Liquidity Ratios: Can You Meet Short Term Obligations with Current Resources?

Liquidity Ratios: can you meet short term obligations with current resources?

Current Ratio

• Creditors want high
• Shareholders low
• Short term solvency

Quick Ratio/Acid test

• Inventories are least liquid
• Pay off short term without selling inventory
• If below avg, bad. Have to liquidate

Asset Management Ratios

TAT

• Money made in sales for every dollar invested in assets
• Below avg → not generating enough business relative to investment

FAT

• How effectively using plant and equipment
• inflation can cause problems
• Fixed assets reported using historical cost
• Mature firm → higher fixed assets turn over ratio (FAT ratio)

DSO

• Average collection period
• Number of days sales are in receivables
• Above average → customers not paying on time

Inventory turn over

• Inventory reported at cost
• Inventory should be campred to cost. NOT TO SALES
• COGS=cost of goods sold except depreciation + depreciation
• Inventory turnover ratio=COGS/inventories

Debt Management Ratios: measure extent to which firm uses debt for finance business

Debt to Asset Ratio: how much assets financed with debt

Debt to equity ratio

Liabilities to Asset Ratio= extent of assets not finance with equity

TIE ( time interest earned) ratio

• Interest coverage ratios
• How much operating income can decline before cant pay interest
• Interest is paid with pre tax dollars
• Issues: interest is not the only fixed finance charge. Firms have lease payments
• Issues: EBIT does not represent all cash flow
• Used by long term bondholders

EBITDA coverage ratio: ability to service debt

• Used for short term lenders like banks

Profitability Ratio: rate of return on sales and assets

Combined effects of liquidity, asset management and debt management

Net Profit Margin

• If below average, inefficient operations or bad interest

Operating Profit Margin

• Operation performance before interest expenses

Basic Earning Power (BEP) ratio

• Earning power before taxes

Return on Total Asset (ROA)

• Below average: low basic earning power/ high interest costs from too much debt

Return on Common Equity (ROE)

• Stockholders invest to get a return, tells how well they are doing in accounting sene

Market value ratio: what investors think.

• Relates stock price to cash flow, earning and value
• Measures companies stocks against each other

PE Ratio

• How much are investors willing to pay for a dollar of reported profits
• High for firms with strong growth prospect
• Low for risky firms

Price/Cash flow ratio

• Performance before impact of interest
• Measures operating performance

Market/Book Ratio

• Book value per share
• Companies with higher rates of return on equity have higher averages
• Book value= Record of how much stockholders invested (PAST)
• Market value: investors expectations of future cash flow (FUTURE)

Common Size Analysis

• Income statement divided by sales
• Balance sheet divided by assets
• Compares income and balance statements over time and across companies

Du Pont Eqn

• Ties ratios together
• Focus on:

• Expense control (profit margin)
• Asset utilization ( total asset turn over )
• Debt utilization ( equity multiplier)

• Shows how factors combine to determine Return on Equity (ROE)
• High financial leverage → high equity multiplier

Problems with Ratio Analysis

• Different divisions  make it harder to compare industry averages
• Industry average doesn’t provide challenging target
• Inflation affects balance sheet and net income, distorting analysis
• Seasonal factors
• Window dressings make them look better
• Different accounting and operating practices