Financial Statement Analysis Text

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Financial Statements
Financial statements are a collection of documents describing the financial state of a business. They may be internal (prepared and used within the business) or external (prepared and used outside the business). External statements are usually prepared by external accountants or auditors. They consist of an Auditor’s Report, Income Statement, Balance Sheet, Cash Flow Statement or other reconciling statement and Notes to the Financial Statements. The Auditor’s Report (or Accountant’s Report) is often titled Notice to Reader. It states whether the statements are based on an audit (highest level), review or compilation (lowest level) engagement. It also states the extent to which the reader should rely on the information. If audited, the report should state that the auditor believes the statements fairly represent the company. Auditor’s Reports not signed by the auditor are likely only draft copies. The Income Statement is sometimes referred to as the ro!it and "oss Statement. It lists the revenues in terms of sales and other revenues. It lists the cost o! goods sold, providing the gross margin (sales less costs of goods sold). It also lists and adds the selling and administration expenses.

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The difference between the gross margin and selling and administration expenses is called pro!its !rom operations. Deduced from the pro!its !rom operations are prior period ad#ustments and unusual items (usually profits or loss from sale of fixed assets) to arrive at the !IT (net $e!ore interest ant taxes). Interest is then deducted to yield the net before taxes. "inally, taxes are deducted to determine the net income. The Balance Sheet lists the assets, lia$ilities and e%uit& (ownership) of the business. The assets are listed on the left, in order of li#uidity. The assets are broken into short term assets (also referred to as current assets) and long term assets. The short term assets are generally used within a year and consist of cash, mar'eta$le securities, accounts receiva$le, inventory and prepaid expenses. The long term assets consist of vehicles, plant and e%uipment, land and intangi$le assets (goodwill, patents, capitali(ed research and development and capitali(ed startup costs). The right side of the Balance Sheet lists lia$ilities (also referred to as de$t) and owner’s e%uit& (also referred to as net worth or shareholders e%uit&). Current lia$ilities consist of accounts pa&a$le and the current portion o! long term de$t. The shareholders e%uit& is broken into proceeds from

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the sale of shares (or paid in capital) and retained earnings (sum of previous net incomes less cash dividends) The total of all assets on the left hand side e#uals the total of all lia$ilities and owner’s e%uit& on the right hand side. The Cash Flow Statement, Sources and )ses o! Funds or Changes in *or'ing Capital Statement is a reconciling statement. It reconciles the changes in cash or wor'ing capital (current assets less current lia$ilities) to the changes in Balance Sheet and Income Statement items. The Cash Flow Statement is broken into cash !low !rom operations, cash !low !rom !inancing and cash !low !rom investments. Notes to the Financial Statement, or are notes which provide information to the reader. It includes changes in accounting policy, a breakdown of plant and e#uipment and depreciation, details on non$arms length transactions, pending law suits, and significant events or transactions which occurred during the audit. Comparative !inancial statements include a side by side comparison of the income statement and balance sheet to those of prior years.

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Internal !inancial statements usually consist of an Income Statement, Balance Sheet and +anager’s Comments. The Income Statement usually compares the results to budget and reports the variances to the budgeted amount. The +anager’s Report comments on the operating changes to the $udget and its effects on the variances.

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Financial Statement Analysis Side-by-Side Analysis This is usually the first step in financial statement analysis. It is also the only step taken by many recipients of financial statements. In this method, the reader simply eyeballs the financial statements. %sing this method, the reader does not have to do any calculations. During this approach, the reader can see whether there are any material changes to financial statements figures, whether the business has earned a profit and whether the profits have improved over the previous period. The side,$&,side anal&sis is also referred to as hori(ontal anal&sis or comparative anal&sis. Notes to Financial Statements The second step to financial statement analysis is reading the notes. They do not re#uire any calculations and enable the reader to see whether

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ad&ustments should be made if and when calculations are made. The notes to the financial statement provide a breakdown of some figures, explain the method of accounting used in determining the reported figures and provide other important items of information to the readers. They are important in the analysis of a business. They should be examined before doing any other analysis to determine whether there is any information that suggests a change of business or ad&ustments that may be needed to current figures to forecast future results or ratios. The notes may contain a breakdown of the control, ownership and accounting for investments in other companies. 'artial ownerships, which are not consolidated, may indicate profits from these partially owned companies that are not reported in the income statement. If profits continue, they should show in future periods as dividend income or gain on disposal of investments. (hen doing calculations, any unreported current year)s profits from the investments should be included in profits and the accumulated non$reported profits should be included in the investment and owner)s e#uity. Inventories using "IF- (last$in$first$out) accounting indicate that the inventories are valued based on old values, whereas those using FIF-

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(first$in$first$out) indicate the inventories are valued at the most recent prices. If the company holds inventories which decrease in value over time, such as computers and other electronics, the use of "IF- indicates that the inventories and income may be overstated. * note on prices being ad&usted to the lower of actual and replacement costs will decrease concerns about obsolete and overpriced inventories. otes may indicate that the propert&, plant and e%uipment values may not reflect the costs of replacing them. There may also be a note on impairment to !ixed assets which would indicate that the assets are overstated. +verstated depreciation rates will indicate that the depreciated value of the fixed assets and the income are understated. The breakdown of intangi$le assets will disclose how the value was determined and how they are being amorti,ed. It will also disclose whether current expenditures on research and development are capitali,ed or expensed. The amount of intangible assets compared to their amorti,ation rates and the profits derived from them should be compared to similar companies to determine whether they are overvalued. ension $ene!its may indicate obligations which have not been accounted for. %nderstated

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obligations indicate that the net worth and income is overvalued. It may also indicate unreasonably high pensions being paid to executives. +ther contingencies may indicate outstanding claims and whether a contingency has been provided for such. *d&ustments may be needed to provide contingencies for the extent and risk of these claims. This area may show claims which have depressed the current price of the shares. Depending on the extent of the effect on the share price, the perceived risk of the contingency and the risk attitude of the investor, this may present either a high$risk high$reward investment opportunity or an investment to avoid. If shown in the notes on income taxes, losses carried !orward indicate the extent to which future profits are not taxable. This creates a higher after$ tax return until the losses carried forward have been used up. The extent of anticipated future profits will determine the value of the losses carried !orward. Stoc' options may cause a concern about dilution if there are significant options outstanding and-or the striking price is significantly below the current value of the business. * large amount of stock options may present an incentive to overstate income in an attempt to raise stock prices through aggressive accounting. If stock options were re$

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issued at a lower striking price after a drop in prices, the insiders may be unreasonably benefiting from stock, or stock market volatility. .oncentration of business, or accounts receivable, with a few customers, or a large portion with one customer, may be a concern about the effect that the risk or loss of that key customer may create to future income. In the Related art& .ransactions, a determination should be made as to whether they are being made for the benefit of the owners or the company. If they indicate unusual benefits to the owners such as low interest loans, there should be concern about whether the owners are more intent on their personal gains than those of the business. Su$se%uent Events will state significant events which happened since the date of the financial statements. These events may indicate that future results may be significantly different than prior results. Changes in Accounting olic& may indicate that ad&ustments are needed when comparing previous results. .ontinuous changes to accounting policies may indicate the company is changing accounting policies to create a more positive income statement.

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rior eriod Ad#ustments should be read as to what caused a change in previously reported figures. .onsecutive years of reporting prior period ad#ustments raises concerns about the accounting and the auditor)s ability to find and make the corrections in the correct period. Quantity of Changes in Financial Statement Figures This method determines the dollar value of any changes in figures. The extent of the changes is determined by subtracting the previous period figures from the period figures. (ie/ if the figures for the years 0112, 0110 and 0113 are 45,611, 46,211 and 46,311, the changes would be 4711 846,211 $ 45,6119 for 0110 and 4011 846,311 $ 46,2119 for 0113). This shows the dollar amount of changes from one period to the next. Percent Changes in Financial Statement Figures This method calculates the change as a percent, instead of a dollar figure.

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To determine the percent change, the dollar change is divided by the previous figure (ie/ as in the example above, the 4711 change would be divided by 45,611, yielding a 23.3: change). This method enables the reader to see which figures are changing #uicker than others. Real Dollar Comparisons This method removes the extent of inflation from the figures so the reader can see the figures in real (current) dollar terms. "igures from previous periods are increased by the rate of inflation over that period. Real Dollar Changes +nce real dollar figures are determined for the previous periods, the reader can calculate real dollar changes. These are changes above, or below, the rate of inflation. These figures are calculated by subtracting the previous inflated figures from the next period (ie/ inflated 0112 figures from inflated 0110 figures or inflated prior period figures from non$inflated current period figures).

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Real Dollar Percent Changes This techni#ue shows the real changes in terms of percent instead of dollars. To calculate these figures, divide the real dollar change by the inflated figure for the previous period. ote that consecutive years of real dollar losses in sales or income (profits) is a concern as it shows that the business is growing at a slower rate than inflation. If such is the case, the company may be heading for financial troubles. It also indicates that the slow growth in the business should, at best, be treated as an annuity. The amount of net tangible assets per share should be compared to its current share price to determine the extent of the risk should the business collapse. Common Si ed Ratios Common si(ed ratios are ratios based on a percent of sales for income statement items and a percent of total assets for balance sheet items. These enable a side by side comparison of different si,ed companies. They are usually used for side by side comparisons of period to period results. They are an easy way to compare results.

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Common si(ed income statement ratios show the efficiencies and cost overruns. ;ometimes this method is referred to as vertical anal&sis or cross,sectional anal&sis. Changes in Common Si ed Ratios The changes in common si(ed ratios show whether the efficiency of the business, as measured as a percent of sales, is improving. It also shows how the asset mix, as a percent of total assets, is changing. To calculate these changes, subtract the previous period common si(ed ratio form the current period. Percent Changes in Common Si ed Ratios This calculation shows the degree, as a percent change, in the common si(ed ratios. These percent changes are determined by dividing the change in a common si(ed ratio by the common si,ed ratio for the previous period (ie/ if the common si,ed ratios were 3.6: and 5.0:, the change in common si(ed ratio would be 1.<: and

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the percent change in the common si(ed ratio would be 01: 81.<: divided by 3.6:9). Dollar per Share This techni#ue enables the reader to view the financial statements as if they were allocated to each share, or to 2,111 shares. This is a useful techni#ue to use when the number of outstanding shares has changed. It enables the reader to view the figures relative to their investment in shares. This approach involves dividing the financial statement figures by the number of shares outstanding (or to the thousands of shares outstanding). Change in Dollar per Share +nce the dollar per share calculation is done, the changes from period to period can be calculated by subtracting the previous dollar per share, for any individual item, figure from the current one.

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Percent Change in Dollar per Share This approach calculates the extent of the changes in dollar per share figures in terms of percent. This calculation is mage by dividing the change in dollar per share by the previous period dollar per share figure. Common Dollar !nvestment This is a techni#ue that enables the reader to compare various investments in a common term, money invested. In this approach, the financial statement figures are divided by the mar'et capitali(ation (number of shares outstanding x the market price per share) or suggested selling price for the business. If comparing different periods for the same company, using their market prices at the end of each period will compare similar investments in the company at different points in time. ;ince the figures are small, it is usually better to calculate the figures per 42,111 investment instead of per dollar.

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Change in Common Dollar !nvestment This approach enables the reader to determine the changes of investing at this period than at a previous point in time. This involves subtracting the common dollar (or 42,111) investment figures from the previous period to those of the current period. Percent Change in Common Dollar !nvestment Figures This expresses the change in common dollar investment as a percent. It is accomplished by dividing the change in common dollar investment by the previous period common dollar investment figure. Comparisons to N"!# .omparing costs to NBI. (Net $e!ore Income and .axes) determines the effect that improvements in cost categories will have on !IT. ;ome costs may have a numeric value that exceeds that on the !IT. These costs create a greater

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percent gain in !IT than their percentage decrease. *n example is a cost which has a numeric value 01: greater than !IT. * 2: decrease in that cost would produce a 2.0: improvement in !IT. This method enables management to determine where to concentrate to achieve improvements and the effects that their percentage improvement will have on the !IT. Ratio Analysis This is the method of analysis used by most people who do any more than a cursory analysis of the financial statements. =atio analysis enables the user to compare numbers from different categories. It also enables the reader to compare differing si,ed businesses. >ost of our ratios are derived by comparing Balance Sheet and Income Statement figures. ?ater in this book we provide over 011 ratios. These are divided into "i%uidit& Ratios, "everage Ratios, E!!icienc& Ratios, ro!ita$ilit& Ratios, .urnover Ratios, Cash Flow Ratios, Sales Ratios, Investment Ratios, "a$or Ratios, Costs per

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Emplo&ee Ratios, /iscretionar& Cost Ratios, roductivit& and 0nowledge Ratios and -ther Accounting Ratios. $ptimal Performance The optimal per!ormance is a calculation of what the business could perform based on the best results of previous years. The optimal result is the highest sales figure, the lowest common si,ed ratios times this sales figure for variable costs, and the lowest cost for fixed costs. Side-by-Side Comparisons to $ptimal +nce the optimal per!ormance is calculated, it can be placed beside actual results for a side,$&,side comparison. Actual sales are compared to optimal sales (highest sales of previous years). 1aria$le costs are compared to actual sales multiplied by optimal common si(ed ratios. *ctual gross margin (sales less varia$le costs) is separated into sales volume (8actual sales x optimal common si(ed ratios9 @ 8optimal sales x optimal common si(ed ratios9).

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Fixed costs are compared to optimal costs (optimal sales x optimal common si(ed ratio for that item). Dollar Comparisons to $ptimal This calculates the extent to which line items and total profits could have been improved had the business performed at their optimal. It shows the extent of business losses due to su$,optimal per!ormance. This method is a variance anal&sis by comparing actual results to the optimal. E!!icienc& variances are calculated by subtracting !lexed optimal varia$le costs (optimal common si(ed ratio for variable cost item x actual sales) from actual varia$le costs. Sales volume variance is calculated by subtracting the optimal gross margin (optimal sales x optimal common si(ed ratios) from the optimal !lexed gross margin (actual sales x optimal common si(ed ratios). -ptimal !ixed costs are subtracted from actual !ixed costs. ote that all variances will be negative numbers, also referred to as un!avora$le variances.

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Percent Comparisons to $ptimal This calculation shows the extent, in terms of percent improvement, that the business needs for various line items to bring them to their optimal. These calculations are made by dividing the variances by the actual results. The sales volume variance will be divided by the optimal !lexed gross margin. Real Dollar $ptimal Analysis This is an offshoot of optimal anal&sis, using inflated figures. This is the same as the optimal anal&sis, except real dollar !igures (income statement figures inflated by the inflation rate) are used to calculate the optimal performance. (hile the common si(ed ratios will remain the same, this method forces the optimal !igures to account for price variances due to inflation. %ariance Analysis 1ariance anal&sis is used internally by comparing actual income statement results to budget. The

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resulting variances are either !avora$le (better than budgeted) or un!avora$le (worse than budgeted). The budget results used may be actual $udget, or a !lexed $udget, where the budget is ad&usted to reflect what the budget would have been for the actual amount produced. The difference between the actual and flexed budget is referred to as the production variance or !lexed $udget variance. The difference between the actual budget and original budget is called the activit& variance. ;ome variances are broken into factors which contribute to the changes. In a !lexed $udget, cost o! sales may be broken into price variance ((actual price @ standard or budgeted price) x actual usage) and %ualit& variance ((actual usage @ budgeted usage) x budgeted price). 2ualit& variances may be broken into mix variance ((budgeted mix @ actual mix) x actual #uantity) and &ield variances (budgeted #uantity of individual input item @ actual #uantity of input item) x budgeted cost). "a$or variances may be broken into la$or rate variance ((actual rate @ budgeted rate) x actual usage) and la$or e!!icienc& variance or la$or use variance ((actual hours @ budgeted hours) x budgeted rate).

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"usiness %aluation The value o! a pu$lic compan& can be determined by multiplying the number of outstanding common shares by the price per share. The value o! a private compan& is based upon the greater of the value as a going concern or the disposal value. The disposal value can be determined based on the balance sheet items. *ll lia$ilities are based on actual prices. Assets are based on their recovery after disposal costs. Typical asset recoveries are 211: for cash, A<: for mar'eta$le securities, B1: for accounts receiva$le and 61: for inventor&. Fixed assets need to be appraised. .osts for canceling contracts and leases reduce the disposal value. The ongoing $usiness value is based on the business continuing operations. *ll non$arms length transactions are converted to arms$length prices. .alculations are made regarding changes to bring ratios to normal with ad&ustments to the price made for excess cash or insufficient cash. Interest rates are ad&usted to current levels.

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The resulting ad&usted income statement is ad&usted by a multiplier, which is usually between 3 to 5 times. The price is reduced by the amount of excess cash and increased by the amount of additional investment re#uired. The multiplier is a factor of performance measures such as growth in sale, growth in profits, years of sales growth and years of profit growth. +ther ad&ustments are made for market considerations such as number of interested purchasers and industry expectations.

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&i'uidity Ratios
The li%uidit& ratios are the basic bank financial ratios. "i%uidit& ratios are the financial statement ratios which measure the ability of a business to meet its short term financial obligations on time and, as such, are usually used by potential creditors. "i%uidit& ratios are also referred to as solvenc& ratios. Cash Ratio Cash Ratio ( cash ) current liabilities* The cash ratio (cash to current liabilities ratio) measures the immediate amount of cash available to satisfy short term debt. * ratio of 1.6/2 or greater is preferred. Acid #est Ratio Acid #est Ratio ( +cash , mar-etable securities. ) current liabilities

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The acid test ratio measures the immediate amount of cash immediately available to satisfy short term debt. *n acid test ratio of 1.<6/2 or greater is preferred. Quic- Ratio Quic- ratio ( +cash , mar-etable securities , accounts receivable. ) current liabilities* The %uic' ratio is used to evaluate li#uidity. Cigher %uic' ratios are needed when a company has difficulty borrowing on short term notice * %uic' ratio of over 2/2 indicates that if the sales revenue disappeared, the business could meet its current obligations with the readily available D#uickD funds on hand. * %uic' ratio of 2/2 is considered satisfactory unless the ma&ority of D#uick assetsD are in accounts receivable and the company has a pattern of collecting accounts receivable slower than paying accounts payable. The %uic' ratio is one of 25 key business ratios used by Dun and !radstreet.

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Current Ratio Current Ratio ( current assets ) current liabilities* The current ratio is used to evaluate the li#uidity, or ability to meet short term debts. Cigh current ratios are needed for companies that have difficulty borrowing on short term notice. The generally acceptable current ratio is 0/2 The minimum acceptable current ratio is 2/2 The current ratio is one of 25 key business ratios used by Dun and !radstreet. The current ratio is also known as the real ratio or wor'ing capital ratio. Accounts Receivable to Accounts Payable Ratio Accounts Receivable to Accounts Payable ( accounts receivable ) accounts payable The accounts receiva$le to accounts pa&a$le ratio is also called the receiva$les to pa&a$les ratio.

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This ratio shows the extent to which payables can be paid through collection of receivables. * ratio of 2/2 or greater shows that the business has more money owing to it than it owes to others. * ratio above 2.06/2 indicates that all payables can be paid by factoring receivables. %nless the business is a cash business, or the receivables have not been paid through recent cash increases from collections, a ratio below 2/2 is a concern as the business owes more to others than what is owed to them. Cash Debt Coverage Ratio Cash Debt Coverage ( +cash flo/ from operations - dividends. ) total debt* The cash de$t coverage ratio shows the percent of debt that current cash flow can retire. * cash de$t coverage ratio of 2/2 (211:) or greater shows that the company can repay all debt within one year.

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Current &iabilities to !nventory Current &iabilities to !nventory ( current liabilities ) inventory The current lia$ilities to inventor& ratio is used by Dun and !radstreet. This ratio indicates the extent to which business relies on the sale of its inventory to pay its debt. * ratio above 2/2 is a concern. Current &iabilities to Net 0orth Current &iabilities to Net 0orth ( current liabilities ) shareholder e'uity The current lia$ilities to net worth ratio is one of the 25 ratios used by Dun and !radstreet to determine credit risk. The larger the ratio, the greater the risk for creditors. * ratio of more than 1.7</2 is a concern for lenders.

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Current &iabilities to #otal &iabilities Current &iabilities to #otal &iabilities ( current liabilities ) +current liabilities , long term debt. The current lia$ilities to total lia$ilities ratio is also called the short,term de$t ratio or %ualit& o! de$t ratio. This ratio shows the extent to which debt is payable in the current year. * low ratio indicates less concern for ability to pay debts during the current year. Fi1ed Assets to Net 0orth Fi1ed Assets to Net 0orth ( fi1ed assets ) shareholders e'uity The !ixed assets to net worth ratio is used by Dun and !radstreet. Eenerally, a low ratio is favored. * high ratio may be a concern as it indicates a low wor'ing capital to net worth ratio.

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* ratio above 1.<6/2 indicates possible over$ investment in fixed assets. &i'uidity !nde1 &i'uidity !nde1 ( ++accounts receivable 1 collection period. , +inventory 1 cycle period.. ) +cash , accounts receivable , inventory.* The li%uidit& index indicates the number of days during which assets are removed from cash. * low li%uidit& index indicates that the business can turn money over more times yielding higher sales. * high or increasing ratio may indicate problems converting inventory purchases into cash receipts from sales. &ong #erm Debt to Shareholders 2'uity &ong #erm Debt to Shareholders 2'uity ( long term debt ) shareholders e'uity* This ratio indicates the extent to which the business is financed through long term debt.

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* ratio of greater than 2/2 indicates that the business is heavily levered and may not be able to attain further financing through debt. * ratio of less than 2/2 indicates that the business may be able to attain further funding through debt, which is usually #uicker to attain than e#uity financing. Net 0orth to #otal Debt Net 0orth to #otal Debt ( net /orth ) +current liabilities , long term debt. The net worth to total de$t ratio is also referred to as net worth to total lia$ilities or solvenc& ratio. This ratio compares what is owned by the investors to what is owed to creditors. * ratio of 2/2 or greater is preferred by lenders as it indicates that more of the business is owned by the investors than the amount owed to creditors. #otal Assets to #otal Debt #otal Assets to #otal Debt ( total assets ) +current liabilities , long term debt.

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This ratio compares the amount of the assets of the business to what it owes. * ratio of 0/2 or greater is preferred as it indicates that less than half of assets are encumbered with debt. * ratio of greater than 0/2 indicates that more of the business is owned by investors than creditors. #otal &iabilities to Net 0orth #otal &iabilities to Net 0orth ( total liabilities ) shareholders e'uity The total lia$ilities to net worth ratio is used by Dun and !radstreet. * low or decreasing ratio is preferred by creditors. * ratio above 2/2 is a concern to lenders as creditors would have a larger stake in the business than the shareholders.

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0or-ing Capital from $perations to #otal &iabilities 0or-ing Capital from $perations to #otal &iabilities ( +operating profit plus depreciation. ) total liabilities This ratio measures the degree by which internally generated working capital is generated to satisfy obligations. This ratio indicates the interest rate charge that the business can weather before while still generating a positive cash flow.

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&everage Ratios
"everage ratios are the financial statement ratios which show the degree to which the business is leveraging itself through its use of borrowed money. "everage ratios are of direct interest to current and potential lenders and investors, as they wish to know the expected return that the business will achieve from borrowing money. Capital Ac'uisition Ratio Capital Ac'uisition Ratio ( +cash flo/ from operations - dividends. ) cash paid for ac'uisitions and investments in other companies* The capital ac%uisition ratio reflects the companyFs ability finance capital expenditures from internal sources. * ratio of less than 2/2 (211 :) indicates that capital ac#uisitions are draining more cash from the business than it is generating.

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Capital 2mployment Ratio Capital 2mployment Ratio ( sales ) +o/ners e'uity - non-operating assets.* The capital emplo&ment ratio is also referred to as the capital employed ratio. The capital emplo&ment ratio shows the amount of sales which ownerFs investment in operations generates. * high or increasing ratio is preferred. +ar'eta$le securities are considered non, operating assets. Capital Structure Ratio Capital Structure Ratio ( long term debt ) +shareholders e'uity , long term debt.* The capital structure ratio shows the percent of long term financing represented by long term debt. * capital structure ratio over 61: indicates that a company may be near their borrowing limit (often 76:).

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Capital to Non-Current Assets Ratio Capital to Non-Current Assets Ratio ( o/ners e'uity ) non-current assets * higher capital to non,current assets ratio indicates that it is easier to meet the businessF debt and creditor commitments. * high ratio may indicate insufficient working capital being used to generate sales. Cash Ratio Cash Ratio ( cash ) current liabilities The cash ratio (cash to current liabilities ratio) measures the immediate amount of cash available to satisfy short term debt. * ratio above 1.<6/2 is preferred. Cash "alance Cash "alance ( +cash 1 345 days. ) +cost of sales 6e1cluding depreciation7.

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The cash $alance ratio is also referred to as da&s cash $alance* The cash $alance ratio indicates the number of days that a company can pay its debts, as they become due, out of current cash. * low ratio may indicate a high reliance on collecting receivables to pay debts as they become due. ;uch reliance can turn a collection problem #uickly into a credit problem. Debt to 2'uity Ratio Debt to 2'uity Ratio ( +Short #erm Debt , &ong #erm Debt. ) #otal Shareholders 2'uity The de$t to e%uit& ratio is also referred to as de$t ratio, !inancial leverage ratio, gearing ratio or leverage ratio. The de$t to e%uit& 3de$t or !inancial leverage) ratio indicates the extent to which the business relies on debt financing. %pper acceptable limit of the de$t to e%uit& (de$t or !inancial leverage) ratio is usually 0/2, with no more than one$third of debt in long term.

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Eenerally, lenders prefer a ratio of 2/2 or lower as it indicates that more of the business is owned by the investors than by the debtors. * high !inancial leverage or de$t to e%uit& ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Debt Ratio Debt Ratio ( total liabilities ) total assets The de$t ratio is also known as the de$t to assets ratio. The de$t ratio shows the reliance on debt financing. This ratio indicates the extent to which assets are encumbered by debt. * high de$t ratio is unfavorable because it indicates that the company is already overburdened with debt. * ratio of greater than 1.6/2 or greater indicates that the business is financed more from debt than from shareholders.

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* ratio near or above 1.6/2 indicates that the business may have problems obtaining further credit or debt financing. Defensive !nterval Period Defensive !nterval Period ( +cash , mar-etable securities , accounts receivable. ) average daily purchases* This ratio indicates how long a business can operate on its li#uid assets without needing further revenues. The de!ensive interval period reveals near$term li#uidity as a basis to meet expenses. 2'uity 8ultiplier 2'uity 8ultiplier ( total assets ) shareholders e'uity* The e%uit& multiplier discloses the amount of investment leverage. * ratio above 0/2 indicates that the business is overleveraged and may have problems obtaining further credit or loans.

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Financial &everage Ratio Financial &everage Ratio ( total debt ) shareholders e'uity* The !inancial leverage ratio is also referred to as the de$t to e%uit& ratio or gearing ratio. The !inancial leverage ratio indicates the extent to which the business relies on debt financing. %pper acceptable limit of the !inancial leverage ratio is usually 0/2, with no more than one$third of debt in long term. * high financial leverage ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Fi1ed Assets to Short #erm Debt Fi1ed Assets to Short #erm Debt ( fi1ed assets ) +accounts payable , current portion of long term debt.* The !ixed assets to short term de$t ratio can indicate dangerous financial policies due to business vulnerability in a tight money market.

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* low !ixed assets to short term de$t ratio indicates the return on fixed assets may not be reali,ed before long term liabilities mature. Fi1ed Costs to #otal Assets Ratio Fi1ed Costs to #otal Assets ( fi1ed costs ) total assets *n increase in the !ixed costs to total assets ratio may indicate higher fixed charges, possibly resulting in greater instability in operations and earnings. Fi1ed Coverage Ratio Fi1ed Coverage ( earnings before interest and ta1es ) fi1ed charges* The !ixed coverage ratio indicates the ability of a business to pay fixed charges (fixed costs) when business activity falls. The !ixed coverage ratio is also referred to as the !ixed charge coverage ratio. !nterest Coverage Ratio

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!nterest Coverage Ratio ( +net income , interest. ) interest* The interest coverage ratio is also referred to as the times interest earned ratio. The interest coverage ratio indicates the extent of which earnings are available to meet interest payments. * lower interest coverage ratio means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates. &ong #erm Debt to Current &iabilities &ong #erm Debt to Current &iabilities ( long term debt ) current liabilities The long term de$t to current lia$ilities ratio is also referred to as inde$tedness ratio4 This ratio shows the extent to which the business has financed its debt by long term debt. * higher ratio indicates that the ma&ority of debt is not payable in the current year. &ong #erm Debt to Shareholder9s 2'uity

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&ong #erm Debt to Shareholder9s 2'uity ( long term debt ) shareholders e'uity* * high ratio is unfavorable because it indicates possible difficulty in meeting long term debt obligations. Non-Current Assets to Non-Current &iabilities Non-Current Assets to Non-Current &iabilities ( non-current assets ) non-current liabilities This ratio indicates protection (collateral) for long term creditors. * lower ratio means that there is a lower amount of assets backing long term debt. $perating &everage $perating &everage ( percent change in 2"!# ) percent change in sales* The operating leverage reflects the extent to which a change in sales affects earnings.

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* high operating leverage ratio, with a highly elastic product demand, will cause sharp earnings fluctuations.

Retained 2arnings to #otal Assets Retained 2arnings to #otal Assets ( retained earnings ) total assets This ratio indicates the extent to which assets have been paid for by company profits. * retained earnings to total assets ratio near 2/2 (211:) indicates that growth has been financed through profits, not increased debt. * low ratio indicates that growth may not be sustainable as it is financed from increasing debt, instead of reinvesting profits. Short #erm Debt to Depreciation Short #erm Debt to Depreciation ( current portion of long term debt ) depreciation * short term de$t to depreciation ratio of close to 2/2 (211:) indicates that the repayment of

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long term debt is in line with the life of the assets. This ratio should be in line with inflation in fixed asset prices. Short #erm Debt to &iabilities Short #erm Debt to &iabilities ( +accounts payable , current portion of long term debt. ) +accounts payable , current portion of long term debt, long term debt. This ratio indicates li#uidity. * higher ratio means less li#uidity. Short #erm Debt to &ong #erm Debt Short #erm Debt to &ong #erm Debt ( +accounts receivable , current portion of long term debt. ) long term debt* The short to long term de$t ratio can indicate if a business is vulnerable to a money market s#uee,e.

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:ears Debt :ears Debt ( total debt ) +operating profits , depreciation. The &ears de$t ratio indicates the number of years that cash flows at the current rate will be needed to repay all debt.

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2fficiency Ratios
E!!icienc& ratios are the financial statement ratios that measure how effectively a business uses and controls its assets. E!!icienc& ratios are of concern to current and potential lenders, investors and owners as they wish to see how efficient the business is run. E!!icienc& ratios are often referred to as activit& ratios. Accounts Payable to Sales Accounts Payable to Sales ( accounts payable ) sales The accounts pa&a$le to sales ratio measures the extent to which creditors are being paid. * high or increasing ratio may indicate that operations are being financed through suppliers. * high ratio may indicate a problem paying creditors. This ratio is used by Dun and !radstreet.

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Accounts Receivable #urnover Ratio Accounts Receivable #urnover Ratio ( annual credit sales ) average accounts receivable This is the ratio of the number of times that accounts receivable amount is collected throughout the year. * high accounts receiva$le turnover ratio indicates a tight credit policy. * low or declining accounts receiva$le turnover ratio indicates a collection problem, part of which may be due to bad debts. Age of !nventory Age of !nventory ( 345 days ) inventory turnover ratio The age o! inventor& ratio is also referred to as the num$er o! da&s inventor&, da&s inventor&, average inventor& period, da&s sales in inventor& or inventor& holding period4 The age o! inventor& shows the number of days that inventory is held prior to being sold.

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*n increasing age o! inventor& ratio indicates a risk in the companyFs inability to sell its products. Individual inventory items should be examined for obsolete or overstocked items. * low or decreasing age o! inventor& ratio may indicate that sufficient inventory is not being held to meet demands. The age o! inventor& should be compared to competitors. Assets to Sales Assets to Sales ( total assets ) sales The assets to sales ratio indicates the amount of assets re#uired for each dollar of sales. Cigh ratios may indicate poor sales. * low ratio may indicate insufficient investment. The assets to sales ratio is used by Dun and !radstreet. Average Collection Period Collection Period ( +accounts receivable ; 345 days. ) credit sales

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Collection Period ( 345 days ) accounts receivable turnover ratio The average collection period is sometimes referred to as da&s to collect. The average collection period calculation uses the average accounts receivable over the sales period. The collection period or average collection period must be compared to competitors to see whether the credit given, and customer risk, is in line with the industry. * high collection period shows a high cost in extending credit to customers. The collection period is used by Dun and !radstreet. * collection period more than one$third longer than credit terms (ie/ 51 days for companies with 31 day terms of payment) is a concern. Average $bligation Period Average $bligation Period ( accounts payable ) average daily purchases*

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The average o$ligation period is sometimes referred to as o$ligation period or da&s to pa&. The average o$ligation period ratio measures the extent to which accounts payable represents current obligations (rather than overdue ones). * high or increasing ratio may indicate problems paying bills as they become due. "ad Debts Ratio "ad Debts Ratio ( bad debts ) accounts receivable* The $ad de$ts ratio is an overall measure of the possibility of the business incurring bad debts. The higher the $ad de$ts ratio< the greater the cost of extending credit. "rea-even Point "rea-even Point ( fi1ed costs ) contribution margin* The $rea'even point is the point at which a business breaks even (incurs neither a profit nor a loss).

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The $rea'even point is the minimum amount of sales re#uired to make a profit. Increasing $rea'even points (period to period) indicates an increase in the risk of losses. Cash "rea-even Point Cash "rea-even Point ( +fi1ed costs depreciation. ) contribution margin per unit* The cash $rea'even point indicates the minimum amount of sales re#uired to contribute to a positive cash flow. Cash Dividend Coverage Cash Dividend Coverage ( +cash flo/ from operations. ) dividends* The cash dividend coverage ratio reflects the companyFs ability to meet dividends from operating cash flow. * cash dividend coverage ratio of less than 2/2 (211 :) indicates that dividends are draining more cash from the business than it is generating.

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Cash 8aturity Coverage Cash 8aturity Coverage ( +cash flo/ from operations - dividends. ) current portion of long term maturities* The cash maturit& coverage ratio indicates the ability to repay long term maturities as they mature. The cash maturit& coverage ratio indicates whether long term debt maturities are in time with operating cash flow. Cash Reinvestment Ratio Cash Reinvestment Ratio ( increases in fi1ed assets and /or-ing capital ) +net income , depreciation.* This ratio indicates the degree to which net income is absorbed (reinvested) in the business. * cash reinvestment ratio of greater than 2/2 (211:) indicates that more cash is being used in the business than being obtained.

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Cash Return on Assets Cash Return on Assets +e1cluding interest. ( +cash flo/s from operations before interest and ta1es. ) total assets* Cash Return on Assets +including interest. ( +cash flo/ from operations. ) total assets* * higher cash return on assets ratio indicates a greater cash return. The cash return on assets 3excluding interest5 contains no provision for replacing assets or future commitments. The cash return on assets 3including interest5 indicates internal generation of cash available to creditors and investors. Cash #urnover Ratio Cash #urnover ( +cost of sales =e1cluding depreciation>. ) cash* Cash #urnover Ratio ( +345 days.) cash balance ratio* The cash turnover ratio indicates the number of times that cash turns over in a year.

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Collection Period to Payment Period Collection Period to Payment Period ( collection period ) payment period* The collection period to pa&ment period above 2/2 (211:) indicates that suppliers are being paid more rapidly than the company is collecting from their customers. Days of &i'uidity Days of &i'uidity ( +'uic- assets 1 345 days. ) years cash e1penses* The da&s o! li%uidit& ratio indicates the number of days that highly li#uid assets can support without further cash coming from cash sales or collection of receivables. Fi1ed Charge Coverage Ratio Fi1ed Charge Coverage Ratio ( +Net !ncome "efore !nterest and #a1es - interest , fi1ed costs. ) fi1ed costs* The !ixed charge coverage ratio indicates the risk involved in ability to pay fixed costs when business activity falls.

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!nventory #urnover Ratio !nventory #urnover Ratio ( cost of goods sold ) average inventory* The inventor& turnover ratio measures the number of times a company sells its inventory during the year. * high inventor& turnover ratio indicated that the product is selling well. The inventor& turnover ratio should be done by inventory categories or by individual product. 8argin of Safety Ratio 8argin of Safety Ratio ( +e1pected sales brea-even sales. ) brea-even sales* The margin o! sa!et& ratio shows the percent by which sales exceed the breakeven point. $perating Cycle $perating Cycle ( days of inventory , collection period

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-perating C&cle is the time from receiving inventory to collecting money on its sale. * low or decreasing ratio indicates the inventory is turning over and being collected in a timely manner. * high ratio indicates the inventory is not selling or there are problems collecting on the sale. Payment Period Payment Period ( +345 days 1 supplies payable. ) inventory* The pa&ment period indicates the average period for paying debts related to inventory purchases. * high pa&ment period may indicate that the business is having problems generating cash to pay for inventory purchases. During growth periods, the pa&ment period may increase due to increased inventory purchases to support increased sales.

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Payment Period to Average !nventory Period Payment Period to Average !nventory Period ( payment period ) average inventory period * pa&ment period to average inventor& period above 2/2 (211:) indicates that the inventory is sold before it is paid for (inventory does not need to be financed). The average inventor& period is also known as the inventor& holding period4 Payment Period to $perating Cycle Payment Period to $perating Cycle ( payment period ) +average inventory period , collection period.* * pa&ment period to operating c&cle ratio above 2/2 (211:) indicates that the inventory is sold and collected before it is paid for (inventory does not need to be financed). * high pa&ment period to operating c&cle ratio indicates that the company may be vulnerable to tightened terms of payments from their suppliers.

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(the average inventor& period is also known as the inventor& holding period) Revenue per 2mployee Revenue per employee +net sales per employee. ( net sales ) number of employees This ratio indicates the average revenue generated per person employed. It shows how productive employees are and how efficient the business is. Sales to !nventory Sales to !nventory ( sales ) inventory The sales to inventor& ratio shows the speed which inventory is sold. This ratio varies with different lines, markups and businesses. This ratio should be compared to other businesses. ?ow sales to inventor& ratios indicate excessive inventory.

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Gxtremely high figures may indicate insufficient inventory to met demand resulting in lost sales. The sale to inventor& ratio is used by Dun and !radstreet.

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Profitability Ratios
The pro!ita$ilit& ratios are the basic bank financial ratios. ro!ita$ilit& ratios are the financial statement ratios which focus on how well a business is performing in terms of profit. ro!ita$ilit& ratios are of direct concern for current and potential investors. Cash Debt Coverage Ratio Cash Debt Coverage ( +cash flo/ from operations - dividends. ) total debt* The cash de$t coverage ratio shows the percent of debt that current cash flow can retire. * cash de$t coverage ratio of 2/2 (211:) or greater shows that the company can repay all its debt within one year. Cash Return on Assets Cash Return on Assets +21cluding !nterest. ( +cash flo/s from operations before interest and ta1es. ) total assets*

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Cash Return on Assets +!ncluding !nterest. ( +cash flo/ from operations. ) total assets* * higher cash return on assets ratio indicates a greater cash return. The cash return on assets 3excluding interest5 contains no provision for replacing assets or future commitments. The cash return on assets 3including interest5 indicates internal generation of cash available to creditors and investors. Cash Return to Shareholders Cash Return to Shareholders ( cash flo/ from operations ) shareholders e'uity The cash return to shareholders ratio indicates a return earned by shareholders. * ratio above 21: is preferred. Contribution 8argin Ratio Contribution 8argin ( sales - variable costs*

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Contribution 8argin Ratio ( +sales - variable costs.)sales* Contri$ution margin is the amount generated by sales to cover fixed costs. The contri$ution margin ratio indicates the percent of sales available to cover fixed costs and profits. Current Return on #raining and Development Current Return on #raining and Development ( increase in productivity and -no/ledge contribution ) training costs This ratio is a general indicator of the current return on training and development. Debt Service Coverage Ratio Debt Service Coverage Ratio ( net operating income ) +interest , current portion of &#D. The de$t service coverage ratio is also called the de$t coverage ratio, de$t service capacit& ratio or /SCR.

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The de$t service coverage ratio shows the ability to meet annual interest and debt repayment obligations. * ratio of less than 2/2 means the business does not have sufficient cash flow to meet its debt re#uirements. Deflated Profit ?ro/th Deflated Profit ?ro/th ( +current profits @ +prior profits 1 inflation rate.. ) prior profits The de!lated pro!it growth shows the amount of growth not due to inflation. * positive number indicates that the profits are growing faster than inflation. * negative number indicates a real decline in profits. 2arning Po/er 2arning Po/er ( net profit ) +shareholders e'uity @ intangible assets. Earning power is also referred to as net pro!it to tangi$le net worth.

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This measures the return on invested capital and retained earnings. 2"!# to Current &iabilities 2"!# to Current &iabilities ( 2"!# ) current liabilities This ratio shows the ability to cover current liabilities with earnings. * ratio above 2/2 is preferred. 2"!# to #otal Sales 2"!# to #otal Sales ( 2"!# ) total sales This ratio is also referred to as Return on Sales. EBI. to .otal Sales evaluates the operational efficiency of the business. * low or declining ratio indicates that the business is near its breakeven point.

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21penses to Current Assets 21penses to Current Assets ( +cost of sales , operating e1penses , ta1es. ) average current assets* The expenses to current assets ratio shows the ade#uacy of current assets to satisfy ongoing business related expenses. ?ross Profit 8argin Ratio ?ross Profit 8argin Ratio ( gross profit ) sales* The gross pro!it margin ratio is also called gross margin ratio. To calculate gross pro!it, subtract cost of sales (variable costs) from sales. (i.e. gross profit H sales $ cost of sales) * low gross pro!it margin ratio (or gross margin ratio) indicates that a low amount of earnings, re#uired to pay fixed costs and profits, is generated from revenues. * low gross pro!it margin ratio (or gross margin ratio) indicates that the business is unable to control its production costs.

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The gross pro!it margin ratio (or gross margin ratio) provides clues to the companyFs pricing, cost structure and production efficiency. The gross pro!it margin ratio (or gross margin ratio) is a good ratio to benchmark against competitors. ?ro/th in 2arnings per Share +2PS. ?ro/th in 2arnings Per Share +2PS. ( +2PS at end of period - 2PS at beginning of period. ) 2PS at beginning of period The growth in earnings per share indicates the amount of growth for investors. This ratio helps determine the multiplier used in calculating the companyFs market value. * higher ratio yields a higher multiplier. The trend in this ratio indicates whether growth is steady, sporadic, accelerating or declining. * high or increasing ratio is preferred.

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Net !ncome !ncreases to Pay !ncreases Net !ncome !ncreases to Pay !ncreases ( change in net income ) change in salaries< /ages and benefits This ratio shows whether net income is increasing faster than wages (in dollar terms). * ratio of less than 2/2 (211:) indicates that profitability increases are less than the increases in wages. * recurring ratio of less than 2/2 (211:) indicates eroding profits and is a cause for concern. This ratio calculates the effect in dollar terms. The analyst should also calculate percent increase in net income to percent increase in salaries, wages and benefits. Net !ncome to Assets Net !ncome to Assets ( net profit before ta1es ) total assets* The net income to assets ratio is also referred to as the return on assets ratio.

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The net income to assets ratio provides a standard for evaluating how efficiently financial management employs the average dollar invested in the firmFs assets, whether the dollar came from investors or creditors. * low net income to assets ratio indicates that the earnings are low for the amount of assets. The net income to assets ratio measures how efficiently profits are being generated from the assets employed. * low net income to assets ratio compared to industry averages indicates inefficient use of business assets. Net !ncome to Fi1ed Charges Net !ncome to Fi1ed Charges ( net income ) fi1ed charges et income to fixed charges indicates the ability to pay fixed costs. * low or declining ratio indicates possible problems paying fixed costs, and posting a profit.

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Net Profit 8argin Ratio Net Profit 8argin Ratio +After #a1 8argin Ratio. ( net profit after ta1 ) sales* Preta1 8argin Ratio ( net profit before ta1es ) sales* $perating Profit 8argin +$perating 8argin. ( net income from operations ) sales* These ratios are also called return on sales and $asic earning power. These three pro!it margin ratios state how much profit the company makes for every dollar of sales. The net pro!it margin ratio is the most commonly used pro!it margin ratio. * low net pro!it margin ratio indicates that low amount of earnings re#uired to pay fixed costs and profits are generated from revenues. * low net pro!it margin ratio indicates that the business is unable to control its production costs. The net pro!it margin ratio provides clues to the companyFs pricing, cost structure and production efficiency.

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The net pro!it margin ratio is a good ratio to benchmark against competitors. Net $ne #ime ?ains to Net !ncome Net $ne #ime ?ains to Net !ncome ( e1traordinary profit or loss ) net income * rising percent in extraordinary profit - loss or prior period ad&ustments indicates deterioration in earnings #uality, which will be reflected in a lower multiplier when determining the value of the shares. Non-$perating !ncome to Net !ncome Non-operating !ncome to Net !ncome ( nonoperating income ) net income Increasing ratios may indicate changes in accounting made to boost profits. Increasing ratios may mean that the business is moving away from its core business.

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$perating !ncome to 0ages and Salaries $perating !ncome to 0ages and Salaries ( operating income ) +salaries , /ages , benefits. This ratio shows the relationship between operating income and amount of wages and salaries paid. * declining trend indicates a narrowing of margins and is a cause for concern. $perating 8argin $perating 8argin ( +earnings before interest and ta1es. ) sales* The operating margin is also referred to as operating pro!it margin, or EBI. to sales ratio. The operating margin ratio determines whether the fixed costs are too high for the production volume. * high or increasing ratio is preferred.

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Percent Change in $perating !ncome vs* Sales %olume Percent change in operating income vs* sales volume ( A change in operating income ) A change in sales volume *n increase may indicate higher fixed charges. Profit ?ro/th Profit ?ro/th ( +current profit @ previous profit. The profit gro/th shows the extent to which the profits improved over the previous year. * low or declining pro!it growth indicates that the business may have matured and sales and profits have reached their plateau. * low or declining ratio is a cause for concern about future profits. Profit ?ro/th Consistency

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Profit ?ro/th Consistency ( number of consecutive years that profits /ere greater than those of the previous year The pro!it growth consistenc& shows the number of years that profits have grown. Profits per 2mployee Profits per 2mployee +Net !ncome per 2mployee. ( net income ) number of employees This ratio indicates the average profit generated per person employed. * high or increasing ratio indicates that employees are highly productive. Return on Assets Return on Assets ( net profit before ta1es ) total assets* The return on assets ratio provides a standard for evaluating how efficiently financial management employs the average dollar invested in the firmFs assets, whether the dollar came from investors or creditors.

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* low return on assets ratio indicates that the earnings are low for the amount of assets. The return on assets ratio measures how efficiently profits are being generated from the assets employed. * low return on assets ratio compared to industry averages indicates inefficient use of business assets. Dun and !radstreet use this ratio using after tax profits. Return on Capital 2mployed Return on Capital 2mployed ( N"!# ) +total assets @ current liabilities. The return on capital emplo&ed is also referred to as R-CE. This ratio shows the return on capital regardless of whether borrowed or invested. The return on capital emplo&ed should be greater than the interest rate. * return on capital emplo&ed that is less than the interest rate indicates that the investors would

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yield a higher return by lending money than by investing. Return on Common 2'uity Return on Common 2'uity ( +net income @ preferred share dividends. ) +shareholders e'uity @ preferred shares. The return on common e%uit& shows the return after factoring out preferred shares. * return of greater than 21: indicates the ability to pay dividends and retain sufficient funds for future growth. Return on !nvested Capital Return on !nvested Capital ( net income ) +shareholders e'uity @ retained earnings. This ratio shows the return based on the original investment in the company. Return on !nvestment Ratio Return on !nvestment Ratio ( net profits before ta1 ) shareholders e'uity*

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The return on investment ratio provides a standard return on investorFs e#uity. The return on investment ratio is also referred to as return on shareholders e%uit&, return on e%uit&, return on net worth, return on investment or R-I. Return on investment is a key ratio for investors. * ratio above 1.21/2 (21:) shows ability to pay dividends and sustain growth. This is one of the 25 ratios used by Dun and !radstreet to determine credit. Return on Sales Return on Sales ( net after ta1 profit ) sales The return on sales is also referred to as net pro!it margin. The return on sales is a key indicator of business profit. The return on sales indicates the ability to whether falling sales or rising costs.

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* high or increasing ratio is preferred as it indicates growing profits as a percent of sales. * low or declining ratio indicates that the business is dropping towards its breakeven point. This ratio is one of Dun and !radstreet)s 25 ratio indicators. Return on 0or-ing Capital Return on 0or-ing Capital ( sales ) +current assets @ current liabilities. The return on wor'ing capital is also known as wor'ing capital productivit&. The return on wor'ing capital indicates the ability of working capital to generate sales. *n increasing ratio indicates increasing productivity as sales are growing faster than the resources re#uired to generate them. #imes !nterest 2arned Ratio #imes !nterest 2arned Ratio ( +net income , interest. ) interest*

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The times interest earned ratio indicates the extent of which earnings are available to meet interest payments. * lower times interest earned ratio means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates.

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Sales Ratios
The sales ratios indicate the ade#uacy of sales. Sales ratios are of direct concern of management and owners as they indicate whether the cost and return of achieving the sales figures. Deflated Sales ?ro/th Deflated Sales ?ro/th ( +current sales @ +prior sales 1 inflation rate.. ) prior sales The de!lated sales growth shows the amount of growth in sales not due to inflation. * positive number indicates that the sales are growing faster than inflation. * negative number indicates a real decline in sales. Sales ?ro/th Sales ?ro/th ( current year sales @ previous years sales The sales growth measures the amount that sales increased over the previous year

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Sales ?ro/th Consistency Sales ?ro/th Consistency ( number of consecutive years of positive sales gro/th Sales growth consistenc& measures the ability of the company to continue to grow in terms of sales. Sales to Accounts Payable Sales to Accounts Payable ( sales ) accounts payable * high sales to accounts pa&a$le ratio indicates the inability to obtain short$term credit on the form of cost$free funds to finance sales growth. Sales to Advertising and Promotion Sales to Advertising and Promotion ( sales ) +mar-eting , advertising , promotion. This ratio calculates the amount of sales generated by marketing efforts. * ratio below 21/2 is a concern as most businesses budget 21: of sales to those efforts.

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Sales to Advertising< Promotion and Rent Sales to Advertising< Promotion and Rent ( sales ) +mar-eting , advertising , promotion , rent. This ratio is most applicable to retail business. This ratio includes rent as a factor to reflect that higher rents are paid for places with higher traffic of exposure. * ratio below </2 is a concern. Sales to "rea-even Point Sales to "rea--even +or "rea-even. Point ( sales ) brea--even point This ratio reflects the extent to which profits are not vulnerable to a decline in sales. * sales to $rea'even point ratio near 2/1 (211:) means that the company is #uite vulnerable to economic declines. * ratio below 2/2 (211:) indicates that the companyFs sales are inade#uate to cover fixed costs.

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Sales to Cash Sales to Cash ( sales ) cash This is sometimes referred to as cash turnover ratio. * high sales to cash ratio may indicate a cash shortage. * low ratio many reflect the holding of idle and unnecessary cash balances. The sales to cash ratio indicates the number of times that cash turns over per year. * high sales to cash ratio may indicate inade#uate cash on hand. This may lead to financial problems if further financing is not available at reasonable prices. Sales to Current Assets Sales to Current Assets ( sales ) current assets * high sales to current assets ratio indicates deficient working capital.

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* decreasing ratio may indicate that the company has slowed down production resulting in lower inventory of finished goods. Sales to Fi1ed Assets Sales to Fi1ed Assets ( sales ) fi1ed assets* The sales to !ixed assets ratio is often called the asset turnover ratio. * low sales to !ixed assets ratio means inefficient utili,ation or obsolescence of fixed assets, which may be caused by excess capacity or interruptions in the supply of raw materials. Sales to Net !ncome Sales to Net !ncome ( sales ) net income * high ratio indicates a low return on sales. * high sales to net income ratio indicates a low profit margin or a high breakeven point compared to current sales. * declining ratio indicates increased profitability.

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Sales to #otal Assets Sales to #otal Assets ( sales ) total assets * low ratio indicates that the total assets of the business are not providing ade#uate revenue. Sales to 0or-ing Capital Sales to 0or-ing Capital ( sales ) +current assets @ current liabilities. * high ratio may indicate inade#uate working capital which reflects negatively on li#uidity. The sales to wor'ing capital is one of 25 key business ratios used by Dun and !radstreet. #rend in Sales #rend in Sales is the rate at /hich sales are increasing or decreasing The trend in sales is also referred to as the sales trend. * high, positive ratio indicates high growth. * positive ratio is preferred.

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!nvestment Ratios
Investment ratios are used by investors to analy,e stocks. ;ome of the ratios listed in other sections may also be used by investors. Accounts Receivable #urnover Ratio Accounts Receivable #urnover Ratio ( annual credit sales ) average accounts receivable This is the ratio of the number of times that accounts receivable amount is collected throughout the year. * high accounts receiva$le turnover ratio indicates a tight credit policy. * low or declining accounts receiva$le turnover ratio indicates a collection problem, part of which may be due to bad debts. Assets per 2mployee Assets per 2mployee ( fi1ed assets ) number of employees

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Assets per emplo&ee is also called the capital intensit& ratio. This ratio shows the commitment to infrastructure and mechani,ation. "eta "eta ( percent change in share price ) percent change in inde1 Beta measures the volatility of a stock. * $eta above 2/2 indicates the stock price will move by a larger percentage than the index. * $eta below 2/2 indicates that the percentage change in the stock price will move less than the index. * $eta with a negative number indicates that the stock will move in the opposite direction to the market. These stocks reduce the risk of market fluctuation. The ;tandard and 'oor 611, or a similar index, is used in this calculation.

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"oo- %alue per Share "oo- %alue per Share ( shareholders e'uity ) number of shares outstanding The $oo' value per share is an indicator of the underlying value of the net assets of the company. This ratio indicates the likely return to the shareholder if the business is li#uidated. "usiness %alue Premium "usiness %alue Premium ( +capitali ed value @ shareholders e'uity. ) shareholders e'uity "usiness %alue Premium ( +mar-et price per share @ boo- value per share. ) boo- value per share The $usiness value premium compares the market value of a business to the book value. This ratio shows the premium to book value that the stock is trading at. * $usiness valuation premium ratio near ,ero indicates that the shares are selling near their book value.

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* negative ratio indicates the shares are selling below the breakup value of the business. In this case, a profit could be made by buying the business and selling off the assets.

Cash Dividend Coverage Ratio Cash Dividend Coverage ( +cash flo/ from operations. ) dividends* The cash dividend coverage ratio reflects the companyFs ability to meet dividends from operating cash flow. * cash dividend coverage ratio of less than 2/2 (211 :) indicates that dividends are draining more cash from the business than it is generating. Cash to Current &iabilities Cash to Current &iabilities ( cash ) current liabilities Cash to current lia$ilities is also called the cash ratio.

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Cash to current lia$ilities measures the ability of cash to pay off current debt. * ratio below 1.6/2 indicates possible cash flow problems due to buildup of accounts receivable or insufficient cash. Cash to 0or-ing Capital Cash to 0or-ing Capital ( cash ) +current assets @ current liabilities. This ratio shows the extent to which working capital is immediately available. Collection Period Collection Period ( +accounts receivable ; 345 days. ) credit sales Collection Period ( 345 days - accounts receivable turnover ratio The average collection period calculation uses the average accounts receivable over the sales period. The collection period or average collection period must be compared to competitors to see

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whether the credit given, and customer risk, is in line with the industry. * high collection period shows a high cost in extending credit to customers. Cost of Capital Cost of Capital ( +interest rate , +shareholder9s e'uity 1 +net profit ) mar-et capitali ation.. ) +shareholder9s e'uity , &#D , +B*5 1 current portion of &#D.. The cost o! capital is the hurdle rate in internal investment decisions as they should return at least as much as the cost of financing them. 'ro&ects should not be invested in unless the internal rate of return (I==) is at or above the cost o! capital. Cost o! capital is the interest rate usually used by the business to determine the net present value ( 'I) of any investment decision. Current Assets to Current &iabilities Current Assets to Current &iabilities ( current assets ) current liabilities

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The current assets to current lia$ilities ratio is also referred to as the current ratio. The current ratio measures the ability of current assets to cover current liabilities. * ratio above 0/2 is usually preferred. Current Assets to Sales Current Assets to Sales ( current assets ) sales The current assets to sales ratio indicates the extent current assets are leveraged. * low ratio indicates aggressive management seeking a high return on investment. * low ratio indicates that sales may be lost due to insufficient inventory or a tight credit policy. Current Assets to #otal Assets Current Assets to #otal Assets ( current assets ) total assets This ratio shows the percent of assets which turnover within the year.

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This ratio measures the ability to cover the total debt with current assets. *n increasing, or positive, current assets to total assets ratio indicates the business is able to satisfy debt obligations using current assets. Current &iabilities to !nventory Current &iabilities to !nventory ( current liabilities ) inventory The current lia$ilities to inventor& is one of 25 ratios used by Dun and !radstreet. This ratio indicates the reliance on available inventory for payment of debt. This assumes other working capital figures remain the same. Current &iabilities to #otal Debt Current &iabilities to #otal Debt ( current liabilities ) +current liabilities , long term debt. This ratio measures the percent of liabilities that are payable within the year.

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* high or increasing current lia$ilities to total de$t ratio indicates a reliance on short term financing. Current Portion of &#D to Net !ncome Current Portion of &#D to Net !ncome ( current portion of &#D ) net income This ratio indicates the ability to pay current portion of ?TD as it becomes due. * ratio of less than 2/2 indicates inability to repay current portion of ?TD as it becomes due. Debt to 2'uity Ratio Debt to 2'uity Ratio ( +short term debt , long term debt. ) total shareholders e'uity The /e$t to E%uit& Ratio is also referred to as /e$t Ratio, Financial "everage Ratio or "everage Ratio. The de$t to e%uit& 3de$t or !inancial leverage) ratio indicates the extent to which the business relies on debt financing.

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%pper acceptable limit of the de$t to e%uit& (de$t or !inancial leverage) ratio is usually 0/2, with no more than one$third of debt in long term. * high !inancial leverage or de$t to e%uit& ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Debt !ncome Ratio Debt !ncome Ratio ( total debt ) net income The de$t income ratio shows the debt as a portion of net income. It is the inverse of the &ears de$t ratio, which indicates the number of years to pay off all debts and replace assets when they become due. Deflated 0age ?ro/th Deflated 0age ?ro/th ( +current /ages @ +prior /ages 1 inflation rate.. ) prior /ages The de!lated wage growth shows the amount of growth not due to inflation. * positive number indicates that the wages are growing faster than inflation.

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* negative number indicates a real decline in wages. Dividend Payout Ratio Dividend Payout Ratio ( dividends ) net earnings The dividend pa&out ratio shows the proportion of earnings that are paid out in dividends. * low ratio indicates that a large portion of the profits are retained and likely invested for growth. * high or increasing payout ratio indicates the business may not be able to maintain current dividend payouts. Dividends per Common Share Dividends per Common Share ( +dividends @ preferred share dividend. ) number of common shares outstanding This ratio indicates the return to the shareholder in terms of current dividends received.

99

Dividend :ield Dividend :ield ( annual dividends per share ) price per share* The dividend &ield is the yield a company pays out to its shareholders in terms of dividends. 2arnings per Share 2arnings per Share ( net earnings ) number of shares outstanding Earnings per share is also referred to as E S or return to shareholders. This shows the return to the shareholder. * declining earnings per share is a cause for concern. 2nterprise %alue 2nterprise %alue ( mar-et capitali ation , debt , preferred shares @ cash @ mar-etable securities The enterprise value shows the valuation based on a takeover.

100

If the enterprise value is negative, the business can be bought for its cash holdings. 2'uity per Common Share 2'uity per Common Share ( +shareholders e'uity @ preferred shares. ) number of shares outstanding E%uit& per common share is also called boo' value per common share. The e'uity per common share shows the amount available to common shareholders once all debts are paid. Financial &everage Ratio Financial &everage Ratio ( total debt ) shareholders e'uity* The !inancial leverage ratio is also referred to as the de$t to e%uit& ratio. The !inancial leverage ratio indicates the extent to which the business relies on debt financing. %pper acceptable limit of the !inancial leverage ratio is usually 0/2, with no more than one$third of debt in long term.

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* high !inancial leverage ratio indicates possible difficulty in paying interest and principal while obtaining more funding. Fi1ed Assets to Shareholders 2'uity Fi1ed Assets to Shareholders 2'uity ( fi1ed assets ) shareholders e'uity This ratio shows the percent by which the shareholders e#uity figure is determined by stated value of fixed assets. * high ratio is of some concern in a business li#uidation as some fixed assets such as e#uipment and tangible assets may sell for less than book value and property and plant may sell at more than book value. Fi1ed Asset #urnover Ratio Fi1ed Asset #urnover Ratio ( net sales ) property< plant and e'uipment The fixed assets turnover ratio measures the return on plant and e#uipment.

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This ratio will likely decline in the year of ma&or fixed asset purchases, but their effects should be shown in future years. *n increasing ratio after a ma&or increase in plant and e#uipment indicates that the investment was effective. Fi1ed Charge Coverage Ratio Fi1ed Charge Coverage Ratio ( +Net !ncome "efore !nterest and #a1es , fi1ed costs. ) fi1ed costs* The !ixed charge coverage ratio indicates the risk involved in ability to pay fixed costs when business activity falls. ?earing Ratio ?earing Ratio ( long term debt ) shareholders e'uity* The gearing ratio is also referred to as the long term de$t to shareholders e%uit& ratio. * ratio above 2/2 is a concern as it indicates that the business has excessive debt.

103

?ross Profit 8argin Ratio ?ross Profit 8argin Ratio ( gross profit ) sales* The gross pro!it margin ratio is also called gross margin ratio. To calculate gross pro!it, subtract cost of sales (variable costs) from sales. (i.e. gross profit H sales $ cost of sales) * low gross pro!it margin ratio (or gross margin ratio) indicates that low amount of earnings, re#uired to pay fixed costs and profits, is generated from revenues. * low gross pro!it margin ratio (or gross margin ratio) indicates that the business is unable to control its production costs. The gross pro!it margin ratio (or gross margin ratio) provides clues to the companyFs pricing, cost structure and production efficiency. The gross pro!it margin ratio (or gross margin ratio) is a good ratio to benchmark against competitors.

104

?ro/th in 2arnings per Share +2PS. ?ro/th in 2arnings Per Share +2PS. ( +2PS at end of period - 2PS at beginning of period. ) 2PS at beginning of period The growth in earnings per share indicates the amount of growth for investors. This ratio helps determine the multiplier used in calculating the companyFs market value. * higher ratio yields a higher multiplier. The trend in this ratio indicates whether growth is steady, sporadic, accelerating or declining. !nterest "urden !nterest "urden ( interest e1pense ) 2"!# The interest $urden indicates the extent to which interest affects earnings. * ratio above 2/2 indicates interest expense is greater than the before interest profits, creating a loss.

105

!nterest Coverage !nterest Coverage ( 2"!# ) interest e1pense The interest coverage shows the ability to pay interest expenses. * ratio of 2.6 to 0.1 is desirable. !nventory to Current Assets !nventory to Current Assets ( inventory) current assets The inventor& to current assets ratio shows the extent to which current assets consist of inventory. This ratio indicates the li#uidity of the current assets. * ratio of 2/2 is considered acceptable. * rate of below 2/2 is preferred. !nventory to 0or-ing Capital !nventory to 0or-ing Capital ( inventory ) /or-ing capital

106

Inventory to working capital measures that ability to generate cash using its working capital at the current inventory level. * ratio below 1.7< (7<:) is preferred. !nventory #urnover Ratio !nventory #urnover Ratio ( cost of goods sold ) average inventory* The inventor& turnover ratio measures the number of times a company sells its inventory during the year. * high inventor& turnover ratio indicated that the product is selling well. The inventor& turnover ratio should be done by inventory categories or by individual product. &ease Coverage Ratio &ease Coverage ( +lease payments , operating profit. ) +lease payments , interest. The lease coverage ratio shows the ability to meet lease payment obligations.

107

&#D to Net !ncome &#D to Net !ncome ( &#D ) net income This ratio indicates the portion on long term debt that can be repaid from net income. &#D to #otal Capitali ation &#D to #otal Capitali ation ( &#D ) +&#D , shareholders e'uity. The "./ to total capitali(ation ratio is also called the capital structure ratio. This ratio measures the percent of financing with ?TD. * ratio above 1.6/2 shows that over half the capitali,ation is in long term debt. * "./ to total capitali(ation ratio below 1.6/2 indicates that the business may be able to fund further capital re#uirements with debt. .ompanies with ratios above 1.6/2 are usually considered to be overleveraged.

108

8ar-et Capitali ation 8ar-et Capitali ation ( price per share 1 number of outstanding shares >arket capitali,ation is the value of the business placed on it by the stock market. 8ar-et Price to "oo8ar-et Price to "oo- ( mar-et capitali ation ) shareholders e'uity The mar'et price to $oo' ratio shows the premium placed on the company as an on$going concern. 8ar-et Price to Sales 8ar-et Price to Sales ( mar-et capitali ation ) total sales The mar'et price to sales is also referred to the price to sales ratio. This ratio shows the number of times the shares are selling above the current sales. This is a ratio often used for startups and high tech companies.

109

8ar-et %alue Added 8ar-et %alue Added ( mar-et capitali ation @ shareholders e'uity The mar'et value added is also referred to as the +1A. The mar'et value added shows the premium above book value that the market has placed on the company. Net !ncome to #otal Debt Net !ncome to #otal Debt ( net income ) +short term debt ( long term debt. This ratio compares the amount of income to the amount of debt. The net income to de$t indicates the interest rate increase that a company is able to withstand. Net Profit 8argin Ratio Net Profit 8argin Ratio +After #a1 8argin Ratio. ( net profit after ta1 ) sales* Preta1 8argin Ratio ( net profit before ta1es ) sales*

110

$perating Profit 8argin +$perating 8argin. ( net income before interest and ta1es ) sales* These three pro!it margin ratios state how much profit the company makes for every dollar of sales. The net pro!it margin ratio is the most commonly used pro!it margin ratio. * low pro!it margin ratio indicates that a low amount of earnings, re#uired to pay fixed costs and profits, are generated from revenues. * low pro!it margin ratio indicates that the business is unable to control its production costs. The pro!it margin ratio provides clues to the companyFs pricing, cost structure and production efficiency. The pro!it margin ratio is a good ratio to benchmark against competitors. $lympic 8odel $lympic 8odel ( sales gro/th consistency , profit gro/th consistency @ absolute value of +sales gro/th consistency @ profit gro/th consistency.

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This measures the number of years that the company has improved in both sales and profit increases over the prior year. * score of 21 or more indicates exceptional performance. Preferred Dividend Coverage Preferred Dividend Coverage ( net profit ) preferred stoc- dividends The pre!erred dividend coverage measures the ability to cover preferred dividend payments. Price to 2arnings Ratio Price to 2arnings ( mar-et capitali ation ) net earnings The price to earnings ratio is also called mar'et price to E S, price6earnings ratio, p6e ratio or p6e. The price6earnings ratio shows the multiple of earnings that the company)s shares trade at.

112

Price to #angible "oo- %alue Price to #angible "oo- %alue ( mar-et capitali ation ) +shareholders e'uity @ intangible assets. * price to tangi$le $oo' value above 2/2 shows the market has placed a premium on the business as a going concern. The higher the ratio is above 2/2, the higher the stock is trading above its breakup value. Quic- Assets to !nventory Quic- Assets to !nventory ( +cash , mar-etable securities , accounts receivable. ) inventory The %uic' assets to inventor& shows the extent to which current assets are li#uid. * ratio above 2/2 is preferred. Quic- Assets to #otal Assets Quic- Assets to #otal Assets ( +cash , mar-etable securities , accounts payable. ) +current assets , long term assets.

113

The %uic' assets to total assets ratio shows the extent to which the assets of the company are li#uid. This ratio shows the extent to which the assets of the company are available to pay debt. Retained 2arnings ?ro/th Rate Retained 2arnings ?ro/th Rate ( +net income dividends. ) common shareholdersC e'uity * lower retained earnings growth ratio reflects the companyFs inability to generate internal funds. Retention Rate Retention Rate ( ++net profit after ta1es @ dividends.)net profit after ta1es. 1 BDDA Retention Rate ( B @ payout rate The retention rate is the portion of the profits retained in the company. *s the retention rate decreases, the ability of the business to grow decreases.

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#a1 "urden #a1 "urden ( !ncome #a1 ) 2arnings before ta1 The tax $urden is also referred to as the e!!ective tax rate. The .ax Burden is usually constant. * decline in the .ax Burden may indicate that operations have been moved to an area of lower taxes. #otal Assets to Debt #otal Assets to Debt ( total assets ) +current liabilities , long term debt. This ratio measures the extent to which total debt is covered by assets. 0or-ing Capital to Debt 0or-ing Capital to Debt ( +current assets @ current liabilities ) +current liabilities , long term debt. The wor'ing capital to de$t measures the ability to eliminate debt using working capital.

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* high or increasing ratio indicates increasing ability to repay debt. * ratio of 0/2 or higher is generally accepted. * ratio below 0/2 indicates an excessive de$t to e%uit& ratio. 0or-ing Capital to #otal Assets 0or-ing Capital to #otal Assets ( +current assets @ current liabilities. ) total assets The wor'ing capital to total assets ratio is also referred to as net current assets to total assets. The wor'ing capital to total assets shows the extent to which assets are li#uid after paying current liabilities. 0or-ing Capital #urnover 0or-ing Capital #urnover ( sales ) +current assets @ current liabilities. The wor'ing capital turnover shows to extent to which sales are generated from working capital.

116

* high or increasing ratio indicates ability to generate sales from its working capital.

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118

Cash Flo/ Ratios
The cash !low ratios enable the user to analy,e the .ash "low ;tatement included in the "inancial ;tatements. Cash Flo/ Coverage Ratio Cash Flo/ Coverage Ratio ( cash flo/ from operations , interest ) current portion of &#D* The cash !low coverage ratio indicates the ability to make interest and principal payments as they become due. * cash !low coverage ratio of less than 2/2 indicates bankruptcy within two years. Cash Flo/ from $perations to Current Portion of &#D Cash Flo/ from $perations to Current Portion of &#D ( cash flo/ from operations ) current portion of long term debt This ratio is also referred to as the cash !low ade%uac& ratio.

119

This ratio indicates the ability to retire debt as currently structured. * ratio of less than 2/2 (211:) indicates that debt is structured to be repaid #uicker than the company has the ability to. Cash Flo/ from $perations to Net !ncome Cash Flo/ from $perations to Net !ncome ( +cash flo/ from operations. ) net income The cash !low !rom operations to net incomes ratio indicates the extent to which net income generates cash in a business. * decline in the cash !low !rom operations to net income ratio indicates a cash flow problem. Cash Flo/ from Sales to #otal Sales Cash Flo/ from Sales to #otal Sales ( +cash flo/ from operations - dividends. ) total sales The cash !low !rom sales to sales ratio indicates the degree to which sales generate cash retained by the business.

120

* positive cash !low !rom sales to sales ratio means that sales are generating cash flow. Cash Flo/ per Common Share Cash Flo/ per Common Share ( +cash flo/ from operations @ preferred stoc- dividends. ) number of shares outstanding Cash !low per common share shows the amount of cash the company is generating each common share outstanding. Cash Flo/ to Current &iabilities Cash Flo/ to Current &iabilities ( cash flo/ from operations ) current liabilities This ratio measures the ability to cover current liabilities with cash flow. * value of over 2/2 is desired. * value of 2/2 or greater indicates ability to cover current liabilities with cash flow.

121

Cash Flo/ to !nterest Cash Flo/ to !nterest ( cash flo/ from operations ) interest e1pense This ratio shows the ability to cover interest from cash flow. Cash Flo/ to &ong #erm Debt Cash Flo/ to &ong #erm Debt ( cash flo/ ) long term debt The cash !low to long term de$t ratio appraises the ade#uacy of available funds to pay obligations. Cash Flo/ to Shareholders 2'uity Cash Flo/ to Shareholders 2'uity ( cash flo/ from operations ) shareholders e'uity This ratio shows the cash return on invested capital and retained earnings.

122

Cash Flo/ to #otal Assets Cash Flo/ to #otal Assets ( cash flo/ from operations ) total assets This ratio indicates the amount of cash the company can generate relative to its si,e. Cash Flo/ to #otal Debt Cash Flo/ to #otal Debt ( cash flo/ from operations ) +short term debt ( long term debt. This ratio indicates the ability to repay the debts of the business. * low or decreasing ratio indicates concerns about the ability to pay out its debt load. Net Cash Flo/ for !nvesting Net Cash Flo/ for !nvesting ( +purchase of fi1ed assets and securities. ) net cash flo/s from financing activities* The net cash !lows !or investing ratio determines the ade#uacy of debt and e#uity issuances.

123

$perations Cash Flo/ plus Fi1ed Charges to Fi1ed Charges $perations Cash Flo/ plus Fi1ed Charges to Fi1ed Charges ( +cash flo/ from operations , fi1ed cost. ) fi1ed costs This ratio indicates the risk involved when business activity, and ability to pay fixed costs, falls. $perations Cash Flo/ plus !nterest to !nterest $perations Cash Flo/ plus !nterest to !nterest ( +cash flo/ from operations , interest. ) interest This ratio indicates the cash actually available to meet interest charges. * ratio of less than 2/2 (211:) indicates insufficient cash flow is being generated to meet current interest payments. $perations Cash Flo/ to Current &iabilities $perations Cash Flo/ to Current &iabilities ( cash flo/ from operations ) current liabilities

124

If the operations cash !low to current lia$ilities ratio keeps increasing, it may indicate that cash inflows are increasing and need to be invested.

125

126

&abor Ratios
The la$or ratios are used to analy,e the labor portion of a business. Change in 2mployment Change in 2mployment ( increase)+decrease. in the number of employees This ratio shows how many more (fewer) employees the company has than the previous year. Fi1ed &abor to #otal &abor Fi1ed &abor to #otal &abor ( fi1ed labor costs +including benefits. ) total labor costs +including benefits. This ratio shows the extent to which labor costs are fixed. * low percent is preferred, especially in industries with volatile demands or seasonality.

127

&abor Cost to Net !ncome &abor Cost to Net !ncome ( +salaries< /ages and benefits. ) net income This ratio measures the extent to which la$or costs (number of employees x average wage and benefit per employee) affect net income. This ratio indicates the extent to which a reduction in unproductive labor (as a percent of total labor costs) may increase net income. &abor Costs to Sales &abor Costs to Sales ( +salaries< /ages and benefits. ) sales The la$or cost to sales is also referred to as la$or to revenue or la$or cost percentage. This ratio shows the extent to which labor costs account for the sales price. Percent Change in People 2mployed Percent Change in People 2mployed ( ++the change in the number of employees. )

128

number of employees in previous year. 1 BDDA This ratio shows the percent growth in number of employees. Percent !ncrease in 0ages and Salaries per 2mployee Percent !ncrease in 0ages or Salaries per 2mployee ( ++current year average /age and benefit per employee - previous year average /age and benefit per employee.) previous year average /age and benefit per employee. 1 BDDA This ratio indicates the percent increase in the average annual income (including benefits) per employee. Percent !ncrease in 0ages to Profits Percent !ncrease in 0ages to Profits ( percent increase in /ages and benefits per employee ) percent increase in profits This ratio shows whether wage increases are in line with profit increases.

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* continued ratio above 2/2 indicates that wage increases are eroding profits. Profits per 2mployee Profits per 2mployee +Net !ncome per 2mployee. ( net income ) number of employees This ratio indicates the average profit generated per person employed. * high or increasing pro!its per emplo&ee indicates that the employees are productively employed.

130

Costs per 2mployee Ratios
;ome business costs are dependent on the number of people employed. These cost per emplo&ee ratios enable the user to see whether costs are changing and assist in budgeting. Average 0age and "enefit per 2mployee Average 0age and "enefit per 2mployee ( +salaries , /ages , benefits. ) number of employees This ratio indicates the average cost (excluding overhead allocations) of each person employed. Fi1ed Costs per 2mployee Fi1ed Costs per 2mployee ( fi1ed costs ) number of employees This ratio shows the average amount spent on overhead for each employee in the period. This shows the overhead factor that each employee must carry.

131

Fi1ed Costs +e1cluding labor. per 2mployee Fi1ed costs +e1cluding labor. per employee ( fi1ed costs - fi1ed labor costs ) number of employees The !ixed costs 3excluding la$or5 per emplo&ee ratio shows the overhead factor (excluding labor) that each employee carries. !ncrease in 0ages and Salaries per 2mployee !ncrease in 0ages or Salaries per 2mployee ( current year average /age and benefit per employee - previous year average /age and benefit per employee This ratio indicates the dollar amount of increase in the average annual income (including benefits) per employee. $ffice Repairs and Supplies per 2mployee $ffice Repairs and Supplies per 2mployee ( office repairs and supplies ) number of employees This ratio shows the cost of office repairs and supplies per employee.

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This is one factor that may be taken into consideration when planning staff reductions, or budget planning. Phone Costs per 2mployee Phone costs per employee ( phone costs ) number of employees This ratio shows the cost of telephone charges per employee. This is one factor that may be taken into consideration when planning staff reductions, or budget planning. #raining Costs per 2mployee #raining Costs per 2mployee ( training costs ) number of employees This ratio shows the average amount spent on training each employee in the period. * decline may indicate future declines in productivity. *n increase may indicate and increase in employee turnover.

133

134

Discretionary Cost Ratios
These discretionar& cost ratios enable the investor to see whether discretionary costs have been deferred. Discretionary Costs as a Percent of Sales Discretionary Costs ( advertising , research and development , training , repairs and maintenance costs Discretionary Costs as a Percent of Sales ( +discretionary costs ) sales. 1 BDDA * decreasing trend indicates profit may have come from reductions in discretionary costs which may negatively affect future profits. 2'uipment Replacement Ratio 2'uipment Replacement Ratio ( change in undepreciated assets ) depreciation* The e%uipment replacement ratio indicates whether the company is spending sufficient funds on replacing assets.

135

2'uipment Ep-eep Ratio 2'uipment Ep-eep Ratio ( e'uipment repairs and replacement costs ) total revenues* * decline in the e%uipment up'eep ratio indicates eroding revenues. Repairs and 8aintenance to Associated Assets Repairs and 8aintenance to Associated Assets ( repairs and maintenance ) fi1ed assets * decreasing trend may indicate a companyFs failure to maintain capital facilities.

136

Productivity and Fno/ledge Ratios
roductivit& and 'nowledge ratios are a rough calculation of the assets and contribution due to the skills of the employees. Productivity and Fno/ledge Contribution Productivity and Fno/ledge Contribution ( net income - normal return on investment This ratio shows the amount of net income that comes from employees (versus capital). In a competitive environment, margins and profits will be forced to yield normal returns for shareholders. This ratio indicates the contribution of the company being run better or smarter than normal. Productivity and Fno/ledge Contributed per 2mployee Productivity and Fno/ledge Contributed per 2mployee ( productivity and -no/ledge contribution ) number of employees

137

This ratio indicates the average amount of excess net income that each employee adds through experience, training, productivity and creativity. Productivity and Fno/ledge Assets Productivity and Fno/ledge Assets ( productivity and -no/ledge contribution 1 4 This ratio indicates the amount of assets residing in the knowledge and skills of employees. Percent ?ro/th in Productivity and Fno/ledge Assets Percent ?ro/th in Productivity and Fno/ledge Assets ( gro/th in productivity and -no/ledge assets ) previous year productivity and -no/ledge assets This ratio indicates the rate of growth or decline in the #uality of employees.

138

&ong #erm Return on #raining and Development &ong #erm Return on #raining and Development ( increase in productivity and -no/ledge assets ) training costs This ratio is a general indicator of the long term return on training and development. *n average of several yearsF ratios should be used to compensate for training and development cost fluctuations.

139

140

$ther Ratios
These are some other ratios which are useful but didn)t fit into the other categories. Altman9s G-Score -score ( B*H a , B*I b , 3*3 c , d e /here J a ( /or-ing capital< b ( retained earnings< c ( operating income< d ( sales< e ( total assets< f ( net /orth and g ( total debt , *4 f g

The Altman (,score is a bankruptcy prediction calculation. The (,score measures the probability of insolvency (inability to pay debts as they become due). 2.B or less indicates a very high probability of insolvency. 2.B to 0.< indicates a high probability of insolvency.

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0.< to 3.1 indicates possible insolvency. 3.1 or higher indicates that insolvency is not likely. =ecent studies have determined that the reliability rate of this predictor is not significantly over 61 :, indicating that it is only slightly better than a coin toss. Audit Ratio Audit Ratio ( audit costs ) sales * high audit ratio indicates that more audit time was re#uired because of problems with the companyFs accounting records or control procedures. Daily Savings in Delayed Cash Payments Daily Savings in Delayed Cash Payments ( accounts payable 1 +interest rate ) 345. This calculates the daily savings of holding back payments, or not paying ahead of due dates.

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!nterest Cost of !nventory !nterest Cost of !nventory ( inventory 1 interest rate The interest cost o! inventor& reflects the interest associated with holding inventory. Insurance, storage, theft and obsolescence costs must be added to the interest cost of inventory when determining the total inventory holding costs. $verhead to #otal &abor $verhead to #otal &abor ( fi1ed costs) variable +direct. labor costs The overhead to direct la$or ratio shows the overhead factor per direct labor dollar. $verhead to %ariable Costs $verhead to %ariable Costs ( fi1ed costs ) variable costs This ratio shows the overhead factor per variable dollar cost.

143

Percent 21port 2arnings Percent 21port Revenues ( +e1port earnings 1 BDDA. ) total revenue The percent export earnings indicates the earnings volume risk associated with currency risks. Percent 21port Revenues Percent 21port Revenues ( +e1port revenue 1 BDDA. ) total revenue The percent export revenue indicates the sales volume risk associated with currency risks. Percent Enstable Foreign Assets Percent Enstable Foreign Assets ( +assets in politically unstable countries 1 BDDA. ) total assets The percent unsta$le !oreign assets indicates the amount of assets at risk because of political instability of the country(ies) of origin.

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Percent Enstable Foreign 2arnings Percent Enstable Foreign 2arnings ( +earnings from politically unstable countries 1 BDDA. ) net earnings The percent unsta$le !oreign earnings indicates the amount of earnings at risk because of political instability of the country(ies) of origin. Percent Enstable Foreign Revenues Percent Enstable Foreign Revenues ( +revenues from politically unstable countries 1 BDDA. ) total revenues The percent unsta$le !oreign revenues indicates the amount of revenue at risk because of political instability of the country (ies) of origin. Quality Ratio Quality Ratio ( B - +sales returns and allo/ances ) sales.* The %ualit& ratio, or product %ualit& ratio, indicates the extent of acceptance (in dollar terms) of the product or services sold.

145

The analyst should look to see whether the #uality is increasing or decreasing. * decrease in the %ualit& ratio indicates declining product #uality, which may lead to decreasing sales or profit margins.

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Index
acid test ratio accounts payable accounts payable to sales accounts receivable accounts receivable to accounts payable ratio accounts receivable turnover ratio accounts receivable turnover ratio *ccountant)s =eport activity ratios activity variance actual fixed costs actual variable costs after tax margin ratio after tax margin ratio age of inventory *ltman)s ,$score asset turnover ratio asset recoveries assets per employee assets to sales audit engagement audit ratio *uditor)s =eport average collection period average collection period average inventory period average obligation period average wage and benefit per employee 06 0 5< 0 0< 5B B< 2 5< 02 2B 2A <1 21A 5B 23A B6 00 B< 5A 2 251 2 5A A2 5B 61 20A

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Index cont. bad debts ratio basic earning power !alance ;heet !alance ;heet !alance ;heet beta book value per share breakeven point budget business valuation business value premium capital ac#uisition ratio capital intensity ratio capitali,ed research and development capitali,ed startup costs capital employment ratio capital structure ratio capital structure ratio capital to non$current assets ratio cash cash balance cash breakeven point cash debt coverage ratio cash debt coverage ratio cash dividend coverage cash dividend coverage ratio cash dividend coverage ratio cash flow coverage cash flow from financing 62 <1 2 0 5 BB BA 62 3 00 BA 36 B< 0 0 37 37 217 3< 0 37 60 0B 72 60 22< A1 22B 3

148

Index .on. cash flow from investing cash flow from operations cash flow from operations to current portion of ?TD cash flow from operations to net income cash flow from sales to total sales cash flow per common share cash flow ratios .ash "low ;tatement .ash "low ;tatement cash flow to current liabilities cash flow to interest cash flow to long term debt cash flow to shareholders e#uity cash flow to total assets cash flow to total debt cash maturity coverage cash ratio cash ratio cash ratio cash reinvestment ratio cash return on assets cash return on assets cash return to shareholders cash to current liabilities cash turnover ratio cash turnover ratio cash turnover ratio change in common dollar investment 3 3 22< 22B 22B 22A 22< 2 3 22A 201 201 201 201 201 63 06 3< A1 63 65 72 70 A1 65 B5 A2 27

149

Index .ont. change in dollar per share change in employment .hanges in *ccounting 'olicy changes in !alance ;heet changes in common si,ed ratios changes in cash changes in Income ;tatement .hanges in (orking .apital collection period collection period collection period to payment period common dollar investment common si,ed income statement ratios common si,ed ratios common si,ed ratios comparative analysis comparisons to optimal comparisons to !IT comparative financial statements compilation engagement contingencies contribution margin ratio contribution margin cost of capital cost of goods sold costs per employee ratios cross$sectional analysis current assets current assets 25 206 A 3 23 3 3 3 61 A2 66 26 23 20 23 6 2A 27 3 2 B 70 73 A0 2 20A 23 0 3

150

Index .ont. current assets to current liabilities current assets to sales current assets to total assets current liabilities current liabilities current liabilities to inventory current liabilities to inventory current liabilities to net worth current liabilities to total debt current liabilities to total liabilities current portion of long term debt current portion of ?TD to net income current ratio current ratio current return on training and development customers daily savings in delayed cash payments days cash balance days inventory days of li#uidity days sales in inventory days to collect days to pay debt debt coverage ratio debt income ratio debt to assets ratio debt to e#uity ratio A0 A3 A3 0 3 0A A5 0A A5 31 0 A5 0< A0 73 A 251 3< 5B 66 5B 61 62 0 73 A7 3A 3B

151

Index .ont. debt to e#uity ratio debt to e#uity ratio debt to e#uity ratio debt ratio debt ratio debt service capacity debt service coverage ratio defensive interval period deflated sales growth deflated profit growth deflated wage growth depreciation rates discretionary cost ratios discretionary costs as a percent of sales disposal value dividend payout ratio dividends per common share dividend yield dollar comparisons to optimal dollar per share D;.= earning power earnings per share G!IT to current liabilities G!IT to sales ratio G!IT to total sales effective tax rate efficiency ratios efficiency variances 51 A6 AA 3A A6 73 73 51 B2 75 A7 < 233 233 00 A< A< AB 2A 25 73 75 AB 76 <0 76 225 5< 2A

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Index .ont. enterprise value G'; e#uipment replacement ratio e#uipment upkeep ratio e#uity per common share e#uity multiplier expenses to current assets external statements favorable variance "I"+ financial leverage ratio financial leverage ratio financial leverage ratio financial leverage ratio financial statement analysis "inancial ;tatements fixed assets to short term debt fixed assets to net worth fixed assets to shareholders e#uity fixed assets turnover ratio fixed charge coverage ratio fixed charge coverage ratio fixed charge coverage ratio fixed costs fixed costs to total assets ratio fixed costs per employee fixed costs (excluding labor) per employee fixed coverage ratio AB AB 233 235 AA 51 77 2 02 7 3B 51 A5 AA 6 2 52 31 211 211 50 66 212 2A 50 20A 231 50

153

Index .ont. fixed labor to total labor flexed budget flexed budget variance flexed optimal variable costs gearing ratio gearing ratio gearing ratio goodwill gross margin gross margin gross margin ratio gross margin ratio gross profit gross profit margin ratio gross profit margin ratio growth in earnings per share growth in earnings per share hori,ontal analysis impairment to fixed assets Income ;tatement Income ;tatement increases in wages and salaries per employee indebtedness ratio intangible assets intangible assets interest interest burden interest cost of inventory 206 02 02 2A 3B 51 212 0 2 2B 77 210 77 77 210 7< 213 6 < 2 5 231 53 0 < 0 213 252

154

Index cont. interest coverage interest coverage ratio interest rates internal financial statements internal statements inventories inventory inventory holding period inventory to current assets inventory to working capital inventory turnover ratio inventory turnover ratio investment ratios investments in other companies labor cost percentage labor cost to net income labor cost to sales labor costs labor efficiency variance labor rate variance labor ratios labor to revenue labor use variance labor variances land lease coverage ratio leverage ratio leverage ratio leverage ratios 215 50 03 5 2 7 0 5B 215 215 67 216 B< 7 207 207 207 207 02 02 206 207 02 02 0 216 3B A5 36

155

Index cont. liabilities ?I"+ li#uidity index li#uidity ratios long term assets long term debt to current liabilities long term debt to shareholders e#uity long term debt to shareholders e#uity long term debt to shareholders e#uity long term return on training and development losses carried forward ?TD to net income ?TD to total capitali,ation >anager)s .omments margin of safety ratio market capitali,ation market capitali,ation market price to book market price to sales market value added marketable securities marketable securities mix variance multiplier >I* !IT !IT 0 < 32 06 0 53 32 53 212 23< B 217 217 5 67 26 21< 217 21< 21B 0 37 02 03 21B 0 27

156

net before interest and taxes Index cont. net before taxes net cash flows for investing net current assets to total assets net income net income increases to pay increases net income to assets net income to fixed charges net income to total debt net profit to tangible net worth net profit margin ratio net profit margin ratio net one time gains to net income net worth net worth to total debt net worth to total liabilities non$current assets to non$current liabilities non$operating assets non$operating income to net income otes to the "inancial ;tatements otes to the "inancial ;tatements otes to the "inancial ;tatements otice to =eader number of days inventory obligation period office repairs and supplies per employee olympic model ongoing business value operations cash flow plus fixed charges

0 0 202 225 0 7B 7B 7B 21B 75 <1 21B <2 0 30 30 55 37 <2 2 3 6 2 5B 62 231 21A 00

157

to fixed charges Index cont. operations cash flow plus interest to interest operations cash flow to current liabilities operating cycle operating income to wages and salaries operating leverage operating margin operating margin operating margin operating profit margin operating profit margin operating profit margin optimal analysis optimal common si,ed ratios optimal gross margin optimal flexed gross margin optimal flexed gross margin optimal fixed costs optimal performance optimal result optimal sales other ratios overhead to total labor overhead to variable costs owner)s e#uity paid in capital patents payment period

200

200 200 67 <0 55 <1 <0 21B <1 <0 21B 01 2B 2A 2A 01 2A 2B 2B 2B 23A 252 252 0 3 0 6<

158

Index cont. payment period to average inventory period payment period to operating cycle p-e ratio p-e pension benefits percent change in common dollar investment figures percent change in dollar per share percent change in operating income vs. sales volume percent change in people employed percent changes in common si,ed ratios percent changes in financial statement figures percent comparisons to optimal percent export earnings percent export revenues percent growth in productivity and knowledge assets percent increase in wages and salaries per employee percent increase in wages to profits percent unstable foreign assets percent unstable foreign earnings percent unstable foreign revenues phone costs per employee plant and e#uipment 6B 6B 221 221 < 27 26 <3 207 23 21 01 250 250 237 20< 20< 250 253 253 232 0

159

preferred dividend coverage Index cont. prepaid expenses pretax margin ratio pretax margin ratio price-earnings ratio price to earnings price to tangible book value price variance prior period ad&ustments 'rior 'eriod *d&ustments product #uality ratio production variance productivity and knowledge assets productivity and knowledge contributed per employee productivity and knowledge contribution productivity and knowledge ratios 'rofit and ?oss ;tatement profit growth profit growth consistency profit margin ratio profit margin ratios profitability ratios profits per employee profits per employee profits from operations property, plant and e#uipment #uantity of changes in financial statement figures

221 0 <1 21B 221 221 222 02 0 21 253 02 237 236 236 236 2 <3 <5 21B 21B 72 <5 20B 0 < 21

160

#uality of debt ratio Index cont. #uality ratio #uality variance #uick assets to inventory #uick assets to total assets #uick ratio ratio analysis real dollar changes real dollar comparisons real dollar optimal analysis real dollar percent changes receivables to payables ratio =elated 'arty Transactions repairs and maintenance to associated costs research and development retained earnings retained earnings growth rate retained earnings to total assets retention rate return on assets ratio return on assets return on capital employed return on common e#uity return on e#uity return on invested capital return on investment return on investment return on net worth

31 253 02 222 222 07 2< 22 22 01 20 0< A 235 A 3 220 56 220 7A <5 <6 <7 << <7 << <B <<

161

return on sales Index cont. return on sales return on shareholders e#uity return on working capital return to shareholders revenue per employee revenues review engagement =+.G =+I sales growth sales growth consistency sales ratios sales to accounts payable sales to advertising and promotion sales to advertising, promotion and rent sales to breakeven point sales to cash sales to current assets sales to fixed assets sales to inventory sales to net income sales to total assets sales to working capital sales trend sales volume sales volume variance sales volume variance selling and administration expenses

<1 << <B <B A7 6A 2 2 <6 << B2 B0 B2 B0 B0 B3 B3 B5 B5 B6 6A B6 B7 B7 B7 2B 2A 2A 2

162

shares Index cont. shareholders e#uity short term assets short$term debt ratio short term debt to depreciation short term debt to liabilities short term debt to long term debt side$by$side analysis side$by$side comparisons to optimal solvency ratios solvency ratio ;ources and %ses of "unds stock options sub$optimal performance ;ubse#uent Gvents tax burden taxes times interest earned total assets to debt total assets to total debt total liabilities to net worth training costs per employee trend in sales unfavorable variance unfavorable variance unusual items value of a public company value of a private company variable costs

0 0 0 31 56 57 57 6 2B 06 30 3 B 2A A 223 3 <B 223 30 33 232 B7 2A 02 0 00 00 2B

163

variances Index cont. variance analysis variance analysis vehicles vertical analysis working capital working capital from operations to total liabilities working capital productivity working capital to debt working capital to total assets working capital turnover years debt yield variances

3 2A 01 0 23 3 35 <B 223 225 225 57 02

164

Sources of !nformation
>ost of the ratios and descriptions contained in this book are from website, ///*bi /i *ca, of "i /i Consulting ?roup &td*, of .algary, *lberta, .anada, a private company owned by the author of this book. Those ratios and descriptions are incorporated into ratio analysis spreadsheets which the business sells. The ratios on the !i,wi, site come mainly from the development of a financial troubleshooting system that incorporates the ratios in 7.he Financial .rou$leshooter8, a 2AA3 >cEraw Cill book written by Jae K. ;him, Joel E. ;iegel and David >inars. ;ome ratios were referenced from 79:9 Business ratios; A +anagers <and$oo' o! /e!initions< 2'uations and Computer AlgorithmsK a 2AA3 >c?ane 'ublications book written by ;heldon Eates. Dunn and !radstreet ratios come from an online source ///*chrononhotonthologos*com. Three articles written by K. >. Cagen were sourced online. These article are 7Financial Anal&sis .ools !or +anaging =our Business8, 7Reading Financial Statements with an

165

Anal&tical E&e8 , and 7.he Notes to the Financial Statement +a& $e *orth Noting8. +ther online sources were used to clarify ratio definitions.

166

Financial Statement Analysis Calculators
>ost of the analysis of the financial statements re#uires arithmetic to calculate a ratio or several of the other analysis methods. "i /i Consulting ?roup &td. of .algary, *lberta, .anada has put together a >icrosoft Gxcel spreadsheet that calculates all the ratios plus all of the other calculations, with the exception of analysis of the notes, and variance analysis. The spreadsheet follows the order of this book and refers to the page number for easy reference. There is a chart to easily recogni,e trends and compare the previous three periods with the benchmark from the input data. 'ercent changes to the ratio, and percent comparison to the benchmark, are stated. In addition, it displays LAlertLM when the most recent period of a ratio is above the generally accepted figure. For a sample< send an email to fsasampleMbi /i *ca stating Nre'uest sampleK in the information line* This spreadsheet, and copies of this book, can be ordered by mail or online. ;ee ordering details at www.bi,wi,.ca-financialNstatementNanalysis.html. To speed delivery time, the spreadsheet is sent as an email attachment.

167

!i,wi, .onsulting Eroup ?td. speciali,es in business analysis. In addition to the spreadsheet which corresponds to this book, they develop and sell other ratio analysis spreadsheets including the explanations and charts, an inventory management spreadsheet system, a business valuation spreadsheet, and non$financial #uestion sets for analy,ing businesses. !i,wi, .onsulting Eroup ?td. also developed, using Dr. Jae ;him)s book “The Financial Troubleshooter”, and sell a financial analysis and solution system in which the <1 ratios from the ratio spreadsheet and the 511 possible financial problem scenario #uestions refer to the page in Dr. ;him)s book (also included) which explains what will happen if the financial problem is not solved and how to solve the financial problem.

168

$rdering #his "oo.opies of this book, or a >icrosoft Gxcel spreadsheet for the business analysis calculations, may be ordered through !i,wi, .onsulting Eroup ?td. at www.bi,wi,.ca-financialNstatementNanalysis.html. .ontact byronObi,wi,.ca for prices on multiple copies of the book or associated spreadsheets.

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