Accounting Ratios

# Why Accounting Ratios

Accounting Ratios are often used to make business decisions. They are useful indicators of a company's performance and financial situation and allows you to compare firms of different size within an industry, but not between firms in different industries. Most accounting ratios can be calculated from the information provided by the Basic Accounting documents (financial statements). More importantly, these ratios make relationships in the business more understandable compared to financial statements. Based on these ratios, people such as Investors, Stockholders, Lenders & Managers of company get a quick picture of the company's current financial situation and about its financial future.

What can make accounting ratios difficult to use is that their definitions are not standardized. You often have to do a little investigation to make sure that the definitions from multiple sources are the same. Some of the definitions in your textbook are not the most common definitions. You can find the abbreviated list that you will be given on the final exam, as well as some time value of money equations, in this github repository. There is also a direct link to the PDF version of the sheet.

Ratios are industry specific. Hence it can be seen as an ambiguous interpretation some times. You can see industry norms through this database but it requires a Portland State University ODIN account.

Accounting Ratios are grouped in to five categories, listed below:

• Debt Management
• Liquidity
• Asset Management
• Profitability
• Market Trend

### Debt Management

Debt Ratio

(1)
\begin{align} Debt\,Ratio=\frac{Total\,Liabilities}{Total\,Assets} \end{align}

Probability that the Lender can recover the Principal.
Alternate definition can be found here.

Note that, in a business context, there is not a good or bad direction for the debt ratio. The best debt ratio is usually something in the middle. This has to do with the firm balancing the cost of raising capital through borrowing and issuing new stock.

As a firm has more debt, and higher debt ratios, the cost of the debt, in terms of the interest rate they will be charged, increases. That makes issuing more stock, and building the expectations for dividends and capital appreciation, cheaper. Selling more stock would lower the debt ratio.

A similar process happens with issuing new stock. The more you issue, the more investors will require in terms of dividends and appreciation. That makes bonds more attractive.

The balance point tends to be different by industry. Industries with highly variable net income flows tend to find it easier to issue bonds. Those with low variability net income tend to find it easier to issue stock. This is because investors usually require a premium, higher returns, to compensate for the uncertainty.

Times-interest-earned Ratio

(2)
\begin{align} Times-interest-earned Ratio=\frac{EBIT}{Interest\,Expense} \end{align}

EBIT-Earnings before Interest and Income Taxes

Probability that the Borrower will make payments on time.
Alternate definition can be found here.

### Liquidity Analysis

As with many of the other ratios, it is possible to have a ratio that is too high and possible to have one that is too low. If the current or quick ratio, which measures adequacy of working capital are too low, firms tend to either take out loans or sell assets to meet current expenses. If they have too much working capital, they are missing out on the opportunity to make long-term investments and earn higher returns.

Current Ratio

(3)
\begin{align} Current\,Ratio=\frac{Current\,Assets}{Current\,Liabilities} \end{align}

Probability that the firm will either sell an assets or take out a loan in the near future.
Alternate definition can be found here.

Quick Ratio(Acid Test)

(4)
\begin{align} Quick\,Ratio=\frac{Current\,Assets-Inventories}{Current\,Liabilities} \end{align}

Probability of the firm paying all its current liabilities if due immediately.
Alternate definition can be found here.

### Asset Management

Inventory Turnover Ratio

(5)
\begin{align} Inventory\;Turnover\,Ratio=\frac{Total\,Revenue}{Average\,Inventory\,Balance} \end{align}

Probability of filling a large one-time order.
Alternate definition can be found here.

Asset Turnover

(6)
\begin{align} Total\,Asset\,Turnover=\frac{Total\,Revenue}{Total\,Assets} \end{align}

Probability of filling a persistent increase of sales.
Alternate definition can be found here.

The inventory turnover ratio measures how many times the company sold and replaced its inventory over a specific period. Lower ratios mean holding excessive stocks of inventory which is unproductive. However when its comes to filling a large one-time order there is a high probably of filling the order.

The total assets turnover ratio measures how effectively the firm used its total assets in generating its revenue. If inventory is a very large fraction of total assets, a low ratio means company has too much invested in inventory, plants and equipment compared to the size of sales.

In general, inventory turnover ratio provides guidance on one time increases in sales and asset turnover ratio gives guidance on persistent increases in sales.

Day's Sales Outstanding (Accounts Receivable Turnover)

(7)
\begin{align} DSO=\frac{Accounts\,Receivables}{Average\,Sales\,per\,day} \end{align}

Definition of Day's Sales Outstanding can be found here.

The Day's Sales Outstanding Ratio is a measure of how many times a company's accounts receivable have been turned in to cash during the year. Also this ratio shows how long the customers of a business wait before paying what they owe.

Generally a high turnover figure is desirable, because it indicates that a company collects revenues effectively, and that its customers pay bills promptly. A high figure also suggests that a firm's credit and collection policies are sound. There is also an argument that there are advantages to a low number. By extending credit to customers you can increase sales.

### Profitability Analysis and Market Value Analysis

Return on Total Assets

(8)
\begin{align} Return\,On\,Total\,Assets=\frac{EBIT}{Average\,Total\,Assets} \end{align}

Definition can be found here.

EBIT-Earnings before Interest and Taxes

Return on Common Equity (ROE)

(9)
\begin{align} ROE=\frac{Net\,Income-Preferred\,Dividents}{Common\,Stock+Retained\,Earnings+Capital\,Surplus} \end{align}

Definition can be found here. Note for Return on Common Equity please see 1 under Investopedia explains Return on Equity (ROE).

Price-to-Earnings Ratio (P/E Ratio)

(10)
\begin{align} P/E\,Ratio=\frac{Price\,Per\,Share}{Earnings\,Per\,Share} \end{align}

Definition can be found here.

Book Value per Share

(11)
\begin{align} Book\,Value\,per\,Share=\frac{Stock\,Holders\,Equity-Preferred\,Stock}{Common\,Shares\,Outstanding} \end{align}

Definition can be found here.

A link to some accounting ratio flashcards.

# How a Lender Views a Borrower

One method of financing a company's debt is through a bank loan. In this situation lenders use company's Debt Ratio and Its Times-Interest-Earned Ratio to evaluate the loan process. If the ratios are in unsatisfactory condition the lenders may either not grant the loan or may charge a higher interest rate.
Lower debt ratios and Higher Times interest earned Ratios are preferred by lenders because these two ratios are indicators of business's ability to pay its long term liabilities. In other words, the probability of the lender recovering their money is high.

# How Adequate is Working Capital

The excess of current assets over current liabilities is known as Working Capital, a figure that indicates the extent to which current assets can be converted to cash to meet current obligations.

(12)
\begin{align} Working \; Capital=Current\,Assets-Current\,Liabilities \end{align}

Current Ratio is a good indicator of how adequate the working capital is.The larger the working capital,the better able the business is to pay its debt.Generally a current ratio of 2 to 1 (or greater than 1) is considered favorable for larger working capital, but only if the inventory is highly demandable.
When the inventory is slow moving and less demandable, Quick Ratio replaces the current ratio for this purpose. It measures how well a company can meet its obligations without having to liquidate or depend too heavily on its inventory.

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# Bibliography

Park, Chan s. Contemporary Engineering Economics.4th ed. Department of industrial and systems Engineering Auburn University,Upper Saddle River,New Jersey 07458, 2007

# Questions

Here are a few questions that will help you prepare for the exam.

page revision: 98, last edited: 06 Sep 2016 18:34