Key Financial Indicators

Business Inside
 Key Financial Indicators
Measures of asset liquidity
 See equations 1 and 2 on page 12 of booklet
Measures of solvency
 See equations 3, 4, 5 and 6 on page 13 of booklet
Measures of after-tax profitability
 See equations 7, 8 and 9 on page 13 of booklet
Measures of economic efficiency
 See equations 10, 11, 12, 13 and 14 on page 14 of booklet
Measures of debt repayment capacity
 See equations 15 – 17 on page 15 of booklet
 Measures of Asset Liquidity
1. Current ratio:
• Current assets divided by current liabilities.
• Demonstrates ability to cover scheduled current liabilities for the
coming year out current assets and still have “cash” left over.
• Should exceed 1.0 to be technically liquid.
• Some firms fail despite exceeding this hurdle.
 Measures of Asset Liquidity
1. Current ratio:
• Current assets divided by current liabilities.
• Demonstrates ability to cover scheduled current liabilities for the
coming year out current assets and still have “cash” left over.
• Should exceed 1.0 to be technically liquid.
• Some firms fail despite exceeding this hurdle.

2. Working capital:
• Current assets minus current liabilities.
• Expresses liquidity in dollars rather than ratio.
• Should be positive.
• Cash is King!
 Balance Sheet Structure

Current
Currentratio
ratio==$57,314
$57,314/ /$79,000
$79,000==.725
.725==illiquid
illiquid
Working
Workingcapital
capital==$57,314
$57,314--$79,000
$79,000==-21,686
-21,686==illiquid
illiquid
 Measures of Credit Liquidity
1. Unused credit reserves:
• LOC extended by lender less current loans on LOC. The unused
portion of your credit limit on your personal credit card is an
example of credit liquidity.
• Demonstrates ability to cover scheduled current liabilities for the
coming year out existing available credit.
• Should positive to be technically liquid.
• We will cover the implicit cost of credit liquidity later in the course.
 Cash Flow Statement -4
Producer
Producerdrew
drewdown
downan anLOC
LOC
In
Inmonths
monthsof ofMay
Mayand
andJune
Juneand
and
repaid balance in July
repaid balance in July

IfIfthe
thelender
lenderisiswilling
willingtotoextend
extendaamaximum
maximumLOCLOCofof$100,000,
$100,000,the
theunused
unusedline
lineofof
credit
creditororcredit
creditliquidity
liquidityisis$89,155
$89,155ininMay
Mayand
andJune
June($100,000
($100,000--$10,845).
$10,845).
Measures of Cash Flow Liquidity
1. Monthly cash position:
• Monthly cash position (surplus of cash available less cash
required) on the firm’s monthly cash flow statement.
• Demonstrates ability to cover scheduled current liabilities for a
particular month out expected surplus cash position.
• Should positive to be technically liquid.
• Knowledge of the firm’s cash flow liquidity requires that the firm
maintain a monthly cash flow statement.
Cash Flow Statement - 1
 Measures of Solvency
1. Debt ratio:
• Total debt divided by total assets.
• Demonstrates ability to liquidate the firm, pay off all liabilities
from
the net proceeds from the sale of all assets, and still have “cash”
left over.
• Should not exceed 0.50 to minimize financial risk exposure.
• Some firms fail however at lower levels.
 Measures of Solvency
1. Debt ratio:
• Total debt divided by total assets.
• Demonstrates ability to liquidate the firm, pay off all liabilities from
the net proceeds from the sale of all assets, and still have “cash”
left over.
• Should not exceed 0.50 to minimize financial risk exposure.
• Some firms fail however at lower levels.

2. Leverage ratio:
• Total debt divided by equity or net worth.
• Often a credit standard in loan approval decisions.
• Should not exceed 1.0 to minimize financial risk exposure.
• Effects of rising interest rates.
 Balance Sheet Structure

The
Thedebt
debtratio
ratio==$250,000
$250,000/ /$727,314
$727,314==.34
.34which
whichisisless
lessthan
than0.50
0.50
The
Theleverage
leverageratio
ratio==$250,000
$250,000/ /$398,314
$398,314==.63
.63which
whichisisless
lessthan
than1.0
1.0
 Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.
 Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.

2. Rate of return on equity:

• Net income divided equity.
• Demonstrates the after-tax return on owner equity invested
in the firm.
• Should be positive; the higher the better.
 Measures of Profitability
1. Rate of return on assets:
• Net income plus interest divided by total assets.
• Demonstrates the after-tax return to the total capital invested
in the firm.
• Should be positive; the higher the better.

2. Rate of return on equity:

• Net income divided equity.
• Demonstrates the after-tax return on owner equity invested
in the firm.
• Should be positive; the higher the better.

These
Thesemeasures
measuresof
ofprofitability
profitabilitycan
canbe
beexpressed
expressedon
oneither
eitheraapre-tax
pre-taxor
or
after-tax basis.
after-tax basis.
Income Statement Structure

The
TheROA
ROA==(9,655
(9,655++$50,000)
$50,000)/ /$727,314
$727,314==0.082
0.082or
or8.2%
8.2%
The
TheROE
ROE==9,655
9,655/ /$398,314
$398,314==0.024
0.024or
or2.4%
2.4%
Measure of Debt Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and term loan interest
payments less withdrawals) divided by scheduled principal and
interest payments on term loans and capital leases measures
the after tax cash coverage ratio.
• After provision for taxes and withdrawals.
• Should be greater than 1.0.
• Non-farm income often factored in by lenders.
Debt Coverage
Measure of Debt Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and term loan interest
payments less withdrawals) divided by scheduled principal and
interest payments on term loans and capital leases measures
the after- tax cash coverage ratio.
• After provision for taxes and withdrawals.
• Should be greater than 1.0.
• Non-farm income often factored in by lenders.

2. Debt Burden Ratio:

• Total debt outstanding divided by net income.
• Number of years required to retire total debt if net income
remains constant and used entirely for this purpose
• Should be low; the lower the better.
Measure of Debt Repayment Capacity
1. Term Debt and Capital Lease Coverage Ratio:
• Cash available from operations to cover scheduled payments
(net income plus depreciation and term loan interest
payments less withdrawals) divided by scheduled principal and
interest payments on term loans and capital leases measures
the after- tax cash coverage ratio.
• After provision for taxes and withdrawals.
• Should be greater than 1.0.
• Non-farm income often factored in by lenders.

2. Debt Burden Ratio:

• Total debt outstanding divided by net income.
• Number of years required to retire total debt if net income
remains constant and used entirely for this purpose
• Should be low; the lower the better.
For
Foraadiscussion
discussionofofnet
netincome
incomeand
andnet
netcash
cashincome
incomeapproaches
approachestoto
measuring
measuringthese
theseratios,
ratios,see
seepage
page15
15ininthe
thecourse
coursebooklet.
booklet.
 Know these Concepts
These are generally accepted financial
indicators of a firm’s financial position and
strength.
We will refer to these indicators
throughout this course.