Ratios Flashcards
(15 cards)
Liquidity ratio Working capital ratio
The working capital ratio, sometimes expressed as the working capital position (and also called the current ratio), is calculated as follows: Current Assets / Current Liabilities
The working capital ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 9 / Item 22
= 12,238,000 / 4,313,000 = 2.84/1
The working capital ratio of 2.84 to 1 means Trans-Canada Retail has $2.84 of cash and equivalents to pay for every $1 of its current liabilities.
How you interpret the ratio depends on the type of business, composition of current assets, inventory turnover rate, and credit terms. A current ratio of 2 to 1 is good but not exceptional, because it means that the company has $2 cash and equivalents to pay for each $1 of its debt. However, suppose 50% of Company A’s current assets are cash, whereas 90% of Company B’s current assets are in inventory. If each company has a current ratio of 2 to 1, Company A is more liquid than B because it can pay its current debts more easily and quickly. The current ratio does not easily translate into multiples. For example, although a current ratio of 2 to 1 is good, it doesn’t follow that a ratio of 20 to 1 is 10 times as good. A company that consistently maintains a current ratio that exceeds 5 to 1 may have an unnecessary accumulation of funds. This situation can arise from sales problems in the form of too much inventory or from financial mismanagement.
Liquidity ratio Quick ratio
The second of the two most common corporate liquidity ratios—the quick ratio (also called the acid test) — is shown below:
Current assets – inventories / current liabilities
The quick ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 9 – Item 5 / Item 22
12,238,000 – 9,035,000 / 4,313,000 = 3,203,000 / 4,313,000 = 0.74/1
The ratio of 0.74 to 1 means that Trans-Canada Retail has 74 cents of current assets, exclusive of inventories, to meet each $1 of current liabilities.
This ratio is a more stringent test than the current ratio. Current assets generally include inventories that can be difficult to convert into cash. For the quick ratio, inventories are subtracted from current assets. The quick ratio, therefore, offers a more conservative test of a company’s ability to meet its current obligations. It shows how well current liabilities are covered by cash and by items with a ready cash value.
There is no absolute standard for the quick ratio, but 1 to 1 or better suggests a good liquid position. However, companies with a quick ratio of less than 1 to 1 may be in equally good shape if they have a high rate of inventory turnover. Inventory that is turned over quickly is the equivalent of cash. In our example, a quick ratio of 0.74 to 1 is probably satisfactory because the company we are looking at is a retail store chain. This industry is characterized by large inventories and a high turnover rate.
Risk analysis ratio Asset coverage
The asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non-debt liabilities have been satisfied.
The asset coverage ratio is calculated as follows:
Tangible assets – (current liabilities – short term debt) / total debt outstanding
The asset coverage ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 10 – Item 2 - [Item 22 – (Item 18 + Item 21) / Item 18 + Item 21 + Item 15
19,454,000 - 150,000 – [4,313,000 - (120,000 + 1,630,000)] / 120,000 + 1,630,000 + 1,350,000
16,741,000 / 3,100,000 = 5.4/1
The ratio of 5.4 to 1 means that Trans-Canada Retail has, for example, $5,400 in NTA for each $1,000 of total debt outstanding.
To be conservative, goodwill and other intangible assets are first deducted from the total asset figure. In our example, Trans-Canada Retail Stores Ltd. has $5,400 of assets backing each $1,000 of total debt outstanding after providing for current liabilities. (Short-term borrowings and the current portion of long-term debt are excluded from current liabilities, but they are included in total debt outstanding.) If the industry standard for this ratio is that retail companies should have at least $2,000 of NTA for each $1,000 of total debt outstanding, this company meets—in fact, exceeds—this standard.
Risk analysis ratio Debt-to-equity ratio
The debt-to-equity ratio shows the proportion of borrowed funds used relative to the investments made by shareholders in the company, as follows:
Total Debt Outstanding / Equity
The debt-to-equity ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 21 + + Item 18 Item 15 / Item 14
1,630,000 + 120,000 + 1,350,000 / 13,306,000
3,100,000 / 13,306,000 = 0.233/1 or 23.30%
The debt-to-equity ratio is often expressed as a percentage of debt to equity. In the example above, the total amount of debt represents 23.3% of the size of the total amount of equity. The ratio of 0.233 to 1 is acceptable for Trans-Canada Retail, if it does not exceed the industry standard for retail stores.
If the ratio is too high, it may indicate that the company has borrowed excessively, which increases its financial risk. If the debt burden is too large, it reduces the margin of safety protecting the debtholder’s capital, increases the company’s fixed charges, and reduces earnings available for dividends.
Risk analysis ratio Cash flow to total debt outstanding ratio
Cash flow from operating activities is a measure of a company’s ability to generate funds internally. Other things being equal, a company with a large and increasing cash flow is better able to finance expansion using its own funds, without the need to issue new securities. The cash flow-to-total debt outstanding ratio gauges a company’s ability to repay the funds it has borrowed.
Cash Flow from Operating Activities / Total Debt Outstanding
The ratio of cash flow to total debt outstanding for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 34 + Item 36 - + Item 32 + Item 37 / Item 21 + Item 18 + Item 15
1,298,000 / 3,100,000 = = 0.4187 1 or 41.87%
The ratio of 0.418 to 1 is acceptable for Trans-Canada Retail because it exceeds the 0.2 to 1 or 20% industry standard for retail stores.
Because of the substantial size of non-cash items on a statement of comprehensive income, cash flow from operating activities frequently provides a broader picture of a company’s earning power than profit alone. Consequently, cash flow from operating activities is considered by some analysts to be a better indicator of the ability to pay dividends and finance expansion. To properly analyze cash flow, you must consider it in relation to a company’s total financial requirements. In financial statements, the cash flow statement puts cash flow from operating activities into perspective as a source of funds available to meet financial requirements. A relatively high ratio of cash flow to total debt outstanding is considered positive, whereas a low ratio is negative.
Analysts usually calculate the cash flow-to-total debt outstanding ratio for each of the last five fiscal years. An improving trend is desirable. A declining trend may indicate weakening financial strength unless the individual ratios for each year are well above the minimum standards. For example, if the latest year’s ratio was 0.61 (Year 5) and preceding years’ ratios were 0.60 (Year 4), 0.63 (Year 3), 0.65 (Year 2), and 0.70 (Year 1), there would seem to be no cause for concern because each year’s ratio is strong.
Risk analysis ratio Interest coverage
The interest coverage ratio reveals the ability of a company to pay the interest charges on its debt based on profit that it has available to pay the interest. The ratio also indicates whether there is a margin of safety for interest coverage. Having such a margin is important because a company’s inability to meet its interest charges could result in bankruptcy. Interest coverage is generally considered to be the most important quantitative test of risk when considering a debt security. A level of profit well in excess of interest requirements is deemed necessary as a form of protection against possible adverse conditions in future years.
The formula used to calculate the interest coverage ratio is as follows:
Profit Before Interest Charges and Taxes / Interest Charges
The interest coverage ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 34 + Item 31 + Item 33 - Item 32 / Item 31
1,208,000 + 289,000 + 880,000 - 5,000 / 289,000
2,372,000 / 289,000 = 8.21/1
The calculation shows that Trans-Canada Retail’s interest charges for the year were covered 8.21 times by profit available to pay them. Stated another way, it shows that the company had $8.21 of profit out of which to pay every $1.00 of interest owing.
It is important that you study the year-to-year trend in the interest coverage calculation. Ideally, a company’s coverage will increase year by year to exceed the standard. A stable trend where the company meets the minimum standard is also considered acceptable.
Again, standards vary from industry to industry, not only for companies in different industries, but even for those in the same industry. Standards can depend on past earnings records and future prospects. The record of a company’s interest coverage is particularly important because the company must meet its fixed charges in both good and bad times. Unless it has already demonstrated its ability to do so, it cannot be said to have passed the test.
Operating performance ratio Gross profit margin
The gross profit margin ratio, which is useful both for calculating internal trend lines and for making comparisons with other companies, is calculated as follows:
Revenue - Cost of Sales / Revenue
The gross profit margin ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 24 - Item 25 / Item 24
43,800,000 - 28,250,000 / 43,800,000
15,550,000 / 43,800,000 = 0.355/1 or 35.50%
The gross margin is an indication of the efficiency of management in turning over the company’s goods at a profit. In other words, it shows the company’s rate of profit after allowing for the cost of sales.
Operating performance ratio Net profit margin
The net profit margin ratio, which is an important indicator of the efficiency of a company’s management after taking both expenses and taxes into account, is calculated as follows:
Profit - Share of Profit of Associates / Revenue
The net profit margin ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 34 - Item 32 / Item 24
1,208,000 - 5,000 / 43,800,000
1,203,000 / 43,800,000 = 0.0275/1 or 2.75%
The calculation shows how much of the money the company collected as revenue remains as its profit.
Because this ratio is the result of the company’s operations for the period, it effectively sums up in a single figure management’s ability to run the business.
Operating performance ratio Return on common equity
The net (or after tax) return on common equity ratio, which shows the dollar amount of earnings that were produced for each dollar invested by the company’s common shareholders, is as follows:
Profit / Total Equity
The net return on common equity ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 34 / Item 14
1,208,000 / 13,306,000 = 0.0908/1 or 9.08%
The calculation shows that Trans-Canada Retail earned $0.09 for each dollar invested.
The trend in the return on common equity indicates management’s effectiveness in maintaining or increasing profitability in relation to the common equity capital of the company.
This ratio is very important for common shareholders because it reflects the profitability of their capital in the business.
Operating performance ratio Inventory turnover ratio
The inventory turnover ratio, which measures the number of times that a company’s inventory is turned over in a year, is calculated as follows:
Cost of sales / Inventory
The inventory turnover ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 25 / Item 5
28,250,000 / 9,035,000 = 3.13/1
To calculate inventory turnover in days, divide 365 (days) by the inventory turnover ratio, as follows: 365 / 3.13 = 116.61
The calculation shows that Trans-Canada Retail turns over its inventory 3.13 times over the span of a year, or every 116.61 days.
A high turnover ratio is considered good because the company requires a smaller investment in inventory than one producing the same revenue with a low turnover.
The inventory turnover ratio can be used to compare one company’s efficiency in turning over inventory with others in the same field. It also provides an indication of the adequacy of a company’s inventory for the volume of business being handled.
If a company has an above-average inventory turnover rate for its industry, it generally indicates a better balance between inventory and sales volume. The company is unlikely to be caught with too much inventory if the price of raw materials drops or the market demand for its products falls.
Because a large part of a company’s working capital is usually tied up in inventory, the way in which the inventory position is managed directly affects the company’s earnings and the rate of return earned on the company’s common equity.
Values ratio Percentage dividend payout ratio
The dividend payout ratio, which indicates the percentage of the company’s profit that is paid out to shareholders in the form of dividends, is calculated as follows:
Common share dividends / Profit x 100
Deducting the percentage of earnings being paid out as dividends from 100 gives the percentage of earnings remaining in the business to finance future operations.
The dividend payout ratio for Trans-Canada Retail Stores Ltd. is calculated as follows:
Item 41 / Item 34 x 100
387,500 / 1,208,000 x 100 = 32.08%
The calculation shows that Trans-Canada Retail paid out 32.08% of available earnings as dividends in the year; therefore, 67.92% was reinvested in the business
Dividend payout ratios are generally unstable because they are tied directly to the earnings of the company, which change from year to year. The directors of some companies try to maintain a steady dividend rate through good and poor times to preserve the credit rating and investment standing of the company’s securities. If dividends are greater than earnings for the year, the payout ratio will exceed 100%. Dividends are then taken out of retained earnings, which erodes the value of the shareholders’ equity.
Values ratio Earnings per common share
The EPS ratio, which shows the earnings available to each common share, is calculated as follows:
Profit / Weighted Average Number of Common shares outstanding
Assume that the notes to the financial statements for Trans-Canada Retail Stores Ltd. indicate that the weighted average number of common shares outstanding is 387,500. The EPS ratio for Trans-Canada Retail is therefore calculated as follows:
Item 34 / 387,500 shares
$1,208,000 / 387,500 = $3.12 per share. The calculation shows that Trans-Canada Retail has earned $3.12 for each common share.
Fully diluted EPS can be calculated on common stock outstanding plus common stock equivalents such as convertible preferred stock, convertible debentures, stock options (under employee stock-option plans), and warrants. This figure shows the dilution in EPS that would occur if all equivalent securities were converted into common shares.
Company ABC, which show the following information: * 300,000 warrants can be converted on a 1-for-1 basis into common shares. * The weighted-average number of common shares is 2,800,000 common shares. * The company had a profit of $10,455,000.
Profit / Weighted Average Number of Common Shares Outstanding
$10,455,000 / 2,800,000 = $3.73 per share
To calculate fully diluted EPS, you would have to increase the number of common shares by 300,000 because 300,000 warrants would be converted on the basis of 1 to 1. The formula is therefore adjusted as follows:
Adjusted Profit / Adjusted Weighted Average Number of Common Shares Outstanding
$10,455,000 / 2,800,000 + 300,000
$10,455,000 / 3,100,000 = $3.37 per share.
The calculation shows that Company ABC has $3.37 in fully diluted earnings for each common share
In practice, a common stock’s market price reflects the anticipated trend in EPS for the next 12 to 24 months, rather than the current EPS. Thus, it is common practice to estimate EPS for the next year or two. Accurate estimates for longer periods are difficult because of the many variables involved.
Because of the importance of EPS, analysts pay close attention to possible dilution of the stock’s value. Dilution occurs when the number of shares outstanding increases, which results in each existing shareholder owning a smaller percentage of the company.
Profit, after all prior claims have been met, belongs to the common shareholders. The shareholders will therefore want to know how much has been earned on their shares. If profit is high, directors may declare and pay out a good portion as dividends. Even in growth companies, directors may decide to make at least a small dividend payment because they realize that shareholders like to receive income. On the other hand, if profit is low or the company has suffered a loss, they may not pay dividends on the common shares.
Values ratio Dividend yield
The dividend yield on common stock is the annual dividend rate expressed as a percentage of the current market price of the stock. It represents the investor’s return on the investment, as follows:
Indicated Annual Dividend per Share / Market Price x 100
Assuming a current market price of $26.25 for the common shares of Trans-Canada Retail Stores Ltd., the yield is calculated as follows:
1.00 / 26.25 x 100 = 3.81%
The calculation shows that the dividend yield on Trans-Canada Retail’s common stock is 3.81% of the current market price.
Dividend yields allow analysts to make a quick comparison between the shares of different companies. However, to make a thorough comparison, you must also consider the following factors: * The differences in the quality and record of each company’s management * The proportion of earnings reinvested in each company * The equity behind each share
Values ratio Price to earnings ratio
The P/E ratio is probably the most widely used of all financial ratios because it combines all the other ratios into one figure. It represents the ultimate evaluation of a company and its shares by the investing public. The P/E ratio is calculated only for common stocks, as follows:
Current Market Price of Common Shares / Earnings per Share
Assuming that the current market price of Trans-Canada Retail’s common stock is $26.25, and that the company’s EPS is $3.12, the P/E ratio is calculated as follows:
26.25 / 3.12 = 8.41/1
The calculation shows that the current market price of Trans-Canada Retail’s common stock is 8.41 times the EPS value.
The main reason for calculating EPS, apart from determining dividend protection, is to compare it to the share’s market price. The P/E ratio expresses this comparison in one convenient figure, showing that a share is selling at so many times its actual or anticipated annual earnings. This figure allows you to compare the shares of one company with those of another.
Consider Table 14.4, which shows the earnings per share, current market price, and P/E ratio of two companies: Company A and Company B. Although the EPS of Company A ($2) is double that of Company B ($1), the shares of each company represent equivalent value because A’s shares cost twice as much as B’s. In other words, both companies are selling at 10 times earnings.
The P/E ratio helps analysts determine a reasonable value for a common stock at any time in a market cycle. By calculating a company’s P/E ratio over a number of years, you will find considerable fluctuation, with high and low points. If the highs and lows of a particular stock’s P/E ratio remain constant over several stock market cycles, they indicate selling and buying points for the stock. A study of the P/E ratios of competitor companies and that of the relevant market subgroup index also provides a perspective. The P/E ratio comparison assists in the selection process. For example, if two companies of equal stature in the same industry both have similar prospects but different P/E ratios, the company with the lower P/E ratio is usually the better buy.
As a rule, P/E ratios increase in a rising stock market or with rising earnings. Earnings that increase over time are a favourable sign; the company’s stock price should also rise over time. Investors see rising earnings as a positive development and are willing to pay a higher price for the stock. The increase in the stock price is usually greater than the increase in earnings; therefore, the P/E ratio increases. The reverse is true in a declining market or when earnings decline.
Generally, it is assumed that when investor confidence is high, P/E ratios are also high, and when confidence is low, P/E ratios are low. Because the P/E ratio is an indicator of investor confidence, its highs and lows may vary from market cycle to market cycle.
Values ratio Dividend discount model
The widely used dividend discount model (DDM) illustrates, in a simple way, how companies with stable growth are priced, at least in theory. The model relates a stock’s current price to the present value of all expected future dividends into the indefinite future.
Price = Div0 (1 + g) / r – g = Div1 / r – g
Where: Price = The current intrinsic value of the stock in question Div0 = The dividend paid out in the current year Div1 = The expected dividend paid out by the company in one year r = The required rate of return on the stock g = The assumed constant growth rate for dividends.
ABC Company will pay a dividend of $0.94 this year. If the company reports a constant long-term growth rate (g) of 6%, ABC will pay out an expected dividend in one year’s time of $0.996 or $1.00 ($0.94 × 1.06).
It is technically incorrect to assume that “r” in the denominator is equal to the general level of interest rates or that “g” is simply equal to growth in corporate profits. However, these simplifying assumptions make it possible to illustrate how changes in interest rates and corporate profits affect stock price valuation during a business cycle.
ABC Company is expected to pay a $1 dividend next year. It has a constant long-term growth rate (g) of 6% and a required return (r) of 9%. Based on these inputs, the DDM is calculated as follows:
Price = Div1 / r – g = 1.00 / 0.09 – 0.06 = 33.33
The DDM tells us that, based on the expected dividend, the required return and the growth rate of dividends, the stock has an intrinsic value of $33.33. Thus, if ABC is selling for $25 in the market, the stock would be considered undervalued because it is selling below its intrinsic value. Conversely, if ABC is selling for $40, the stock would be considered overvalued because it is selling above its intrinsic value.
