Ratio Definitions Flashcards
Asset Turnover
Definition:
Measures a company’s ability to generate sales given an investment in fixed assets
- Higher value indicates company uses assets efficiently
- Lower value indicates excessive investments
Working Capital
Definition:
Indicates if there are sufficient current assets to satisfy current liabilities
- Too much working capital = Insufficient use of resources
- Too little working capital = May not meet obligations of creditors
Current Ratio
Definition:
Indicates company’s effectiveness in paying short-term obligations with short-term assets
- High ratio above 1.0 suggests good liquidity
- Optimal ratio level depends on the company’s operating environment
- May be misleading if a significant amount of the company is tied to slow-moving inventory (ex. Boeing)
Debt to Asset Ratio
Definition:
Measures the long-term solvency of the firm
- Can also measure risk, when the company is not able to meet its maturity debt obligations
Times Interest Earned
Definition:
Ability of the company to generate sufficient resources to meet its interest payment obligations
- Shows the amount of earnings before interest expense and income tax relative to the interest expense
- A high ratio is seen as more favourable than a low ratio
Profit Margin
Definition:
Measures the percentage of each dollar of sales that results in net come
- Indicates management’s ability to generate income on every dollar of sales
- Useful when comparing companies in similar industries
Return on Equity
Definition:
Overall measure of profitability, and indicator of value created, from common shareholder’s point of view
- Measures how much the firm earned for each dollar of shareholder’s equity
- If ROE increases over time, the company is generating higher returns to shareholder’s investments
- ROE by itself is not very useful, as we want to see how a company’s ROE changes over time
Return on Assets
Definition:
Ratio of net income to the total assets used to generate this net income
- Considers profitability based on resources contributed by both shareholders and creditors (while ROE is only from the perspective of shareholders)
Price-Earnings (P/E) Ratio
Definition:
Reflects investor’s assessment of the company’s future earnings
- Shows how much an investor is willing to pay for a dollar earning of the company
- Low/High values do not necessarily mean good or bad:
- Low values may mean investors are not confident or the company is undervalued
- High values may mean investors see potential growth
Gross Profit Margin
Definition:
The percentage of revenue available for a company expenses after the cost of goods sold is subtracted
Asset Turnover
Definition:
Measures the efficiency of a company in using assets
- The company with more assets is not necessarily doing better; rather, the one using fewer assets to produce more sales is more efficient
(Dividends) Payout Ratio
Definition:
Percentage of earnings distributed as dividends
- Companies with high growth rates tend to reinvest most of their net income into the business, and tend to have low payout rates
- Some investors prefer high payout ratios and some prefer low payout ratios
- Companies with high payout ratios will have less funds available for growth, so investors interested in share price appreciation may not prefer these companies
- Investors will prefer high payout firms if they seek dividend income
Current Ratio
Definition:
Ability of the firm to use its current assets to pay its current liabilities
Quick Ratio
Definition:
Indicates the amount of quick assets available to satisfy short-term obligations
- Highly current assets are cash, short-term investments (cash equivalents) and net accounts receivables
Accounts Receivable Turnover
Definition:
Shows how quickly a company collects payments from its customers
- Shows the number of times per year that a company collects its receivables
- A high A/R turnover means that the company is efficient at collecting receivables
- A low A/R turnover could lead to cash flow problems
Average Collection Period
Definition:
Indicates the average number of days it takes to collect cash from customers
- A low number indicates that management is effectively collecting receivables
Inventory Turnover
Definition:
Indicates how many times average inventory was produced and sold during the period
- A higher ratio indicates that inventory moves quickly, thus reducing storage and risk of them being obsolete
- A sudden decline in ratio may imply reduction in demand
Days in Inventory
Definition:
Indicates how long inventory is expected to be held by the company
Times Interest Earned
Definition:
Measures the ability of a company to survive over a long period
- Helps long-term creditors and shareholders understand the company’s ability to pay interest
- A high ratio indicates extra buffer to make interest payments if profitability decreases
- A ratio below 1.0 implies the company is unable to make interest payments
Debt to Equity
Definition:
Measures leverage
- A ratio of 1.0 implies half of the company’s assets are financed by equity and half by debt
- Lenders prefer low debt to equity, as it generally indicates less risk and that the company will pay back the lenders
Three key metrics of a company
- Profitability
- Liquidity
- Solvency
Definition: Profitability
Measures the earnings or operating performance of a company
Definition: Liquidity
Measures the company’s ability to meet short-term obligations when they become due, and meet unexpected needs for cash
- Therefore, focuses on the short term current assets and current liabilities
Definition: Solvency
Measures the company’s ability to meet long term commitments and survive over a long period
- A solvent company is defined as a company that has more assets than liabilities
