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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 â€” 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 â€” 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.

Operating Cycle

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.

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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.

Capital Turnover

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 â€” 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.

Chapter

4

Profitability Ratios

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

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EXAMPLE â€” 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 â€” 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.

Chapter

5

Leverage Ratios

Another important group of detail 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 Interest Earned.

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

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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 â€” 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 â€” 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.

Debt Ratio

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 favor a low Debt Ratio. The Debt Ratio is calculated as

follows:

Total Liabilities / Total Assets

EXAMPLE â€” 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 â€” 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 desirable from both creditors and management. Times Interest Earned is

calculated as follows:

Earnings Before Interest and Taxes / Interest Expense

EXAMPLE â€” 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.

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Chapter

6

Market Value Ratios

One final group of detail 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 â€” 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 follows:

Price of Stock / Earnings per Share *

* Earnings per Share are fully diluted to reflect the conversion of securities into common

stock.

EXAMPLE â€” 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.

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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 â€” 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

Dividend Yield

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 â€” 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%

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