Current Ratio

What is the 'Current Ratio'

The current ratio is a liquidity ratio that measures a company's ability to pay
short-term and long-term obligations. To gauge this ability, the current ratio
considers the current total assets of a company (both liquid and illiquid) relative
to that company’s current total liabilities. The formula for calculating a company’s
current ratio is:

Current Ratio = Current Assets / Current Liabilities

The current ratio is called “current” because, unlike some other liquidity ratios, it
incorporates all current assets and liabilities.

A ratio under 1 indicates that a company’s liabilities are greater than its assets and
suggests that the company in question would be unable to pay off its obligations if they
came due at that point. While a current ratio below 1 shows that the company is not in
good financial health, it does not necessarily mean that it will go bankrupt. There are
many ways for a company to access financing, and this is particularly so if a company
has realistic expectations of future earnings against which it might borrow. For example,
if a company has a reasonable amount of short-term debt but is expecting substantial
returns from a project or other investment not too long after its debts are due, it will
likely be able to stave off its debt.

Companies in industries, such as the retail industry, typically have current ratios below
1. This is acceptable to investors given that these companies are able to negotiate long
credit periods with suppliers while offering shorter credit periods to customers. This
means that they would have higher account payables, which falls under current
liabilities, compared to lower account receivables under current assets. These
companies, if operating efficiently, are also able to maintain minimum levels of inventory
on their balance sheets.

The higher the current ratio, the more capable the company is of paying its obligations,
as it has a larger proportion of asset value relative to the value of its liabilities. However,
a high ratio (over 3) does not necessarily indicate that a company is in a state of
financial well-being either. Depending on how the company’s assets are allocated, a
high current ratio may suggest that that company is not using its current
assets efficiently, is not securing financing well, or is not managing its working
capital well. To better assess whether or not these issues are present, a liquidity ratio
more specific than the current ratio is needed.
Quick Ratio
What is the 'Quick Ratio'
The quick ratio is an indicator of a company’s short-term liquidity, and measures
a company’s ability to meet its short-term obligations with its most liquid assets.
Because we're only concerned with the most liquid assets, the ratio excludes
inventories from current assets. Quick ratio is calculated as follows:

Quick ratio = (current assets – inventories) / current liabilities, or

Quick ratio = (cash and equivalents + marketable securities + accounts

receivable) / current liabilities
The quick ratio is also known as the acid-test ratio.

The quick ratio measures the dollar amount of liquid assets available for each dollar of
current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid
assets available to cover each $1 of current liabilities.

While a quick ratio lower than 1 does not necessarily mean the company is going into
default or bankruptcy, it could mean that the company is relying heavily on inventory or
other assets to pay its short term liabilities. The higher the quick ratio, the better the
company's liquidity position. However, too high a quick ratio may indicate that the
company has too much cash sitting in its reserves. It may also mean that the company
has a high accounts receivables, indicating that the company may be having problems
collecting on its account receivables.

Whether accounts receivable is a source of quick ready cash is debatable, however,

and depends on the credit terms that the company extends to its customers. A firm that
gives its customers only 30 days to pay will obviously be in a better liquidity position
than one that gives them 90 days. But the liquidity position also depends on the credit
terms the company has negotiated from its suppliers. For example, if a firm gives its
customers 90 days to pay, but has 120 days to pay its suppliers, its liquidity position
may be reasonable.

The other issue with including accounts receivable as a source of quick cash is that
unlike cash and marketable securities – which can typically be converted into cash at
the full value shown on the balance sheet – the total accounts receivable amount
actually received may be slightly below book value because of discounts offered for
early payment and credit losses.
Debt/Equity Ratio
What is the 'Debt/Equity Ratio'
Debt/Equity (D/E) Ratio, calculated by dividing a company’s total liabilities by its
stockholders' equity, is a debt ratio used to measure a company's financial
leverage. The D/E ratio indicates how much debt a company is using to finance
its assets relative to the value of shareholders’ equity. The formula for calculating
D/E ratios is:

Debt/Equity Ratio = Total Liabilities / Shareholders' Equity

The result can be expressed either as a number or as a percentage.

The debt/equity ratio is also referred to as a risk or gearing ratio.

Given that the debt/equity ratio measures a company’s debt relative to the total value of
its stock, it is most often used to gauge the extent to which a company is taking on debt
as a means of leveraging (attempting to increase its value by using borrowed money to
fund various projects). A high debt/equity ratio generally means that a company has
been aggressive in financing its growth with debt. Aggressive leveraging practices are
often associated with high levels of risk. This may result in volatile earnings as a result
of the additional interest expense.

The Debt/Equity (D/E) ratio can be applied to personal financial statements as well, in
which case it is also known as the Personal Debt/Equity Ratio. Here, “equity” refers not
to the value of stakeholders’ shares but rather to the difference between the total value
of an individual’s assets and the total value of his or her debt or liabilities. The formula
for the personal D/E ratio, then, can be represented as:

D/E = Total Personal Debt / (Total Assets - Total Personal Debt)

The personal debt/equity ratio is often used in financing, as when an individual or small
business is applying for a loan. This form of D/E essentially measures the dollar amount
of debt an individual has for each dollar of equity they have. D/E is very important to a
lender when considering a candidate for a loan, as it can greatly contribute to the
lender’s confidence (or lack thereof) in the candidate’s financial stability.
A candidate with a high personal debt/equity ratio has a high amount of debt relative to
their available equity, and will not likely instill much confidence in the lender that the
candidate can repay the loan. On the other hand, a candidate with a low personal
debt/equity ratio has relatively low debt, and thus poses much less risk to the lender, as
the candidate would appear to have a reasonable ability to repay the loan.

Limitations of Debt/Equity Ratio

As with most ratios, when using the debt/equity ratio, it is very important to consider the
industry in which the company operates. Because different industries rely on different
amounts of capital to operate, and use that capital in different ways, a relatively high
D/E ratio may be common in one industry while a relatively low D/E may be common in
another. For example, capital-intensive industries such as auto manufacturing tend to
have a debt/equity ratio above 2, while companies like personal computer
manufacturers usually are not particularly capital intensive and may often have a
debt/equity ratio of under 0.5. As such, D/E ratios should only be used to compare
companies that operate within the same industry.

Another important point to consider when assessing D/E ratios is that the “Total
Liabilities” portion of the formula may often be determined in a variety of ways by
different companies, some of which are not actually the sum of all of the company’s
liabilities. In some cases, companies will only incorporate debts, such as loans and debt
securities, into the liabilities portion of the formula, while omitting other kinds of
liabilities, such as unearned revenue. In other cases, companies may calculate D/E in
an even more specific way, including only long-term debts and excluding short-term
debts and other liabilities. Yet, “long-term debt” here is not necessarily a term with a
consistent meaning. It may include all long-term debts, but it may also exclude long-
term debts nearing maturity, which are then categorized as “short-term” debts. Because
of these differentiations, one should try to determine how the ratio was calculated and
should be sure to consider other ratios and performance metrics as well when
considering using a company’s debt/equity ratio for investment decisions.
Inventory Turnover
What is 'Inventory Turnover'
Inventory turnover is a ratio showing how many times a company's inventory is
sold and replaced over a period of time. The days in the period can then be
divided by the inventory turnover formula to calculate the days it takes to sell the
inventory on hand. It is calculated as sales divided by average inventory.

Inventory turnover measures how fast a company is selling inventory and is generally
ompared against industry averages. A low turnover implies weak sales and, therefore,
excess inventory. A high ratio implies either strong sales and/or large discounts.

The speed with which a company can sell inventory is a critical measure of business
performance. It is also one component of the calculation for return on assets (ROA); the
other component is profitability. The return a company makes on its assets is a function
of how fast it sells inventory at a profit. As such, high turnover means nothing unless the
company is making a profit on each sale.

Inventory Turnover Example

Inventory turnover is calculated as sales divided by average inventory. Average
inventory is calculated as: (beginning inventory + ending inventory)/2. Using average
inventory accounts for any seasonality effects on the ratio. Inventory turnover is also
calculated using the cost of goods sold (COGS), which is the total cost of inventory.
Analysts divide COGS by average inventory instead of sales for greater accuracy in the
calculation of inventory turnover. This is because sales include a mark-up over cost.
Dividing sales by average inventory inflates inventory turnover.

Approach 1: Sales Divided By Average Inventory

As an example, assume company A has $1 million in sales. The COGS is only
$250,000. The average inventory is $25,000. Using the first equation, the company has
inventory turnover of $1 million divided by $25,000, or 40. Translate this into days by
dividing 365 by inventory days. The answer is 9.125 days. This means under the first
approach, inventory turns 40 times a year, and is on hand approximately nine days.
Approach 2: COGS Divided By Average Inventory
Using the second approach, inventory turnover is calculated as the cost of goods sold
divided by average inventory, which in this example is $250,000 divided by $25,000, or
10. The number of inventory days is calculated by dividing 365 by 10, which is 36.5.
Using the second approach, inventory turns over 10 times a year and is on hand for
approximately 36 days.

The second approach gives a more accurate measure, as it does not include a mark-up.
Only compare inventory turnover that uses the same approach for an apples-to-apples
comparison.
Asset Turnover Ratio
What is 'Asset Turnover Ratio'
Asset turnover ratio measures the value of a company’s sales or revenues
generated relative to the value of its assets. The Asset Turnover ratio can often
be used as an indicator of the efficiency with which a company is deploying its
assets in generating revenue.

Asset Turnover = Sales / Average Total Assets

Asset turnover ratio is typically calculated over an annual basis using either
the fiscal or calendar year. The total assets number used in the denominator can be
calculated by taking the average of assets held by a company at the beginning of the
year and at the year’s end.

Generally speaking, the higher the asset turnover ratio, the better the company is
performing, since higher ratios imply that the company is generating more revenue per
dollar of assets. The asset turnover ratio tends to be higher for companies in certain
sectors than in others. Retail and consumer staples, for example, have relatively small
asset bases but have high sales volume and, thus, often yield the highest asset
turnover ratio. Conversely, firms in sectors, such as utilities and telecommunications,
which have large asset bases will have lower asset turnover. Since this ratio can vary
widely from one industry to the next, considering the asset turnover ratios of a retail
company and a telecommunications company will not make for an accurate
comparison. Comparisons are only meaningful when they are made for different
companies within the same sector.

Limitations of the Asset Turnover Ratio

While the asset turnover ratio should be used to compare apples to apples and oranges
to oranges, this kind of comparison does not necessarily paint the clearest possible
picture. It is possible that a company’s asset turnover ratio in any single year differs
substantially from previous or subsequent years. For any specific company, then, one
would do well to review the trend in the asset turnover ratio over a period of time to
check whether asset usage is improving or deteriorating.

The asset turnover ratio may be artificially deflated when a company makes large asset
purchases in anticipation of a higher growth. Likewise, selling off assets to prepare for
declining growth will artificially inflate the ratio.

Many other factors can affect a company’s asset turnover ratio in a given year, such as
whether or not an industry is cyclical.
Using the Asset Turnover Ratio and Related Ratios
The Asset Turnover ratio is a key component of DuPont analysis, a system that the
DuPont Corporation began using during the 1920s. To understand how companies can
increase return for their shareholders, the DuPont analysis breaks down Return on
Equity (ROE) into three parts, one of which is asset turnover, the other two being profit
margin and financial leverage.

DuPont analysis: ROE = Profit Margin x Asset Turnover x Financial Leverage

Sometimes, investors and analysts are more interested in measuring how quickly a
company turns its fixed assets or current assets into sales. In these cases, the analyst
can use specific ratios, such as the fixed asset turnover ratio or the working capital ratio
to calculate the efficiency of these asset classes.
Accounts Receivable Turnover
Accounts receivable, or A/R turnover, is calculated by dividing a firm’s sales by its
accounts receivable. It is a measure of how efficiently a company is able to collect on
the credit it extends to customers. A firm that is very good at collecting on its credit will
have a lower accounts receivable turnover ratio. It is also important to compare a firm's
ratio with that of its peers in the industry. (Read more in The Importance of Analyzing
Accounts Receivable.)

Inventory Turnover
Inventory turnover is a measure of how efficiently a company turns its inventory into
sales. It is calculated by taking the cost of goods sold and dividing it by inventory. Again,
a lower number is better and indicates that a company is quite efficient at selling off its
inventory.

Key Industries for Accounts Receivable and Inventory

Turnover
The basic fact is that any industry that extends credit or has physical inventory will
benefit from analysis of its accounts receivable turnover and inventory turnover ratios. It
might be easier to cover companies that operate with lower or negligible levels of
accounts receivable and inventory. There are very few industries that operate only on
cash--most companies have to deal in credit as well. However, certain industries may
heavily favor cash. Smaller restaurants or retailers may operate under these terms.
Large retailers that sell consumables, such as Wal-Mart Stores Inc (WMT), Dollar
General Corporation (DG) or CVS Health Corp (CVS, have lower levels of receivables
because many customers either pay in cash or by credit card (credit card companies
likely reimburse these retailers quickly).

Accounts receivable turnover becomes particularly important for industries where credit
is extended for a long period of time. Accounts receivable turnover becomes a problem
with collecting on outstanding credit is difficult or starts to take longer than expected.
One industry where accounts receivable turnover is extremely important is in financial
services. For instance, CIT Group Inc. (CIT) helps extend credit to businesses and
operates a unit that specializes in factoring—helping other companies collect their
outstanding accounts receivables. A firm can either sell its accounts receivables to CIT
Group outright (CIT Group could then keep whatever debts it manages to collect), just
pay CIT Group a fee for help in collections, or some combination of the two. The client
company benefits by freeing up capital (for example, if CIT pays the client company
upfront cash in exchange for the accounts receivable). Selling accounts receivables
(which are after all, a current asset) can be considered a way to get short-term
financing. In some cases, it can help keep a struggling company in business.
Putting It All Together
A measure that combines accounts receivable turnover and inventory turnover is
the cash conversion cycle. It also mixes in the accounts payable or A/P turnover (where
a higher number is better—taking longer to pay a supplier is good for conserving cash).
Taking 365 and dividing each of these turnover ratios will convert them into a measure
that can be analyzed by day in the cash conversion cycle context. It essentially
measures how efficiently a company collects money from its customers and pays its
suppliers for the inventory it needs to generate sales in the first place. You may note the
circularity to the process, which nicely summarizes some of the key components to
managing net working capital.

The Bottom Line

Accounts receivable turnover and inventory turnover are two widely used measures for
analyzing how efficiently a firm is managing its current assets. Analyzing current
liabilities, such as accounts payable turnover, will help capture a better picture of
working capital. Generally, any firm that has receivables and inventory will benefit from
a turnover analysis.
Average Collection Period
What is the 'Average Collection Period'
The average collection period is the approximate amount of time that it takes for
a business to receive payments owed in terms of accounts receivable. The
average collection period is calculated by dividing the average balance of
accounts receivable by total net credit sales for the period and multiplying the
quotient by the number of days in the period.

Calculated as:

Where:
Days = Total amount of days in period
AR = Average amount of accounts receivables
Credit Sales = Total amount of net credit sales during period

The average collection period represents the average number of days between the date
a credit sale is made and the date payment is received from the credit sale. The
average balance of accounts receivable is calculated by adding the beginning balance
in accounts receivable and ending balance in accounts receivable and dividing the total
by 2. When calculating the average collection period for an entire year, 360 may be
used as the number of days in one year for simplicity.

Example of an Average Collection Period

A company has an average accounts receivable balance for the year of $10,000. Total
net sales during this period equal $100,000. The average collection period would be
36.5 days (($10,000/$100,000)*365). This indicates that it takes just over 36 days to
collect an account receivable.

Accounts Receivable Turnover

The average collection period is closely related to the accounts turnover ratio. The
accounts turnover ratio is calculated by dividing total net sales by the average accounts
receivable balance. In the previous example, the accounts receivable turnover would be
10 ($100,000 / $10,000). The average collection period can be calculated using the
accounts receivable turnover by dividing the number of days in the period by the metric.
In this example, the average collection period is the same as before at 36.5 days (365
days / 10).

Calculated Result
In general, a lower average collection period is more favorable than a higher average
collection period. A low average collection period indicates that the organization is
collecting payment faster. However, this may be an indication that its credit terms are
too strict, and customers may seek suppliers or service providers with more lenient
payment terms.

Comparability
As a standalone figure, the average collection period does not hold much value;
instead, it is a metric best suited for comparison over time. A company experiences the
greatest benefit from calculating the average collection period by maintaining the metric
over time and searching for trends. In addition, the calculation may be compared to
competitors and other businesses in the industry. Similar companies should produce
similar financial metrics, so the average collection period can be used as a benchmark
against another company's performance.

Monitoring Collection Period

A company should compare the average collection period to the credit terms extended
to customers. For example, an average collection period of 25 days isn't as concerning
if invoices are issued with a net 30 due date. However, an ongoing evaluation of the
outstanding collection period directly affects the organization's cash flows.
Gross Profit Margin
What is 'Gross Profit Margin'
A gross profit margin is a financial metric used to assess financial health and is
equal to revenue less cost of goods sold as a percent of total revenue. A financial
metric used to assess a firm's financial health by revealing the proportion of
money left over from revenues after accounting for the cost of goods sold. Gross
profit margin is a financial metric used to assess a company's financial health
and business model by revealing the proportion of money left over from revenues
after accounting for the cost of goods sold (COGS). Gross profit margin, also
known as gross margin, is calculated by dividing gross profit by revenues.

Calculated as:

Where: COGS = Cost of Goods Sold

There are several layers of profitability that analysts monitor to assess the performance
of a company, including gross profit, operating profit and net income. Each level
provides information about a company's profitability. Gross profit, the first level of
profitability, tells analysts how good a company is at creating a product or providing a
service compared to its competitors. Gross profit margin, calculated as gross profit
divided by revenues, allows analysts to compare business models with a quantifiable
metric.

Driving Gross Margin

Without an adequate gross margin, a company is unable to pay for its operating
expenses. In general, a company's gross profit margin should be stable unless there
have been changes to the company's business model. For example, when companies
automate certain supply chain functions, the initial investment may be high; however,
the cost of goods sold is much lower due to lower labor costs.

Gross margin changes may also be driven by industry changes in regulation or even
changes in a company's pricing strategy. If a company sells its products at a premium in
the market, all other things equal, it has a higher gross margin. The conundrum is if the
price is too high, customers may not buy the product.
Gross Profit Margin Example
Gross profit margin is used to compare business models with competitors. More
efficient or higher premium companies see higher profit margins. That is, if you have
two companies that both make widgets and one company can make the widgets for a
fifth of the cost and in the same amount of time, that company has the edge on the
market. The company has figured out a way to reduce the costs of goods sold by five
times its competitor. To make up for the loss in gross margin, the competitor counters
by doubling the price of its product, which should increase sales. Unfortunately, it
increased the sales price but decreased demand, as customers did not want to pay
double for the product. The competitor lost gross margin and market share in the
process.
Net Profit Margin
The net profit margin is the ratio of net profits to revenues for a company or business
segment. Expressed as a percentage, net profit margins show how much of each dollar
collected by a company as revenue translates into profit.

Net profitability is an important distinction since increases in revenue do not necessarily

translate into increased profitability. Net profit is the gross profit (revenue minus cost of
goods) minus operating expenses and all other expenses, such as taxes and interest
paid on debt. Although it may appear more complicated, net profit is calculated for us
and shows up on the income statement as net income.

The formula for net profit margin

Or

It's important to note that it's possible for a company to have a negative net profit
margin. A negative net profit margin occurs when a company has a loss for the quarter
or year, but the loss could be a temporary issue for the company. Reasons for losses
could be increases in the cost of labor and raw materials, recessionary periods, and the
introduction of disruptive technological tools that could affect the company's bottom line.

Investors and analysts typically use both gross profit margin and net profit margin to
gauge how efficiently a company's management is in earning profits relative to the costs
involved in producing their goods and services. It's best to compare the margins to
companies within the same industry and over multiple periods to get a sense of
any trends.
Return on Assets – ROA
What is 'Return on Assets - ROA'
Return on assets (ROA) is an indicator of how profitable a company is relative to
its total assets. ROA gives a manager, investor, or analyst an idea as to how
efficient a company's management is at using its assets to generate earnings.
Return on assets is displayed as a percentage and its calculated as:

ROA = Net Income / Total Assets

Note: Some investors add interest expense back into net income when
performing this calculation because they'd like to use operating returns before
cost of borrowing.

Sometimes, the ROA is referred to as "return on investment"

In basic terms, ROA tells you what earnings were generated from invested
capital (assets). ROA for public companies can vary substantially and will be highly
dependent on the industry. This is why when using ROA as a comparative measure, it is
best to compare it against a company's previous ROA numbers or against a similar
company's ROA.

Remember that a company's total assets is the sum of its total

liabilities and shareholder's equity. Both of these types of financing are used to fund the
operations of the company. Since a company's assets are either funded by debt or
equity, some analysts and investors disregard the cost of acquiring the asset by adding
back expense in the formula for ROA. In other words, the impact of taking more debt is
negated by adding back the cost of borrowing to the net income, and using the average
assets in a given period as the denominator. Interest expense is added because the net
income amount on the income statement excludes interest expense. An analyst that
chooses to ignore the cost of debt will use this formula:

ROA = (Net Income + Interest Expense) / Average Total Assets

Return On Equity – ROE
What is 'Return On Equity - ROE'
Return on equity (ROE) is the amount of net income returned as a percentage
of shareholders equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money shareholders
have invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock
holders but after dividends to preferred stock.) Shareholder's equity does not
include preferred shares.

Also known as "return on net worth" (RONW).

In basic terms, ROA tells you what earnings were generated from invested
capital (assets). ROA for public companies can vary substantially and will be highly
dependent on the industry. This is why when using ROA as a comparative measure, it is
best to compare it against a company's previous ROA numbers or against a similar
company's ROA.

Remember that a company's total assets is the sum of its total

liabilities and shareholder's equity. Both of these types of financing are used to fund the
operations of the company. Since a company's assets are either funded by debt or
equity, some analysts and investors disregard the cost of acquiring the asset by adding
back interest expensein the formula for ROA. In other words, the impact of taking more
debt is negated by adding back the cost of borrowing to the net income, and using the
average assets in a given period as the denominator. Interest expense is added
because the net income amount on the income statement excludes interest expense.
An analyst that chooses to ignore the cost of debt will use this formula:

ROA = (Net Income + Interest Expense) / Average Total Assets

ROA is most useful for comparing companies in the same industry, as different industries use
assets differently. For example, the ROA for service-oriented firms, such as banks, will be
significantly higher than the ROA for capital intensive companies, such as construction or utility
companies.