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%