Excellence in Financial Management
Prepared by: Matt H. Evans, CPA, CMA, CFM
This course provides a basic understanding of how to use ratio analysis for evaluating financial
performance. This course is recommended for 2 hours of Continuing Professional Education. In order to
receive credit, you will need to pass a multiple choice exam which is administered over the internet at
Return on Equity
Why Use Ratios?
It has been said that you must measure what you expect to manage and accomplish.
Without measurement, you have no reference to work with and thus, you tend to operate in the dark.
One way of establishing references and managing the financial affairs of an organization is to use ratios. Ratios are simply relationships
between two financial balances or financial calculations. These relationships establish our references
so we can understand how well we are performing financially. Ratios also extend our traditional way of
measuring financial performance; i.e. relying on financial statements. By applying ratios to a set of
financial statements, we can better understand financial performance.
Calculating Return on Equity
For publicly traded companies, the relationship of earnings to equity or Return on Equity is of
prime importance since management must provide a return for the money invested by shareholders. Return on
Equity is a measure of how well management has used the capital invested by shareholders. Return on
Equity tells us the percent returned for each dollar (or other monetary unit) invested by shareholders.
Return on Equity is calculated by dividing Net Income by Average Shareholders Equity (including
EXAMPLE - Net Income for the year was $60,000, total shareholder equity at the
beginning of the year was $315,000 and ending shareholder equity for the year was $285,000. Return
on Equity is calculated by dividing $60,000 by $300,000 (average shareholders equity which
is $315,000 + $285,000 / 2). This gives us a Return on Equity of 20%. For each dollar invested by
shareholders, 20% was returned in the form of earnings.
SUMMARY - Return on Equity is one of the most widely used ratios for publicly traded companies. It
measures how much return management was able to generate for the shareholders. The formula for
calculating Return on Equity is:
Net Income / Average Shareholders Equity
Components of Return on Equity
Return on Equity has three ratio components. The three ratios that make up Return on Equity are:
1. Profit Margin = Net Income / Sales
2. Asset Turnover = Sales / Assets
3. Financial Leverage = Assets / Equity
Profit Margin measures the percent of profits you generate for each dollar of sales. Profit Margin
reflects your ability to control costs and make a return on your sales. Profit Margin is calculated by
dividing Net Income by Sales. Management is interested in having high profit margins.
EXAMPLE - Net Income for the year was $60,000 and Sales were $480,000. Profit Margin
is $60,000 / $480,000 or 12.5%. For each dollar of sales, we generated $.125 of profits.
Asset Turnover measures the percent of sales you are able to generate from your assets. Asset
Turnover reflects the level of capital we have tied-up in assets and how much sales we can squeeze out
of our assets. Asset Turnover is calculated by dividing Sales by Average Assets. A high asset turnover
rate implies that we can generate strong sales from a relatively low level of capital. Low turnover would
imply a very capital-intensive organization.
EXAMPLE - Sales for the year were $480,000, beginning total assets was $505,000 and
year-end total assets are $495,000. The Asset Turnover Rate is $480,000 / $500,000 (average total
assets which is $505,000 + $495,000 / 2) or .96. For every $1.00 of assets, we were able to
generate $.96 of sales.
Financial Leverage is the third and final component of Return on Equity. Financial Leverage is a
measure of how much we use equity and debt to finance our assets. Generally, management tends to prefer equity financing over debt since it carries
less risk. The Financial Leverage Ratio is calculated by dividing Assets by Shareholder Equity.
EXAMPLE - Average assets are $500,000 and average shareholder equity is $320,000. Financial
Leverage Ratio is $500,000 / $320,000 or 1.56. For each $1.56 in assets, we are using $1.00 in
Now let us compare our Return on Equity to a combination of the three component ratios:
From our example, Return on Equity = $60,000 / $320,000 or 18.75% or we can combine the three
components of Return on Equity from our examples:
Profit Margin x Asset Turnover x Financial Leverage = Return on Equity or .125 x .96 x
1.56 = 18.75%.
Now that we understand the basic ratio structure, we can move down to a more detailed analysis with
ratios. Four common groups of ratios are: Liquidity, Asset Management, Profitability and
Leverage. We will also look at market value ratios.
Liquidity Ratios help us understand if we can meet our obligations over the short-run. Higher
liquidity levels indicate that we can easily meet our current obligations. We can use several types of
ratios to monitor liquidity.
Current Ratio is simply current assets divided by current liabilities. Current assets include cash,
accounts receivable, marketable securities, inventories, and prepaid items. Current liabilities include
accounts payable, notes payable, salaries payable, taxes payable, current maturity's of long-term
obligations and other current accruals.
EXAMPLE - Current Assets are $200,000 and Current Liabilities are $80,000. The Current
Ratio is $200,000 / $80,000 or 2.5. We have 2.5 times more current assets than current liabilities.
A low current ratio would imply possible insolvency problems. A very high current ratio might imply
that management is not investing idle assets productively. Generally, we want to have a current ratio
that is proportional to our operating cycle. We will look at the Operating Cycle as part of asset
Acid Test or Quick Ratio
Since certain current assets (such as inventories) may be difficult to convert into cash, we may
want to modify the Current Ratio. Also, if we use the LIFO (Last In First Out) Method for inventory
accounting, our current ratio will be understated. Therefore, we will remove certain current assets
from our previous calculation. This new ratio is called the Acid Test or Quick Ratio; i.e. assets that
are quickly converted into cash will be compared to current liabilities. The Acid Test Ratio measures
our ability to meet current obligations based on the most liquid assets. Liquid assets include cash,
marketable securities, and accounts receivable. The Acid Test Ratio is calculated by dividing the
sum of our liquid assets by current liabilities.
EXAMPLE - Cash is $5,000, Marketable Securities are $15,000, Accounts Receivable
are $40,000, and Current Liabilities are $80,000. The Acid Test Ratio is ($5,000 + $15,000
+ $40,000) / $80,000 or .75. We have $.75 in liquid assets for each $1.00 in current liabilities.
Defensive Interval is the sum of liquid assets compared to our expected daily cash outflows. The
Defensive Interval is calculated as follows:
(Cash + Marketable Securities + Receivables) / Daily Operating Cash Outflow
EXAMPLE - Referring back to our last example, we have total quick assets of $60,000 and
we have estimated that our daily operating cash outflow is $1,200. This would give us a 50 day
defensive interval ($60,000 / $1,200). We have 50 days of liquid assets to cover our cash outflows.
Ratio of Operating Cash Flow to Current Debt Obligations
The Ratio of Operating Cash Flow to Current Debt Obligations places emphasis on cash flows to meet
fixed debt obligations. Current maturities of long-term debts along with notes payable comprise our
current debt obligations. We can refer to the Statement of Cash Flows for operating cash flows.
Therefore, the Ratio of Operating Cash Flow to Current Debt Obligations is calculated as follows:
Operating Cash Flow / (Current Maturity of Long-Term Debt + Notes Payable)
EXAMPLE - We have operating cash flow of $100,000, notes payable of $20,000 and we
have $5,000 in current obligations related to our long-term debt. The Operating Cash Flow to Current
Debt Obligations Ratio is $100,000 / ($20,000 + $5,000) or 4.0. We have 4 times the cash flow to
cover our current debt obligations.
Asset Management Ratios
A second group of ratios are asset management ratios. Asset management ratios measure the
ability of assets to generate revenues or earnings. They also compliment our liquidity ratios. We
looked at one asset management ratio already; namely Total Asset Turnover when we analyzed Return on
Equity. We will now look at five more asset management ratios: Accounts Receivable Turnover, Days in
Receivables, Inventory Turnover, Days in Inventory, and Capital Turnover.
Accounts Receivable Turnover
Accounts Receivable Turnover measures the number of times we were able to convert our receivables
over into cash. Higher turnover ratios are desirable. Accounts Receivable Turnover is calculated as
Net Sales / Average Accounts Receivable
EXAMPLE - Sales are $480,000, the average receivable balance during the year was $40,000
and we have a $20,000 allowance for sales returns. Accounts Receivable Turnover is ($480,000 - $20,000)
/ $40,000 or 11.5. We were able to turn our receivables over 11.5 times during the year.
NOTE - We are assuming that all of our sales are credit sales; i.e. we do
not have any significant cash sales.
Days in Accounts Receivable
The Number of Days in Accounts Receivable is the average length of time required to collect our
receivables. A low number of days is desirable. Days in Accounts Receivable is calculated as follows:
365 or 360 or 300 / Accounts Receivable Turnover
EXAMPLE - If we refer to our previous example and we base our calculation on the full
calendar year, we would require 32 days on average to collect our receivables. 365 / 11.5 = 32 days.
Inventory Turnover is similar to accounts receivable turnover. We are measuring how many times did
we turn our inventory over during the year. Higher turnover rates are desirable. A high turnover rate
implies that management does not hold onto excess inventories and our inventories are highly marketable.
Inventory Turnover is calculated as follows:
Cost of Sales / Average Inventory
EXAMPLE - Cost of Sales were $192,000 and the average inventory balance during the year
was $120,000. The Inventory Turnover Rate is 1.6 or we were able to turn our inventory over 1.6 times
during the year.
Days in Inventory
Days in Inventory is the average number of days we held our inventory before a sale. A low number
of inventory days is desirable. A high number of days implies that management is unable to sell existing
inventory stocks. Days in Inventory is calculated as follows:
365 or 360 or 300 / Inventory Turnover
EXAMPLE - If we refer back to the previous example and we use the entire calendar year for
measuring inventory, then on average we are holding our inventories 228 days before a sale. 365 /
1.6 = 228 days.
Now that we have calculated the number of days for receivables and the number of days for
inventory, we can estimate our operating cycle. Operating Cycle = Number of Days in Receivables +
Number of Days in Inventory. In our previous examples, this would be 32 + 228 = 260 days. So on
average, it takes us 260 days to generate cash from our current assets.
If we look back at our Current Ratio, we found that we had 2.5 times more current assets than
current liabilities. We now want to compare our Current Ratio to our Operating Cycle. Our turnover
within the Operating Cycle is 365 / 260 or 1.40. This is lower than our Current Ratio of 2.5. This
indicates that we have additional assets to cover the turnover of current assets into cash. If our
current ratio were below that of the Operating Cycle Turnover Rate, this would imply that we do not
have sufficient current assets to cover current liabilities within the Operating Cycle. We may have
to borrow short-term to pay our expenses.
One final turnover ratio that we can calculate is Capital Turnover. Capital Turnover measures our
ability to turn capital over into sales. Remember, we have two sources of capital: Debt and Equity.
Capital Turnover is calculated as follows:
Net Sales / Interest Bearing Debt + Shareholders Equity
EXAMPLE - Net Sales are $460,000, we have $50,000 in Debt and $200,000 of Equity. Capital
Turnover is $460,000 / ($50,000 + $200,000) = 1.84. For each $1.00 of capital invested (both
debt and equity), we are able to generate $1.84 in sales.
A third group of ratios that we can use are Profitability Ratios. Profitability Ratios measure the
level of earnings in comparison to a base, such as assets, sales, or capital. We have already reviewed
two profitability ratios: Return on Equity and Profit Margin. Two other ratios we can use to measure
profitability are Operating Income to Sales and Return on Assets.
Operating Income to Sales
Operating Income to Sales compares Earnings Before Interest and Taxes (EBIT) to Sales. By using
EBIT, we place more emphasis on operating results and we more closely follow cash flow concepts.
Operating Income to Sales is calculated as follows:
EBIT / Net Sales
EXAMPLE - Net Sales are $460,000 and Earnings Before Interest and Taxes is $100,000. This
gives us a return of 22% on sales, $100,000 / $460,000 = .22. For every $1.00 of sales, we generated
$.22 in Operating Income.
Return on Assets
Return on Assets measures the net income returned on each dollar of assets. This ratio measures
overall profitability from our investment in assets. Higher rates of return are desirable. Return on
Assets is calculated as follows:
Net Income / Average Total Assets
EXAMPLE - Net Income is $60,000 and average total assets for the year are $500,000. This
gives us a 12% return on assets, $60,000 / $500.000 = .12.
Return on Assets is often modified to ensure accurate measurement of returns. For example, we may want
to deduct out preferred dividends from Net Income or maybe we should include operating assets only and
exclude intangibles, investments, and other assets not managed for an overall rate of return.
Another important group of ratios are Leverage Ratios. Leverage Ratios measure the use of
debt and equity for financing of assets. We previously looked at the Financial Leverage Ratio as part of
Return on Equity. Three other leverage ratios that we can use are Debt to Equity, Debt Ratio, and Times
Debt to Equity
Debt to Equity is the ratio of Total Debt to Total Equity. It compares the funds provided by creditors
to the funds provided by shareholders. As more debt is used, the Debt to Equity Ratio will increase.
Since we incur more fixed interest obligations with debt, risk increases. On the other hand, the use of
debt can help improve earnings since we get to deduct interest expense on the tax return. So we want to
balance the use of debt and equity such that we maximize our profits, but at the same time manage our
risk. The Debt to Equity Ratio is calculated as follows:
Total Liabilities / Shareholders Equity
EXAMPLE - We have total liabilities of $75,000 and total shareholders equity of $200,000.
The Debt to Equity Ratio is 37.5%, $75,000 / $200,000 = .375. When compared to our equity resources,
37.5% of our resources are in the form of debt.
KEY POINT - As a general rule, it is advantageous to increase our use of debt (trading on the equity)
if earnings from borrowed funds exceeds the costs of borrowing.
The Debt Ratio measures the level of debt in relation to our investment in assets. The Debt Ratio
tells us the percent of funds provided by creditors and to what extent our assets protect us from
creditors. A low Debt Ratio would indicate that we have sufficient assets to cover our debt load.
Creditors and management favour a low Debt Ratio. The Debt Ratio is calculated as follows:
Total Liabilities / Total Assets
EXAMPLE - Total Liabilities are $75,000 and Total Assets are $500,000. The Debt Ratio
is 15%, $75,000 / $500,000 = .15. 15% of our funds for assets comes from debt.
NOTE - We use Total Liabilities to be conservative in our assessment.
Times Interest Earned
Times Interest Earned is the number of times our earnings (before interest and taxes) covers our
interest expense. It represents our margin of safety in making fixed interest payments. A high ratio
is desired by both creditors and management. Times Interest Earned is calculated as follows:
Earnings Before Interest and Taxes / Interest Expense
EXAMPLE - Earnings Before Interest Taxes is $100,000 and we have $10,000 in Interest
Expense. Times Interest Earned is 10 times, $100,000 / $10,000. We are able to cover our interest
expense 10 times with operating income.
Market Value Ratios
One final group of ratios that warrants some attention is Market Value Ratios. These ratios
attempt to measure the economic status of the organization within the marketplace. Investors use these
ratios to evaluate and monitor the progress of their investments.
Earnings Per Share
Growth in earnings is often monitored with Earnings per Share (EPS). The EPS expresses the earnings
of a company on a "per share" basis. A high EPS in comparison to other competing firms is desirable. The
EPS is calculated as:
Earnings Available to Common Shareholders / Number of Common Shares Outstanding
EXAMPLE - Earnings are $100,000 and preferred stock dividends of $20,000 need to be paid.
There are a total of 80,000 common shares outstanding. Earnings per Share (EPS) is ($100,000 - $20,000)
/ 80,000 shares outstanding or $1.00 per share.
P / E Ratio
The relationship of the price of the stock in relation to EPS is expressed as the Price to Earnings
Ratio or P / E Ratio. Investors often refer to the P / E Ratio as a rough indicator of value for a
company. A high P / E Ratio would imply that investors are very optimistic (bullish) about the future
of the company since the price (which reflects market value) is selling for well above current earnings.
A low P / E Ratio would imply that investors view the company's future as poor and thus, the price the
company sells for is relatively low when compared to its earnings. The P / E Ratio is calculated as
Price of Stock / Earnings per Share *
* Earnings per Share are fully diluted to reflect the conversion of securities into common stock.
EXAMPLE - Earnings per share is $3.00 and the stock is selling for $36.00 per share.
The P / E Ratio is $36 / $3 or 12. The company is selling for 12 times earnings.
Book Value per Share
Book Value per Share expresses the total net assets of a business on a per share basis.
This allows us to compare the book values of a business to the stock price and gauge differences in
valuations. Net Assets available to shareholders can be calculated as Total Equity less Preferred Equity.
Book Value per Share is calculated as follows:
Net Assets Available to Common Shareholders * / Outstanding Common Shares
* Calculated as Total Equity less Preferred Equity.
EXAMPLE - Total Equity is $5,000,000 including $400,000 of preferred equity. The total
number of common shares outstanding is 80,000 shares. Book Value per Share is ($5,000,000 - $400,000)
/ 80,000 or $57.50
The percentage of dividends paid to shareholders in relation to the price of the stock is called the
Dividend Yield. For investors interested in a source of income, the dividend yield is important since it
gives the investor an indication of how much dividends are paid by the company. Dividend Yield is
calculated as follows:
Dividends per Share / Price of Stock
EXAMPLE - Dividends per share are $2.10 and the price of the stock is $30.00 per share.
The Dividend Yield is $2.10 / $30.00 or 7%
Comparing Financial Statements
One final way of evaluating financial performance is to simply compare financial statements from
period to period and to compare financial statements with other companies. This can be facilitated by
vertical and horizontal analysis.
Vertical analysis compares line items on a financial statement over an extended period of time.
This helps us spot trends and restate financial statements to a common size for quick analysis. For the
Balance Sheet, we will use total assets as our base (100%) and for the Income Statement, we will use
Sales as our base (100%). We will compare different line items on the financial statements to these
bases and express the line items as a percentage of the base.
EXAMPLE - Income Statements for the last three years are summarized below:
| || || || |
|Sales||$300,000 ||$310,000 ||$330,000 |
|Cost of Goods Sold||(110,000) ||(110,000) ||(110,000) |
|G & A Expenses||(80,000) ||(80,000) ||(105,000) |
|Net Income||37% ||34% ||35% |
| || < - - - - Vertical Analysis - - - - > |
|Sales||100% ||100% ||100% |
|Cost of Goods Sold||37% ||34% ||33% |
|G & A Expenses||27% ||32% ||32% |
|Net Income||37% ||34% ||35% |
By expressing balances as percentages, we can easily notice that G & A Expenses are trending up while
Cost of Goods Sold is moving down. This may require further analysis to determine what is behind these
Horizontal analysis looks at the percentage change in a line item from one period to the next.
This helps us identify trends from the financial statements. Once we spot a trend, we can dig deeper
and investigate why the change occurred. The percentage change is calculated as:
(Dollar Amount in Year 2 - Dollar Amount in Year 1) / Dollar Amount in Year 1
EXAMPLE - Sales were $310,000 in 1991 and $330,000 in 1992. The percentage change in
($330,000 - $310,000) / $310,000 = 6.5%
We can apply this analysis "horizontally" down the financial statement for the year 1992:
|Cost of Goods Sold||4.8%|
|G & A Expenses||5.0%|
We started our look at ratio analysis with Return on Equity since this one ratio is at the heart of
financial management; namely we want to maximize returns for the shareholders of the company. Secondly,
we have three ways of influencing Return on Equity. We can change our profit margins, we can change our
turnover of assets, or we can change our use of financial leverage. Next, we looked at how we can
influence the three components of Return on Equity.
There are several ratios that we can monitor, such as acid test, inventory turnover, and debt
to equity. Ratios help us monitor specific financial conditions, such as liquidity or
Ratios are best used when compared or benchmarked against another reference, such as an industry
standard or "best in class" within our industry. This type of comparison helps us establish financial
goals and identify problem areas.
We also can use vertical and horizontal analysis for easy identification of changes within
It should be noted that ratios do have limitations. After all, ratios are usually derived from
financial statements and financial statements have serious limitations. Additionally, comparisons are
usually difficult because of operating and financial differences between companies. None-the-less, if
you want to analyze a set of financial statements, ratio analysis is probably one of the most popular
approaches to understanding financial performance.
Select the best answer for each question. Exams are graded and administered over the internet at
- Which ratio is best used for measuring how well management did in managing the funds
provided by shareholders?
- Profit Margin
- Debt to Equity
- Return on Equity
- Inventory Turnover
- If sales are $600,000 and assets are $400,000, then asset turnover is:
- An extremely high current ratio implies:
- Management is not investing idle assets productively.
- Current assets have been depleted and the company is insolvent.
- Total assets are earning a very low rate of return.
- Current liabilities are higher than current assets.
- If we have cash of $1,500, accounts receivables of $25,500 and current liabilities of $30,000, our quick or acid test ratio would be:
- The number of times we convert receivables into cash during the year is measured by:
- Capital Turnover
- Asset Turnover
- Accounts Receivable Turnover
- Return on Assets
- If our cost of sales are $120,000 and our average inventory balance is $90,000, then our
inventory turnover rate is:
- We can estimate our Operating Cycle by taking the sum of:
- Receivable Turnover + Inventory Turnover
- Days in Receivables + Days in Inventory
- Asset Turnover + Return on Sales
- Days in Sales + Days in Assets
- If Operating Income (Earnings Before Interest Taxes) is $63,000 and Net Sales are $900,000, then Operating Income to Sales is:
- If the price of the stock is $45.00 and the Earnings per Share is $9.00, then the P / E Ratio is:
- Net Income for 1996 was $400,000 and Net Income for 1997 was $420,000. The percentage change in Net Income is:
This course is provided by Excellence in Financial Management. For additional course information, visit www.exinfm.com/training.
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