Financial ratios
Profitability ratios
Liquidity ratios
Solvency ratios
Activity ratios
Profitability ratios
What are the examples of ratios that provide information about the profitability of an entity?
- Profit margin ratio
- Gross margin ratio
- Return on assets
- Return on equity
Liquidity ratios
What are the examples of ratios that provide information about the financial liquidity of an entity?
- Current ratio
- Quick ratio
- Working capital ratio
Solvency ratios
What are the examples of ratios that provide information about the financial solvency of an entity?
- Debt to equity ratio
- Debt to assets ratio
- Long-term debt to equity ratio
Activity ratios
What are the examples of ratios that provide information about the operational activity of an entity?
- Assets turnover ratio
- Inventory turnover ratio
- Days in inventory
- Accounts receivable turnover ratio
- Accounts receivable collection period
- Accounts payable turnover ratio
- Accounts payable payment period
Review Questions
1. How is earnings per Share (EPS) calculated?
Earnings per share (EPS) = (1) / (2)
Where,
(1) = (Net income – Preferred stock dividends)
(2) = Average number of common shares outstanding
If preferred stock dividends = 0, then
Earnings per share (EPS) = Net income / Average number of common shares outstanding
2. How is working capital calculated?
Working capital = Current assets – Current liabilities
3. How is current ratio calculated?
Current ratio = Current assets / Current liabilities
4. How is debt to total assets ratio calculated?
Debt to total assets = Total liabilities / Total assets
5. How is free cash flow calculated?
Free cash flow
= Net cash provided by operating activities – Capital expenditures – Cash dividends
Exercise 1
Entity A had the following balances at December 31, 20×1.
Calculate the required amounts and/or financial ratios.
Current assets = $700,000
Total assets = $1,600,000
Current liabilities = $500,000
Total liabilities = $800,000
Cash provided by operations = $900,000
Capital expenditures = $200,000
Cash dividends = $100,000
Net income = $360,000
Preferred stock dividends = $50,000
Average common shares outstanding = 100,000 shares
1. What is the amount of working capital?
Working capital = Current assets – Current liabilities = 700,000 –500,000 = $200,000
2. What is the current ratio?
Current ratio = Current assets / Current liabilities = 700,000 /500,000 = 1.40
3. What is the debt to total assets ratio?
Debt to total assets = Total liabilities / Total assets = 800,000 /1,600,000 = 0.50 or 50%
4. What is the amount of free cash flow?
Free cash flow = Cash provided by operations – Capital expenditures – Cash dividends
5. What is the amount of Earnings per share (EPS)?
Earnings per Share
= (Net income – Preferred stock dividends) / Average common shares outstanding
= (360,000 –50,000) / 100,000 shares =310,000 / 100 shares =3.10 per share
Exercise 2
Calculate the required ratios based on the following information:
Net sales = $3,000,000
Cost of Goods Sold = $2,100,000
Gross Profit = Net sales – Cost of goods sold = 3,000,000 –2,100,000 = $900,000
Net income = $360,000
1. What is the gross profit rate?
Gross profit rate = Gross profit / Net sales
= (Net sales – Cost of goods sold) / Net sales
= (3,000,000 –2,100,000) / 3,000,000 =900,000 / $3,000,000
= 0.30 or 30%
2. What is the profit margin ratio?
Profit margin ratio = Net income / Net sales = 360,000 /3,000,000 = 0.12 or 12%