Forms 3, 4, 5 - Beneficial ownership of securities

Barriers to Global Convergence of Accounting Standards

1) Differences in views
2) Pressure from business and industry groups
3) Many different countries involved

IFRS Conceptual Framework - Qualitative Characteristics

Relevance
- Information is relevant if it would potentially affect or make a difference in users' decisions
- Information can have predictive value, confirmatory value, or both
- Materiality is a function of the nature and/or magnitude of the information

Faithful representation
- Information is ideally complete, neutral, and free from error.

Characteristics - comparability, verifiability, timeliness, understadability

IFRS Required Reporting Elements

Assets - resources controlled by entity resulting from past transactions; probable future economic benefits flow
to enterprise

Liabilities - obligations resulting from past events; settlements results in probable resource outflow

Equity - shareholders' residual interest; assets less liabilities

Income - increases in economic benefits from enhanced assets, decreased liabilities, or revenues and gains

Expenses - decreases in economic benefits from outflow/depletion of assets, increases in liabilities, expenses
and losses

IFRS - Underlying Assumptions and Element Recognition

Accrual accounting - statements reflect transactions in the period when they actually occur; revenues reported
when they are earned (performance obligations satisfied)

Going concern - assumption that the company will continue in business for the foreseeable future

Financial statement element should be recognized if it is probable that any future economic benefit will flow to
or from the enterprise and the item has a cost or value that can be measured with reliability

IASB General Requirements (IAS No. 1)

Required statements
- Balance sheet
- Income statement
- Statement of comprehensive income
- Change in equity
- Cash flow statement
- Accounting policies, notes

Fundamental Principles
- Fair presentation
- Going concern
- Accrual basis
- Consistency
- Materiality

Presentation Requirements
- Aggregation where appropriate
- No offsetting
- Classified balance sheet
- Minimum information on face (specific line items)
- Minimum disclosure (disclosures in notes)
- Comparative information (previous period)

Summary or differences between IFRS and US GAAP frameworks

Performance Elements
- FASB includes gains, losses, and comprehensive income in addition to revenue and expenses

Financial Position Elements

- FASB defines an asset as a "future economic benefit" rather than the "resource" from which future economic
benefits are expected to flow

Recognition of Elements
- FASB framework does not discuss the term "probable" in its recognition criteria

Measurement of Elements
- FASB framework prohibits revaluations except for certain categories of financial instruments, which have to
be carried at fair value.

Characteristics of an Effective Financial Reporting Framework

Transparency - users should be able to see the underlying economics of the business reflected clearly in the
company's financial statements; full disclosure and fair presentation

Comprehensiveness - framework should encompass the full spectrum of transaction that have financial
consequences; framework flexible enough to adapt to new transactions

Consistency - transactions measured and presented in a similar way across companies and time; sufficient
flexibility to show economic substance

Barriers to a Single Reporting Framework

Valuation
- historical cost requires minimal judgement
- fair value requires considerable judgment but more relevant
- IASB and FASB recognize that some elements should be measure at fair value

Standard Setting Approach

- principles-based require few specific rules
- rules-based are prescriptive but not flexible
- objectives-based combines principles and rules

Measurement
- two potential approaches: asset/liability or revenue/expense
- standards on one will have an effect on the other
- recently, standard-setters have predominantly used an asset/liability approach

Monitoring Developments in Financial Reporting Standards

New Products or Types of Transactions
- Usually arise from economic events, such as new businesses, or from a newly developed financial instrument
or financial structure

Evolving Standards
- Changes in regulations can affect companies' financial reports.

Company Disclosures
- Critical and significant accounting policies
- Accounting estimates
- Changes in policy
- Footnote disclosures and MD&A

Focus:
- What policies have been discussed?
- Do policies cover all significant transactions?
- Which balances require significant estimation?
- Have there been any changes in these disclosures from one year to the next?

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Financial Ratio Analysis

Financial ratios are mathematical comparisons of financial statement accounts or categories. These relationships
between the financial statement accounts help investors, creditors, and internal company management
understand how well a business is performing and areas of needing improvement.

Financial ratios are the most common and widespread tools used to analyze a business' financial standing.
Ratios are easy to understand and simple to compute. They can also be used to compare different companies in
different industries. Since a ratio is simply a mathematically comparison based on proportions, big and small
companies can be use ratios to compare their financial information. In a sense, financial ratios don't take into
consideration the size of a company or the industry. Ratios are just a raw computation of financial position and
performance.

Ratios allow us to compare companies across industries, big and small, to identify their strengths and
weaknesses. Financial ratios are often divided up into seven main categories: liquidity, solvency, efficiency,
profitability, market prospect, investment leverage, and coverage.

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.

Quick Ratio

The quick ratio or acid test ratio is a liquidity 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 the balance 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:

Current Ratio

The current ratio is a liquidity and efficiency ratio that measures a firm's ability to pay off its short-term
liabilities with its current assets. The current ratio is an important measure of liquidity because short-term
liabilities are due within the next year.

This means that a company has a limited amount of time in order to raise the funds to pay for these liabilities.
Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the
short term. This means that companies with larger amounts of current assets will more easily be able to pay off
current liabilities when they become due without having to sell off long-term, revenue generating assets.
Formula

The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric
format rather than in decimal format. Here is the calculation:

GAAP requires that companies separate current and long-term assets and liabilities on the balance sheet. This
split allows investors and creditors to calculate important ratios like the current ratio. On U.S. financial
statements, current accounts are always reported before long-term accounts.

Analysis

The current ratio helps investors and creditors understand the liquidity of a company and how easily that
company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of
current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than current
liabilities.

A higher current ratio is always more favorable than a lower current ratio because it shows the company can
more easily make current debt payments.

If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company isn't
making enough from operations to support activities. In other words, the company is losing money. Sometimes
this is the result of poor collections of accounts receivable.

The current ratio also sheds light on the overall debt burden of the company. If a company is weighted down
with a current debt, its cash flow will suffer.

Example

Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is applying for loans to help
fund his dream of building an indoor skate rink. Charlie's bank asks for his balance sheet so they can analysis
his current debt levels. According to Charlie's balance sheet he reported $100,000 of current liabilities and only
$25,000 of current assets. Charlie's current ratio would be calculated like this:

As you can see, Charlie only has enough current assets to pay off 25 percent of his current liabilities. This
shows that Charlie is highly leveraged and highly risky. Banks would prefer a current ratio of at least 1 or 2, so
that all the current liabilities would be covered by the current assets. Since Charlie's ratio is so low, it is unlikely
that he will get approved for his loan.
Working Capital Ratio

The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm's ability to pay off
its current liabilities with current assets. The working capital ratio is important to creditors because it shows the
liquidity of the company.

Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because
these assets can be converted into cash much quicker than fixed assets. The faster the assets can be converted
into cash, the more likely the company will have the cash in time to pay its debts.

The reason this ratio is called the working capital ratio comes from the working capital calculation. When
current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other
words, it has enough capital to work. The working capital ratio transforms the working capital calculation into a
comparison between current assets and current liabilities.

Formula

The working capital ratio is calculated by dividing current assets by current liabilities.

Both of these current accounts are stated separately from their respective long-term accounts on the balance
sheet. This presentation gives investors and creditors more information to analyze about the company. Current
assets and liabilities are always stated first on financial statements and then followed by long-term assets and
liabilities.

This calculation gives you a firm understanding what percentage a firm's current assets are of its current
liabilities.

Analysis

Since the working capital ratio measures current assets as a percentage of current liabilities, it would only make
sense that a higher ratio is more favorable. A WCR of 1 indicates the current assets equal current liabilities. A
ratio of 1 is usually considered the middle ground. It's not risky, but it is also not very safe. This means that the
firm would have to sell all of its current assets in order to pay off its current liabilities.

A ratio less than 1 is considered risky by creditors and investors because it shows the company isn't running
efficiently and can't cover its current debt properly. A ratio less than 1 is always a bad thing and is often referred
to as negative working capital.

On the other hand, a ratio above 1 shows outsiders that the company can pay all of its current liabilities and still
have current assets left over or positive working capital.
Example

Since the working capital ratio has two main moving parts, assets and liabilities, it is important to think about
how they work together. In other words, how does the ratio change if a firm's current liabilities increase while
the current assets stay the same? Here are the four examples of changes that affect the ratio:

 Current assets increase = increase in WCR

 Current assets decrease= decrease in WCR
 Current liabilities increase = decrease in WCR
 Current liabilities decrease = increase in WCR

Let's take a look at an example. Kay's Machine Shop has several loans from banks for equipment she purchased
in the last five years. All of these loans are coming due which is decreasing her working capital. At the end of
the year, Kay had $100,000 of current assets and $125,000 of current liabilities. Here is her WCR:

As you can see, Kay's WCR is less than 1 because her debt is increasing. This makes her business more risky to
new potential credits. If Kay wants to apply for another loan, she should pay off some of the liabilities to lower
her working capital ratio before she applies.

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 total interest 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.

Quick Ratio

The quick ratio or acid test ratio is a liquidity 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 the balance 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:

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.

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.
Equity Ratio

The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed
by owners' investments by comparing the total equity in the company to the total assets.

The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first
component shows how much of the total company assets are owned outright by the investors. In other words,
after all of the liabilities are paid off, the investors will end up with the remaining assets.

The second component inversely shows how leveraged the company is with debt. The equity ratio measures
how much of a firm's assets were financed by investors. In other words, this is the investors' stake in the
company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that
were financed by debt. Companies with higher equity ratios show new investors and creditors that investors
believe in the company and are willing to finance it with their investments.

Formula

The equity ratio is calculated by dividing total equity by total assets. Both of these numbers truly include all of
the accounts in that category. In other words, all of the assets and equity reported on the balance sheet are
included in the equity ratio calculation.

Analysis

In general, higher equity ratios are typically favorable for companies. This is usually the case for several
reasons. Higher investment levels by shareholders shows potential shareholders that the company is worth
investing in since so many investors are willing to finance the company. A higher ratio also shows potential
creditors that the company is more sustainable and less risky to lend future loans.

Equity financing in general is much cheaper than debt financing because of the interest expenses related to debt
financing. Companies with higher equity ratios should have less financing and debt service costs than
companies with lower ratios.

As with all ratios, they are contingent on the industry. Exact ratio performance depends on industry standards
and benchmarks.

Example

Tim's Tech Company is a new startup with a number of different investors. Tim is looking for additional
financing to help grow the company, so he talks to his business partners about financing options. Tim's total
assets are reported at $150,000 and his total liabilities are $50,000. Based on the accounting equation, we can
assume the total equity is $100,000. Here is Tim's equity ratio.
As you can see, Tim's ratio is .67. This means that investors rather than debt are currently funding more assets.
67 percent of the company's assets are owned by shareholders and not creditors. Depending on the industry, this
is a healthy ratio.

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.

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.

Accounts Receivable Turnover Ratio

Accounts receivable turnover is an efficiency 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 its receivables, 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.

Working Capital Ratio

The working capital ratio, also called the current ratio, is a liquidity ratio that measures a firm's ability to pay off
its current liabilities with current assets. The working capital ratio is important to creditors because it shows the
liquidity of the company.

Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because
these assets can be converted into cash much quicker than fixed assets. The faster the assets can be converted
into cash, the more likely the company will have the cash in time to pay its debts.

The reason this ratio is called the working capital ratio comes from the working capital calculation. When
current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other
words, it has enough capital to work. The working capital ratio transforms the working capital calculation into a
comparison between current assets and current liabilities.

Formula

The working capital ratio is calculated by dividing current assets by current liabilities.

Both of these current accounts are stated separately from their respective long-term accounts on the balance
sheet. This presentation gives investors and creditors more information to analyze about the company. Current
assets and liabilities are always stated first on financial statements and then followed by long-term assets and
liabilities.

This calculation gives you a firm understanding what percentage a firm's current assets are of its current
liabilities.
Analysis

Since the working capital ratio measures current assets as a percentage of current liabilities, it would only make
sense that a higher ratio is more favorable. A WCR of 1 indicates the current assets equal current liabilities. A
ratio of 1 is usually considered the middle ground. It's not risky, but it is also not very safe. This means that the
firm would have to sell all of its current assets in order to pay off its current liabilities.

A ratio less than 1 is considered risky by creditors and investors because it shows the company isn't running
efficiently and can't cover its current debt properly. A ratio less than 1 is always a bad thing and is often referred
to as negative working capital.

On the other hand, a ratio above 1 shows outsiders that the company can pay all of its current liabilities and still
have current assets left over or positive working capital.

Example

Since the working capital ratio has two main moving parts, assets and liabilities, it is important to think about
how they work together. In other words, how does the ratio change if a firm's current liabilities increase while
the current assets stay the same? Here are the four examples of changes that affect the ratio:

 Current assets increase = increase in WCR

 Current assets decrease= decrease in WCR
 Current liabilities increase = decrease in WCR
 Current liabilities decrease = increase in WCR

Let's take a look at an example. Kay's Machine Shop has several loans from banks for equipment she purchased
in the last five years. All of these loans are coming due which is decreasing her working capital. At the end of
the year, Kay had $100,000 of current assets and $125,000 of current liabilities. Here is her WCR:

As you can see, Kay's WCR is less than 1 because her debt is increasing. This makes her business more risky to
new potential credits. If Kay wants to apply for another loan, she should pay off some of the liabilities to lower
her working capital ratio before she applies.

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-year balance 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.

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 other holding 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.

Days Sales in Inventory

The days sales in inventory calculation, also called days inventory outstanding or simply days in inventory,
measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in
inventory ratio shows how many days a company's current stock of inventory will last.

This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash
flows. Both investors and creditors want to know how valuable a company's inventory is. Older, more obsolete
inventory is always worth less than current, fresh inventory. The days sales in inventory shows how fast the
company is moving its inventory. In other words, it shows how fresh the inventory is.

This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company
can convert its inventory into cash sooner. In other words, the inventory is extremely liquid.

Along the same line, more liquid inventory means the company's cash flows will be better.
Formula

The days sales inventory is calculated by dividing the ending inventory by the cost of goods sold for the period
and multiplying it by 365.

Ending inventory is found on the balance sheet and the cost of goods sold is listed on the income statement.
Note that you can calculate the days in inventory for any period, just adjust the multiple.

Since this inventory calculation is based on how many times a company can turn its inventory, you can also use
the inventory turnover ratio in the calculation. Just divide 365 by the inventory turnover ratio

Days inventory usually focuses on ending inventory whereas inventory turnover focuses on average inventory.

Analysis

The days sales in inventory is a key component in a company's inventory management. Inventory is a expensive
for a company to keep, maintain, and store. Companies also have to be worried about protecting inventory from
theft and obsolescence.

Management wants to make sure its inventory moves as fast as possible to minimize these costs and to increase
cash flows. Remember the longer the inventory sits on the shelves, the longer the company's cash can't be used
for other operations.

Management strives to only buy enough inventories to sell within the next 90 days. If inventory sits longer than
that, it can start costing the company extra money.

It only makes sense that lower days inventory outstanding is more favorable than higher ratios.

Example

Keith's Furniture Company's management have been extremely happy with their sales staff because they have
been moving more inventory this year than in any previous year. At the end of the year, Keith's financial
statements show an ending inventory of $50,000 and a cost of good sold of $150,000. Keith's days sales in
inventory is calculated like this:
As you can see, Keith's ratio is 122 days. This means Keith has enough inventories to last the next 122 days or
Keith will turn his inventory into cash in the next 122 days. Depending on Keith's industry, this length of time
might be short or long.

Profitability Ratios

Profitability ratios compare income statement accounts and categories to show a company's ability to generate
profits from its operations. Profitability ratios focus on a company's return on investment in inventory and other
assets. These ratios basically show how well companies can achieve profits from their operations.

Investors and creditors can use profitability ratios to judge a company's return on investment based on its
relative level of resources and assets. In other words, profitability ratios can be used to judge whether
companies are making enough operational profit from their assets. In this sense, profitability ratios relate to
efficiency ratios because they show how well companies are using thier assets to generate profits. Profitability
is also important to the concept of solvency and going concern.

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 big purchase 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.

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 formula 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 income equals total revenues
minus total expenses and is usually the last number reported on the income 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.

Return on Assets Ratio - ROA

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the net
income produced by total assets during a period by comparing net income to the average total assets. In other
words, the return on assets ratio or ROA measures how efficiently a company can manage its assets to produce
profits during a period.

Since company assets' sole purpose is to generate revenues and produce profits, this ratio helps both
management and investors see how well the company can convert its investments in assets into profits. You can
look at ROA as a return on investment for the company since capital assets are often the biggest investment for
most companies. In this case, the company invests money into capital assets and the return is measured in
profits.

In short, this ratio measures how profitable a company's assets are.

Formula

The return on assets ratio formula is calculated by dividing net income by average total assets.

This ratio can also be represented as a product of the profit margin and the total asset turnover.

Either formula can be used to calculate the return on total assets. When using the first formula, average total
assets are usually used because asset totals can vary throughout the year. Simply add the beginning and ending
assets together on the balance sheet and divide by two to calculate the average assets for the year. It might be
obvious, but it is important to mention that average total assets is the historical cost of the assets on the balance
sheet without taking into consideration the accumulated depreciation.

The net income can be found on the income statement.

Analysis

The return on assets ratio measures how effectively a company can earn a return on its investment in assets. In
other words, ROA shows how efficiently a company can convert the money used to purchase assets into net
income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring the
assets in the return calculation by adding back interest expense in the formula.

It only makes sense that a higher ratio is more favorable to investors because it shows that the company is more
effectively managing its assets to produce greater amounts of net income. A positive ROA ratio usually
indicates an upward profit trend as well. ROA is most useful for comparing companies in the same industry as
different industries use assets differently. For instance, construction companies use large, expensive equipment
while software companies use computers and servers.

Example

Charlie's Construction Company is a growing construction business that has a few contracts to build storefronts
in downtown Chicago. Charlie's balance sheet shows beginning assets of $1,000,000 and an ending balance of
$2,000,000 of assets. During the current year, Charlie's company had net income of $20,000,000. Charlie's
return on assets ratio looks like this.

As you can see, Charlie's ratio is 1,333.3 percent. In other words, every dollar that Charlie invested in assets
during the year produced $13.3 of net income. Depending on the economy, this can be a healthy return rate no
matter what the investment is.

Investors would have to compare Charlie's return with other construction companies in his industry to get a true
understanding of how well Charlie is managing his assets.

Return on Capital Employed

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can
generate profits from its capital employed by comparing net operating profit to capital employed. In other
words, return on capital employed shows investors how many dollars in profits each dollar of capital employed
generates.

ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into
consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate
the longevity of a company.

This ratio is based on two important calculations: operating profit and capital employed. Net operating profit is
often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because
it shows the company profits generated from operations. EBIT can be calculated by adding interest and taxes
back into net income if need be.

Capital employed is a fairly convoluted term because it can be used to refer to many different financial ratios.
Most often capital employed refers to the total assets of a company less all current liabilities. This could also be
looked at as stockholders' equity less long-term liabilities. Both equal the same figure.

Formula

Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed
capital.

If employed capital is not given in a problem or in the financial statement notes, you can calculate it by
subtracting current liabilities from total assets. In this case the ROCE formula would look like this:
It isn't uncommon for investors to use averages instead of year-end figures for this ratio, but it isn't necessary.

Analysis

The return on capital employed ratio shows how much profit each dollar of employed capital generates.
Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated
by each dollar of capital employed.

For instance, a return of .2 indicates that for every dollar invested in capital employed, the company made 20
cents of profits.

Investors are interested in the ratio to see how efficiently a company uses its capital employed as well as its
long-term financing strategies. Companies' returns should always be high than the rate at which they are
borrowing to fund the assets. If companies borrow at 10 percent and can only achieve a return of 5 percent, they
are loosing money.

Just like the return on assets ratio, a company's amount of assets can either hinder or help them achieve a high
return. In other words, a company that has a small dollar amount of assets but a large amount of profits will
have a higher return than a company with twice as many assets and the same profits.

Example

Scott's Auto Body Shop customizes cars for celebrities and movie sets. During the year, Scott had a net
operating profit of $100,000. Scott reported $100,000 of total assets and $25,000 of current liabilities on his
balance sheet for the year.

Accordingly, Scott's return on capital employed would be calculated like this:

As you can see, Scott has a return of 1.33. In other words, every dollar invested in employed capital, Scott earns
$1.33. Scott's return might be so high because he maintains low assets level.

Companies with large cash reserves usually skew this ratio because cash is included in the employed capital
computation even though it isn't technically employed yet.
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.

Market Prospect Ratios

Market Prospect ratios are used to compare publicly traded companies' stock prices with other financial
measures like earnings and dividend rates. Investors use market prospect ratios to analyze stock price trends and
help figure out a stock's current and future market value.

In other words, market prospect ratios show investors what they should expect to receive from their investment.
They might receive future dividends, earnings, or just an appreciated stock value. These ratios are helpful for
investors to predict how much stock prices will be in the future based on current earnings and dividend
measurements. For instance, a downward trend in earnings per share and dividend yield point to profitability
problems and could even raise going concern issues. All of these issues point to a lower stock evaluation.

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.

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

Dividend Payout Ratio

The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the form
of dividends during the year. In other words, this ratio shows the portion of profits the company decides to keep
to fund operations and the portion of profits that is given to its shareholders.

Investors are particularly interested in the dividend payout ratio because they want to know if companies are
paying out a reasonable portion of net income to investors. For instance, most start up companies and tech
companies rarely give dividends at all. In fact, Apple, a company formed in the 1970s, just gave its first
dividend to shareholders in 2012.

Conversely, some companies want to spur investors' interest so much that they are willing to pay out
unreasonably high dividend percentages. Inventors can see that these dividend rates can't be sustained very long
because the company will eventually need money for its operations.

Formula

The dividend payout formula is calculated by dividing total dividend by the net income of the company.

This calculation will give you the overall dividend ratio. Both the total dividends and the net income of the
company will be reported on the financial statements.

You can also calculate the dividend payout ratio on a share basis by dividing the dividends per share by the
earnings per share.
Obviously, this calculation requires a little more work because you must figure out the earnings per share as
well as divide the dividends by each outstanding share. Both of these formulas will arrive at the same answer
however.

Analysis

Since investors want to see a steady stream of sustainable dividends from a company, the dividend payout ratio
analysis is important. A consistent trend in this ratio is usually more important than a high or low ratio.

Since it is for companies to declare dividends and increase their ratio for one year, a single high ratio does not
mean that much. Investors are mainly concerned with sustainable trends. For instance, investors can assume that
a company that has a payout ratio of 20 percent for the last ten years will continue giving 20 percent of its profit
to the shareholders.

Conversely, a company that has a downward trend of payouts is alarming to investors. For example, if a
company's ratio has fallen a percentage each year for the last five years might indicate that the company can no
longer afford to pay such high dividends. This could be an indication of poor operating performance.

Generally, more mature and stable companies tend to have a higher ratio than newer start up companies.

Example

Joe's Kitchen is a restaurant change that has several shareholders. Joe reported $10,000 of net income on his
income statement for the year. Joe's issued $3,000 of dividends to its shareholders during the year. Here is Joe's
dividend payout ratio calculation.

As you can see, Joe is paying out 30 percent of his net income to his shareholders. Depending on Joe's debt
levels and operating expenses, this could be a sustainable rate since the earnings appear to support a 30 percent
ratio.

Dividend Yield Ratio

The dividend yield is a financial ratio that measures the amount of cash dividends distributed to common
shareholders relative to the market value per share. The dividend yield is used by investors to show how their
investment in stock is generating either cash flows in the form of dividends or increases in asset value by stock
appreciation.

Investors invest their money in stocks to earn a return either by dividends or stock appreciation. Some
companies choose to pay dividends on a regular basis to spur investors' interest. These shares are often called
income stocks. Other companies choose not to issue dividends and instead reinvest this money in the business.
These shares are often called growth stocks.

Investors can use the dividend yield formula to help analyze their return on investment in stocks.
Formula

The dividend yield formula is calculated by dividing the cash dividends per share by the market value per share.

Cash dividends per share are often reported on the financial statements, but they are also reported as gross
dividends distributed. In this case, you'll have to divide the gross dividends distributed by the average
outstanding common stock during that year.

The shares' market value is usually calculated by looking at the open stock exchange price as of the last day of
the year or period.

Analysis

Investors use the dividend yield formula to compute the cash flow they are getting from their investment in
stocks. In other words, investors want to know how much dividends they are getting for every dollar that the
stock is worth.

A company with a high dividend yield pays its investors a large dividend compared to the fair market value of
the stock. This means the investors are getting highly compensated for their investments compared with lower
dividend yielding stocks.

A high or low dividend yield is relative to the industry of the company. As I mentioned above, tech companies
rarely give dividends at all. So even a small dividend might produce a high dividend yield ratio for the tech
industry. Generally, investors want to see a yield as high as possible.

Example

Stacy's Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly Hills. Stacy's is listed on a
smaller stock exchange and the current market price per share is $15. As of last year, Stacy paid $15,000 in
dividends with 1,000 shares outstanding. Stacy's yield is computed like this.

As you can see, Stacy's yield is one dollar. This means that Stacy's investors receive 1 dollar in dividends for
every dollar they have invested in the company. In other words, the investors are getting a 100 percent return on
their investment every year Stacy maintains this dividend level.
Financial Leverage Ratios

Financial leverage ratios, sometimes called equity or debt ratios, measure the value of equity in a company by
analyzing its overall debt picture. These ratios either compare debt or equity to assets as well as shares
outstanding to measure the true value of the equity in a business.

In other words, the financial leverage ratios measure the overall debt load of a company and compare it with the
assets or equity. This shows how much of the company assets belong to the shareholders rather than creditors.
When shareholders own a majority of the assets, the company is said to be less leveraged. When creditors own a
majority of the assets, the company is considered highly leveraged. All of these measurements are important for
investors to understand how risky the capital structure of a company and if it is worth investing in.

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.

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.

Equity Ratio

The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed
by owners' investments by comparing the total equity in the company to the total assets.

The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first
component shows how much of the total company assets are owned outright by the investors. In other words,
after all of the liabilities are paid off, the investors will end up with the remaining assets.

The second component inversely shows how leveraged the company is with debt. The equity ratio measures
how much of a firm's assets were financed by investors. In other words, this is the investors' stake in the
company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that
were financed by debt. Companies with higher equity ratios show new investors and creditors that investors
believe in the company and are willing to finance it with their investments.
Formula

The equity ratio is calculated by dividing total equity by total assets. Both of these numbers truly include all of
the accounts in that category. In other words, all of the assets and equity reported on the balance sheet are
included in the equity ratio calculation.

Analysis

In general, higher equity ratios are typically favorable for companies. This is usually the case for several
reasons. Higher investment levels by shareholders shows potential shareholders that the company is worth
investing in since so many investors are willing to finance the company. A higher ratio also shows potential
creditors that the company is more sustainable and less risky to lend future loans.

Equity financing in general is much cheaper than debt financing because of the interest expenses related to debt
financing. Companies with higher equity ratios should have less financing and debt service costs than
companies with lower ratios.

As with all ratios, they are contingent on the industry. Exact ratio performance depends on industry standards
and benchmarks.

Example

Tim's Tech Company is a new startup with a number of different investors. Tim is looking for additional
financing to help grow the company, so he talks to his business partners about financing options. Tim's total
assets are reported at $150,000 and his total liabilities are $50,000. Based on the accounting equation, we can
assume the total equity is $100,000. Here is Tim's equity ratio.

As you can see, Tim's ratio is .67. This means that investors rather than debt are currently funding more assets.
67 percent of the company's assets are owned by shareholders and not creditors. Depending on the industry, this
is a healthy ratio.
Coverage Ratios

Coverage ratios are comparisons designed to measure a company's ability to pay its liabilities. On the surface,
coverage ratios might sound a lot like liquidity and solvency ratios, but there is a distinct difference. Coverage
ratios analyze a company's ability to service its debt and other obligations.

In other words, these ratios measure how well companies can afford to make the interest payments associated
with their debt. Some ratios also include obligations that are not typical liabilities like regular dividend
payments to stockholders.

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 total interest 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.

Fixed Charge Coverage Ratio

The fixed charge coverage ratio is a financial ratio that measures a firm's ability to pay all of its fixed charges or
expenses with its income before interest and income taxes. The fixed charge coverage ratio is basically an
expanded version of the times interest earned ratio or the times interest coverage ratio.

The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like lease
payments, insurance payments, and preferred dividend payments can be built into the calculation.

Formula

The fixed charge coverage ratio starts with the times earned interest ratio and adds in applicable fixed costs. We
will use lease payments for this example, but any fixed cost can be added in. This ratio would be calculated like
this:

Note that any number of fixed costs can be used in this formula. This coverage ratio is not limited to only one
cost.

Analysis

The fixed charge coverage ratio shows investors and creditors a firm's ability to make its fixed payments. Like
the times interest ratio, this ratio is stated in numbers rather than percentages.
The ratio measures how many times a firm can pay its fixed costs with its income before interest and taxes. In
other words, it shows how many times greater the firm's income is compared with its fixed costs.

In a way, this ratio can be viewed as a solvency ratio because it shows how easily a company can pay its bills
when they become due. Obviously, if a company can't pay its lease or rent payments, it will not be in business
for much longer.

Higher fixed cost ratios indicate a healthier and less risky business to invest in or loan to. Lower ratios show
creditors and investors that the company can barely meet its monthly bills.

Example

Quinn's Harp Shop is an instrument retailer that specializes in selling and repairing harps. Quinn has been
interest in remodeling the inside of his store but needs a loan in order to afford it. After giving his financial
statements to the bank, the loan officer calculates Quinn's fixed charge coverage ratio.

According to Quinn's income statement, he has $300,000 of income before interest and taxes and interest
expense of $30,000. Quinn's current lease payment is $2,000 a month or $24,000 a year. Here is how Quinn's
ratio is calculated:

As you can see, Quinn's ratio is six. That means that Quinn's income is 6 times greater than his interest and
lease payments. This is a healthy ratio and he should be able to receive his loan from the bank.

Debt Service Coverage Ratio - DSCR

The debt service coverage ratio is a financial ratio that measures a company's ability to service its current debts
by comparing its net operating income with its total debt service obligations. In other words, this ratio compares
a company's available cash with its current interest, principle, and sinking fund obligations.

The debt service coverage ratio is important to both creditors and investors, but creditors most often analyze it.
Since this ratio measures a firm's ability to make its current debt obligations, current and future creditors are
particularly interest in it.

Creditors not only want to know the cash position and cash flow of a company, they also want to know how
much debt it currently owes and the available cash to pay the current and future debt.

Unlike the debt ratio, the debt service coverage ratio takes into consideration all expenses related to debt
including interest expense and other obligations like pension and sinking fund obligation. In this way, the
DSCR is more telling of a company's ability to pay its debt than the debt ratio.

Formula

The debt service coverage ratio formula is calculated by dividing net operating income by total debt service.
Net operating income is the income or cash flows that are left over after all of the operating expenses have been
paid. This is often called earnings before interest and taxes or EBIT. Net operating income is usually stated
separately on the income statement.

Total debt service refers to all costs related to servicing a company's debt. This often includes interest payments,
principle payments, and other obligations. The debt service amount is rarely given in a set of financial
statements. Many times this is mentioned in the financial statement notes, however.

Analysis

The debt service coverage ratio measures a firm's ability to maintain its current debt levels. This is why a higher
ratio is always more favorable than a lower ratio. A higher ratio indicates that there is more income available to
pay for debt servicing.

For example, if a company had a ratio of 1, that would mean that the company's net operating profits equals its
debt service obligations. In other words, the company generates just enough revenues to pay for its debt
servicing. A ratio of less than one means that the company doesn't generate enough operating profits to pay its
debt service and must use some of its savings.

Generally, companies with higher service ratios tend to have more cash and are better able to pay their debt
obligations on time.

Example

Burton's Shoe Store is looking to remodel its storefront, but it doesn't have enough cash to pay for the remodel it
self. Thus, Burton is talking with several banks in order to get a loan. Burton is a little worried that he won't get
a loan because he already has several loans.

According to his financial statements and documents, Burton's had the following:

Net Operating Profits $150,000

Interest Expense $55,000

Principle Payments $35,000

Sinking Fund Obligations $25,000

Here is Burton's debt service coverage calculation:

As you can see, Burton has a ratio of 1.3. This means that Burton makes enough in operating profits to pay his
current debt service costs and be left with 30 percent of his profits.