Course 1: Evaluating Financial
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
A companion toll free course can be accessed
using your touch tone phone. Dial 1-877-689-4097,
press 3 for Voice on Demand and then press 754
for the quick toll free course.
Revised March 5, 2000
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 Retained Earnings).
EXAMPLE â€” 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 â€” 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
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
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
EXAMPLE â€” 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 â€” 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. As debt increases,
we financial leverage increases. 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 â€” 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 equity financing.
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 =
Now that we understand the basic ratio structure, we can move down to a more detail
analysis with ratios. Four common groups of detail 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 â€” 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 management ratios.
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 â€” 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 â€” 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 â€” 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 detail ratios is 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 follows:
Net Sales / Average Accounts Receivable
EXAMPLE â€” 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 â€” 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 â€” 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.