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# Current Ratio

The current ratio is a liquidity andefficiency ratio that measures a firm's ability to pay off its short-term
liabilities with its current assets. The current ratio is an important measure of liquidity because short-term
liabilities are due within the next year.
This means that a company has a limited amount of time in order to raise the funds to pay for these
liabilities. Current assets like cash, cash equivalents, and marketable securities can easily be converted
into cash in the short term. This means that companies with larger amounts of current assets will more
easily be able to pay off current liabilities when they become due without having to sell off long-term,
revenue generating assets.

Formula
The current ratio is calculated by dividing current assets by current liabilities. This ratio is stated in numeric
format rather than in decimal format. Here is the calculation:

GAAP requires that companies separate current and long-term assets and liabilities on thebalance sheet.
This split allows investors and creditors to calculate important ratios like the current ratio. On U.S. financial
statements, current accounts are always reported before long-term accounts.

Analysis

The current ratio helps investors and creditors understand the liquidity of a company and how easily that
company will be able to pay off its current liabilities. This ratio expresses a firm's current debt in terms of
current assets. So a current ratio of 4 would mean that the company has 4 times more current assets than
current liabilities.
A higher current ratio is always more favorable than a lower current ratio because it shows the company
can more easily make current debt payments.
If a company has to sell of fixed assets to pay for its current liabilities, this usually means the company
isn't making enough from operations to support activities. In other words, the company is losing money.
Sometimes this is the result of poor collections of accounts receivable.
The current ratio also sheds light on the overall debt burden of the company. If a company is weighted
down with a current debt, its cash flow will suffer.

Example
Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie is applying for loans to
help fund his dream of building an indoor skate rink. Charlie's bank asks for his balance sheet so they can
analysis his current debt levels. According to Charlie's balance sheet he reported \$100,000 of current
liabilities and only \$25,000 of current assets. Charlie's current ratio would be calculated like this:

As you can see, Charlie only has enough current assets to pay off 25 percent of his current liabilities. This
shows that Charlie is highly leveraged and highly risky. Banks would prefer a current ratio of at least 1 or
2, so that all the current liabilities would be covered by the current assets. Since Charlie's ratio is so low, it
is unlikely that he will get approved for his loan.

Quick Ratio
The quick ratio or acid test ratio is aliquidity ratio that measures the ability of a company to pay its current
liabilities when they come due with only quick assets. Quick assets are current assets that can be
converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or
marketable securities, and current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities
that can easily be converted into cash within the next 90 days. Marketable securities are traded on an
open market with a known price and readily available buyers. Any stock on the New York Stock Exchange
would be considered a marketable security because they can easily be sold to any investor when the
market is open.
The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for
gold by the early miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by
corroding from the acid, it was a base metal and of no value.
The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay
off its current liabilities. It also shows the level of quick assets to current liabilities.
Formula

The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current
receivables together then dividing them by current liabilities.

Sometimes company financial statements don't give a breakdown of quick assets on thebalance sheet. In
this case, you can still calculate the quick ratio even if some of the quick asset totals are unknown. Simply
subtract inventory and any current prepaid assets from the current asset total for the numerator. Here is an
example.

Analysis

The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities
with quick assets. If a firm has enough quick assets to cover its total current liabilities, the firm will be able
to pay off its obligations without having to sell off any long-term or capital assets.
Since most businesses use their long-term assets to generate revenues, selling off these capital assets
will not only hurt the company it will also show investors that current operations aren't making enough
profits to pay off current liabilities.
Higher quick ratios are more favorable for companies because it shows there are more quick assets than
current liabilities. A company with a quick ratio of 1 indicates that quick assets equal current assets. This
also shows that the company could pay off its current liabilities without selling any long-term assets. An
acid ratio of 2 shows that the company has twice as many quick assets than current liabilities.
Obviously, as the ratio increases so does the liquidity of the company. More assets will be easily converted
into cash if need be. This is a good sign for investors, but an even better sign to creditors because
creditors want to know they will be paid back on time.
Example

Let's assume Carole's Clothing Store is applying for a loan to remodel the storefront. The bank asks
Carole for a detailed balance sheet, so it can compute the quick ratio. Carole's balance sheet included the
following accounts:

Cash: \$10,000
Accounts Receivable: \$5,000
Inventory: \$5,000
Stock Investments: \$1,000
Prepaid taxes: \$500
Current Liabilities: \$15,000

## The bank can compute Carole's quick ratio like this.

As you can see Carole's quick ratio is 1.07. This means that Carole can pay off all of her current liabilities
with quick assets and still have some quick assets left over.
Now let's assume the same scenario except Carole did not provide the bank with a detailed balance sheet.
Instead Carole's balance sheet only included these accounts:

Inventory: \$5,000
Prepaid taxes: \$500
Total Current Assets: \$21,500
Current Liabilities: \$15,000

Since Carole's balance sheet doesn't include the breakdown of quick assets, the bank can compute her
quick ratio like this:

Cash Ratio
The cash ratio or cash coverage ratio is a liquidity ratio that measures a firm's ability to pay off its current
liabilities with only cash and cash equivalents. The cash ratio is much more restrictive than the current
ratio or quick ratio because no other current assets can be used to pay off current debt--only cash.
This is why many creditors look at the cash ratio. They want to see if a company maintains adequate cash
balances to pay off all of their current debts as they come due. Creditors also like the fact that inventory
and accounts receivable are left out of the equation because both of these accounts are not guaranteed to
be available for debt servicing. Inventory could take months or years to sell and receivables could take
weeks to collect. Cash is guaranteed to be available for creditors.

Formula
The cash coverage ratio is calculated by adding cash and cash equivalents and dividing by the total
current liabilities of a company.

Most companies list cash and cash equivalents together on their balance sheet, but some companies list
them separately. Cash equivalents are investments and other assets that can be converted into cash
within 90 days. These assets are so close to cash that GAAP considers them an equivalent.
Current liabilities are always shown separately from long-term liabilities on the face of the balance sheet.

Analysis
The cash ratio shows how well a company can pay off its current liabilities with only cash and cash
equivalents. This ratio shows cash and equivalents as a percentage of current liabilities.
A ratio of 1 means that the company has the same amount of cash and equivalents as it has current debt.
In other words, in order to pay off its current debt, the company would have to use all of its cash and
equivalents. A ratio above 1 means that all the current liabilities can be paid with cash and equivalents. A
ratio below 1 means that the company needs more than just its cash reserves to pay off its current debt.
As with most liquidity ratios, a higher cash coverage ratio means that the company is more liquid and can
more easily fund its debt. Creditors are particularly interested in this ratio because they want to make sure
their loans will be repaid. Any ratio above 1 is considered to be a good liquidity measure.

Example
Sophie's Palace is a restaurant that is looking to remodel its dining room. Sophie is asking her bank for a
loan of \$100,000. Sophie's balance sheet lists these items:

Cash: \$10,000
Cash Equivalents: \$2,000
Accounts Payable: \$5,000
Current Taxes Payable: \$1,000
Current Long-term Liabilities: \$10,000

## Sophie's cash ratio is calculated like this:

As you can see, Sophie's ratio is .75. This means that Sophie only has enough cash and equivalents to
pay off 75 percent of her current liabilities. This is a fairly high ratio which means Sophie maintains a
relatively high cash balance during the year.
Obviously, Sophie's bank would look at other ratios before accepting her loan application, but based on
this coverage ratio, Sophie would most likely be accepted.

## Accounts Receivable Turnover Ratio

Accounts receivable turnover is anefficiency ratio or activity ratio that measures how many times a
business can turn its accounts receivable into cash during a period. In other words, the accounts
receivable turnover ratio measures how many times a business can collect its average accounts
receivable during the year.
A turn refers to each time a company collects its average receivables. If a company had \$20,000 of
average receivables during the year and collected \$40,000 of receivables during the year, the company

would have turned its accounts receivable twice because it collected twice the amount of average
receivables.
This ratio shows how efficient a company is at collecting its credit sales from customers. Some companies
collect their receivables from customers in 90 days while other take up to 6 months to collect from
customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are
more liquid the faster they can covert their receivables into cash.
Formula

Accounts receivable turnover is calculated by dividing net credit sales by the average accounts receivable
for that period.

The reason net credit sales are used instead of net sales is that cash sales don't create receivables. Only
credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales simply refers
to sales minus returns and refunded sales.
The net credit sales can usually be found on the company's income statement for the year although not all
companies report cash and credit sales separately. Average receivables is calculated by adding the
beginning and ending receivables for the year and dividing by two. In a sense, this is a rough calculation
of the average receivables for the year.
Analysis

Since the receivables turnover ratio measures a business' ability to efficiently collect itsreceivables, it only
makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are
collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the
company collected its average receivables twice during the year. In other words, this company is collecting
is money from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from
customers sooner, it will be able to use that cash to pay bills and other obligations sooner.
Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A
company with a higher ratio shows that credit sales are more likely to be collected than a company with a
lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is
important.
Example

Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to all of his main
customers. At the end of the year, Bill's balance sheet shows \$20,000 in accounts receivable, \$75,000 of

gross credit sales, and \$25,000 of returns. Last year's balance sheet showed \$10,000 of accounts
receivable.
The first thing we need to do in order to calculate Bill's turnover is to calculate net credit sales and average
accounts receivable. Net credit sales equals gross credit sales minus returns (75,000 25,000 = 50,000).
Average accounts receivable can be calculated by averaging beginning and ending accounts receivable
balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Bill's accounts receivable turnover ratio for the year can be like this.

As you can see, Bill's turnover is 3.33. This means that Bill collects his receivables about 3.3 times a year
or once every 110 days. In other words, when Bill makes a credit sale, it will take him 110 days to collect
the cash from that sale.

## Inventory Turnover Ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by
comparing cost of goods sold with average inventory for a period. This measures how many times
average inventory is "turned" or sold during a period. In other words, it measures how many times a
company sold its total average inventory dollar amount during the year. A company with \$1,000 of average
inventory and sales of \$10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components of performance. The first
component is stock purchasing. If larger amounts of inventory are purchased during the year, the
company will have to sell greater amounts of inventory to improve its turnover. If the company can't sell
these greater amounts of inventory, it will incur storage costs and otherholding costs.
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not
turn effectively. That's why the purchasing and sales departments must be in tune with each other.
Formula

The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average
inventory for that period.

Average inventory is used instead of ending inventory because many companies' merchandise fluctuates
greatly throughout the year. For instance, a company might purchase a large quantity of merchandise
January 1 and sell that for the rest of the year. By December almost the entire inventory is sold and the
ending balance does not accurately reflect the company's actual inventory during the year. Average
inventory is usually calculated by adding the beginning and ending inventory and dividing by two.
The cost of goods sold is reported on the income statement.
Analysis

Inventory turnover is a measure of how efficiently a company can control its merchandise, so it is
important to have a high turn. This shows the company does not overspend by buying too much inventory
and wastes resources by storing non-salable inventory. It also shows that the company can effectively sell
This measurement also shows investors how liquid a company's inventory is. Think about it. Inventory is
one of the biggest assets a retailer reports on its balance sheet. If this inventory can't be sold, it is
worthless to the company. This measurement shows how easily a company can turn its inventory into
cash.
Creditors are particularly interested in this because inventory is often put up as collateral for loans. Banks
want to know that this inventory will be easy to sell.
Inventory turns vary with industry. For instance, the apparel industry will have higher turns than the exotic
car industry.
Example

Donny's Furniture Company sells industrial furniture for office buildings. During the current year, Donny
reported cost of goods sold on its income statement of \$1,000,000. Donny's beginning inventory was
\$3,000,000 and its ending inventory was \$4,000,000. Donny's turnover is calculated like this:

As you can see, Donny's turnover is .29. This means that Donny only sold roughly a third of its inventory
during the year. It also implies that it would take Donny approximately 3 years to sell his entire inventory or
complete one turn. In other words, Danny does not have very good inventory control.

## Asset Turnover Ratio

The asset turnover ratio is an efficiency ratio that measures a company's ability to generate sales from its
assets by comparing net sales with average total assets. In other words, this ratio shows how efficiently a
company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how many sales are
generated from each dollar of company assets. For instance, a ratio of .5 means that each dollar of assets
generates 50 cents of sales.

Formula
The asset turnover ratio is calculated by dividing net sales by average total assets.

Net sales, found on the income statement, are used to calculate this ratio returns and refunds must be
backed out of total sales to measure the truly measure the firm's assets' ability to generate sales.
Average total assets are usually calculated by adding the beginning and ending total asset balances
together and dividing by two. This is just a simple average based on a two-yearbalance sheet. A more indepth, weighted average calculation can be used, but it is not necessary.

Analysis
This ratio measures how efficiently a firm uses its assets to generate sales, so a higher ratio is always
more favorable. Higher turnover ratios mean the company is using its assets more efficiently. Lower ratios
mean that the company isn't using its assets efficiently and most likely have management or production
problems.
For instance, a ratio of 1 means that the net sales of a company equals the average total assets for the
year. In other words, the company is generating 1 dollar of sales for every dollar invested in assets.
Like with most ratios, the asset turnover ratio is based on industry standards. Some industries use assets
more efficiently than others. To get a true sense of how well a company's assets are being used, it must
be compared to other companies in its industry.
The total asset turnover ratio is a general efficiency ratio that measures how efficiently a company uses all
of its assets. This gives investors and creditors an idea of how a company is managed and uses its assets
to produce products and sales.
Sometimes investors also want to see how companies use more specific assets like fixed assets and
current assets. The fixed asset turnover ratio and the working capital ratio are turnover ratios similar to the
asset turnover ratio that are often used to calculate the efficiency of these asset classes.

Example

Sally's Tech Company is a tech start up company that manufactures a new tablet computer. Sally is
currently looking for new investors and has a meeting with an angel investor. The investor wants to know
how well Sally uses her assets to produce sales, so he asks for her financial statements.
Here is what the financial statements reported:

## Beginning Assets: \$50,000

Ending Assets: \$100,000
Net Sales: \$25,000

## The total asset turnover ratio is calculated like this:

As you can see, Sally's ratio is only .33. This means that for every dollar in assets, Sally only generates 33
cents. In other words, Sally's start up in not very efficient with its use of assets.

Debt Ratio
Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its total assets. In a
sense, the debt ratio shows a company's ability to pay off its liabilities with its assets. In other words, this
shows how many assets the company must sell in order to pay off all of its liabilities.
This ratio measures the financial leverage of a company. Companies with higher levels of liabilities
compared with assets are considered highly leveraged and more risky for lenders.
This helps investors and creditors analysis the overall debt burden on the company as well as the firm's
ability to pay off the debt in future, uncertain economic times.
Formula

The debt ratio is calculated by dividing total liabilities by total assets. Both of these numbers can easily be
found the balance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation. The debt ratio shows the
overall debt burden of the companynot just the current debt.
Analysis

The debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total
assets. As with many solvency ratios, a lower ratios is more favorable than a higher ratio.
A lower debt ratio usually implies a more stable business with the potential of longevity because a
company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but .
5 is reasonable ratio.
A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many
assets as liabilities. Or said a different way, this company's liabilities are only 50 percent of its total assets.
Essentially, only its creditors own half of the company's assets and the shareholders own the remainder of
the assets.
A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell
off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm. Once its assets
are sold off, the business no longer can operate.
The debt ratio is a fundamental solvency ratio because creditors are always concerned about being
repaid. When companies borrow more money, their ratio increases creditors will no longer loan them
money. Companies with higher debt ratios are better off looking to equity financing to grow their
operations.
Example

Dave's Guitar Shop is thinking about building an addition onto the back of its existing building for more
storage. Dave consults with his banker about applying for a new loan. The bank asks for Dave's balance
to examine his overall debt levels.
The banker discovers that Dave has total assets of \$100,000 and total liabilities of \$25,000. Dave's debt
ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as many assets as he
has liabilities. This is a relatively low ratio and implies that Dave will be able to pay back his loan. Dave
shouldn't have a problem getting approved for his loan.

## Times Interest Earned Ratio

The times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that
measures the proportionate amount of income that can be used to cover interest expenses in the future.
In some respects the times interest ratio is considered a solvency ratio because it measures a firm's ability
to make interest and debt service payments. Since these interest payments are usually made on a longterm basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the

company can't make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be
considered a solvency ratio.
Formula

The times interest earned ratio is calculated by dividing income before interest and income taxes by the
interest expense.

Both of these figures can be found on the income statement. Interest expense and income taxes are often
reported separately from the normal operating expenses for solvency analysis purposes. This also makes
it easier to find the earnings before interest and taxes or EBIT.
Analysis

The times interest ratio is stated in numbers as opposed to a percentage. The ratio indicates how many
times a company could pay the interest with its before tax income, so obviously the larger ratios are
considered more favorable than smaller ratios.
In other words, a ratio of 4 means that a company makes enough income to pay for its totalinterest
expense 4 times over. Said another way, this company's income is 4 times higher than its interest expense
for the year.
As you can see, creditors would favor a company with a much higher times interest ratio because it shows
the company can afford to pay its interest payments when they come due. Higher ratios are less risky
while lower ratios indicate credit risk.
Example

Tim's Tile Service is a construction company that is currently applying for a new loan to buy equipment.
The bank asks Tim for his financial statements before they will consider his loan. Tim's income statement
shows that he made \$500,000 of income before interest expense and income taxes. Tim's overall interest
expense for the year was only \$50,000. Tim's time interest earned ratio would be calculated like this:

As you can see, Tim has a ratio of ten. This means that Tim's income is 10 times greater than his annual
interest expense. In other words, Tim can afford to pay additional interest expenses. In this respect, Tim's
business is less risky and the bank shouldn't have a problem accepting his loan.

## Fixed Charge Coverage Ratio

The fixed charge coverage ratio is afinancial ratio that measures a firm's ability to pay all of its fixed
charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio is
basically an expanded version of the times interest earned ratio or the times interest coverage ratio.
The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like
lease payments, insurance payments, and preferred dividend payments can be built into the calculation.
Formula

The fixed charge coverage ratio starts with the times earned interest ratio and adds in applicable fixed
costs. We will use lease payments for this example, but any fixed cost can be added in. This ratio would
be calculated like this:

Note that any number of fixed costs can be used in this formula. This coverage ratio is not limited to only
one cost.
Analysis

The fixed charge coverage ratio shows investors and creditors a firm's ability to make its fixed payments.
Like the times interest ratio, this ratio is stated in numbers rather than percentages.
The ratio measures how many times a firm can pay its fixed costs with its income before interest and
taxes. In other words, it shows how many times greater the firm's income is compared with its fixed costs.
In a way, this ratio can be viewed as a solvency ratio because it shows how easily a company can pay its
bills when they become due. Obviously, if a company can't pay its lease or rent payments, it will not be in
Higher fixed cost ratios indicate a healthier and less risky business to invest in or loan to. Lower ratios
show creditors and investors that the company can barely meet its monthly bills.
Example

Quinn's Harp Shop is an instrument retailer that specializes in selling and repairing harps. Quinn has been
interest in remodeling the inside of his store but needs a loan in order to afford it. After giving his financial
statements to the bank, the loan officer calculates Quinn's fixed charge coverage ratio.

According to Quinn's income statement, he has \$300,000 of income before interest and taxes and interest
expense of \$30,000. Quinn's current lease payment is \$2,000 a month or \$24,000 a year. Here is how
Quinn's ratio is calculated:

As you can see, Quinn's ratio is six. That means that Quinn's income is 6 times greater than his interest
and lease payments. This is a healthy ratio and he should be able to receive his loan from the bank.

## Gross Margin Ratio

Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales.
This ratio measures how profitable a company sells its inventory or merchandise. In other words, the
gross profit ratio is essentially the percentage markup on merchandise from its cost. This is the pure profit
from the sale of inventory that can go to paying operating expenses.
Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different.
Gross margin ratio only considers the cost of goods sold in its calculation because it measures the
profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.

Formula
Gross margin ratio is calculated by dividing gross margin by net sales.

The gross margin of a business is calculated by subtracting cost of goods sold from net sales. Net sales
equals gross sales minus any returns or refunds. The broken down formula looks like this:

Analysis
Gross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It
only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their
inventory at a higher profit percentage.

High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can
get a bigpurchase discount when they buy their inventory from the manufacturer or wholesaler, their gross
margin will be higher because their costs are down.
The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has
to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.
A company with a high gross margin ratios mean that the company will have more money to pay operating
expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also
measures the percentage of sales that can be used to help fund other parts of the business. Here is
another great explaination.

Example
Assume Jack's Clothing Store spent \$100,000 on inventory for the year. Jack was able to sell this
inventory for \$500,000. Unfortunately, \$50,000 of the sales were returned by customers and refunded.
Jack would calculate his gross margin ratio like this.

As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel industry. This means that
after Jack pays off his inventory costs, he still has 78 percent of his sales revenue to cover his operating
costs.

## Gross Profit Margin

Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of
goods sold. In other words, it measures how efficiently a company uses its materials and labor to produce
and sell products profitably. You can think of it as the amount of money from product sales left over after
all of the direct costs associated with manufacturing the product have been paid. These direct costs are
typically called cost of goods sold or COGS and usually consist of raw materials anddirect labor.
The gross profit ratio is important because it shows management and investors how profitable the core
business activities are without taking into consideration the indirect costs. In other words, it shows how
efficiently a company can produce and sell its products. This gives investors a key insight into how healthy
the company actually is. For instance, a company with a seemingly healthy net income on the bottom line
could actually be dying. The gross profit percentage could be negative, and the net income could be
coming from other one-time operations. The company could be losing money on every product they
produce, but staying a float because of a one-time insurance payout.
That is why it is almost always listed on front page of the income statement in one form or another. Lets
take a look at how to calculate gross profit and what its used for.

Formula

The gross profit formula is calculated by subtracting total cost of goods sold from total sales.

Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is
broken down into smaller categories of costs like materials and labor. This equation looks at the pure
dollar amount of GP for the company, but many times its helpful to calculate the gross profit rate or margin
as a percentage.
The gross profit percentage formula is calculated by subtracting cost of goods sold from total revenues
and dividing the difference by total revenues. Usually a gross profit calculator would rephrase this equation
and simply divide the total GP dollar amount we used above by the total revenues. Both equations get the
result.

Example
Monica owns a clothing business that designs and manufactures high-end clothing for children. She has
several different lines of clothing and has proven to be one of the most successful brands in her space.
Heres what appears on Monicas income statement at the end of the year.

## Total sales: \$1,000,000

COGS: \$350,000
Rent: \$100,000
Utilities: \$10,000
Office expenses: \$2,500

Monica has an upcoming meeting with investors and wants to know how to find gross profit and what
method to use. First, we can calculate Monicas overall dollar amount of GP by subtracting the \$350,000
of COGS from the \$1,000,000 of total sales like this:

As you can see, Monica has a GP of \$650,000. This means the goods that she sold for \$1M only cost her
\$350,000 to produce. Now she has \$650,000 that can be used to pay for other bills like rent and utilities.
Monica can also compute this ratio in a percentage using the gross profit margin formula. Simply divide
the \$650,000 GP that we already computed by the \$1,000,000 of total sales.

Monica is currently achieving a 65 percent GP on her clothes. This means that for every dollar of sales
Monica generates, she earns 65 cents in profits before other business expenses are paid.

Analysis
The gross profit method is an important concept because it shows management and investors how
efficiently the business can produce and sell products. In other words, it shows how profitable a product is.
The concept of GP is particularly important to cost accountants and management because it allows them
to create budgets and forecast future activities. For instance, Monicas GP was \$650,000. This means if
she wants to be profitable for the year, all of her other costs must be less than \$650,000. Conversely,
Monica can also view the \$650,000 as the amount of money that can be put toward other business
expenses or expansion into new markets.
Investors are typically interested in GP as a percentage because this allows them to compare margins
between companies no matter their size or sales volume. For instance, an investor can see Monicas 65
percent margin and compare it to Ralph Laurens margin even though RL is a billion dollar company. It
also allows investors a chance to see how profitable the companys core business activities are.
General Motors is a good example of this back in the 1990s. GM had a low margin and wasnt making
much money one each car they were producing, but GM was profitable. Why? Because GMs financing
services were raking in the money. In other words, GM was making more money financing cars like a bank
than they were producing cars like a manufacturer. Investors want to know how healthy the core business
activities are to gauge the quality of the company.
They also use a gross profit margin calculator to measure scalability. Monicas investors can run different
models with her margins to see how profitable the company would be at different sales levels. For
instance, they could measure the profits if 100,000 units were sold or 500,000 units were sold by
multiplying the potential number of units sold by the sales price and the GP margin

## Operating Margin Ratio

The operating margin ratio, also known as the operating profit margin, is a profitability ratio that measures
what percentage of total revenues is made up by operating income. In other words, the operating margin
ratio demonstrates how much revenues are left over after all the variable or operating costs have been
paid. Conversely, this ratio shows what proportion of revenues is available to cover non-operating costs
like interest expense.
This ratio is important to both creditors and investors because it helps show how strong and profitable a
company's operations are. For instance, a company that receives 30 percent of its revenue from its
operations means that it is running its operations smoothly and this income supports the company. It also

means this company depends on the income from operations. If operations start to decline, the company
will have to find a new way to generate income.
Conversely, a company that only converts 3 percent of its revenue to operating income can be
questionable to investors and creditors. The auto industry made a switch like this in the 1990's. GM was
making more money on financing cars than actually building and selling the cars themselves. Obviously,
this did not turn out very well for them. GM is a prime example of why this ratio is important.
Formula

The operating margin formula is calculated by dividing the operating income by the net sales during a
period.

Operating income, also called income from operations, is usually stated separately on theincome
statement before income from non-operating activities like interest and dividend income. Many times
operating income is classified as earnings before interest and taxes. Operating income can be calculated
by subtracting operating expenses, depreciation, and amortization from gross income or revenues.
The revenue number used in the calculation is just the total, top-line revenue or net sales for the year.
Analysis

The operating profit margin ratio is a key indicator for investors and creditors to see how businesses are
supporting their operations. If companies can make enough money from their operations to support the
business, the company is usually considered more stable. On the other hand, if a company requires both
operating and non-operating income to cover the operation expenses, it shows that the business'
operating activities are not sustainable.
A higher operating margin is more favorable compared with a lower ratio because this shows that the
company is making enough money from its ongoing operations to pay for its variable costs as well as its
fixed costs.
For instance, a company with an operating margin ratio of 20 percent means that for every dollar of
income, only 20 cents remains after the operating expenses have been paid. This also means that only 20
cents is left over to cover the non-operating expenses.
Example

If Christie's Jewelry Store sells custom jewelry to celebrities all over the country. Christie reports the follow
numbers on her financial statements:
Net Sales:

\$1,000,000

\$500,000

Rent:

\$15,000

Wages:

\$100,000

\$25,000

## Here is how Christie would calculate her operating margin.

As you can see, Christie's operating income is \$360,000 (Net sales all operating expenses). According
to our formula, Christie's operating margin .36. This means that 74 cents on every dollar of sales is used
to pay for variable costs. Only 36 cents remains to cover all non-operating expenses or fixed costs.
It is important to compare this ratio with other companies in the same industry. The gross margin ratio is a

## Fixed Charge Coverage Ratio

The fixed charge coverage ratio is afinancial ratio that measures a firm's ability to pay all of its fixed
charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio is
basically an expanded version of the times interest earned ratio or the times interest coverage ratio.
The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like
lease payments, insurance payments, and preferred dividend payments can be built into the calculation.
Formula

The fixed charge coverage ratio starts with the times earned interest ratio and adds in applicable fixed
costs. We will use lease payments for this example, but any fixed cost can be added in. This ratio would
be calculated like this:

Note that any number of fixed costs can be used in this formula. This coverage ratio is not limited to only
one cost.
Analysis

The fixed charge coverage ratio shows investors and creditors a firm's ability to make its fixed payments.
Like the times interest ratio, this ratio is stated in numbers rather than percentages.
The ratio measures how many times a firm can pay its fixed costs with its income before interest and
taxes. In other words, it shows how many times greater the firm's income is compared with its fixed costs.
In a way, this ratio can be viewed as a solvency ratio because it shows how easily a company can pay its
bills when they become due. Obviously, if a company can't pay its lease or rent payments, it will not be in
Higher fixed cost ratios indicate a healthier and less risky business to invest in or loan to. Lower ratios
show creditors and investors that the company can barely meet its monthly bills.
Example

Quinn's Harp Shop is an instrument retailer that specializes in selling and repairing harps. Quinn has been
interest in remodeling the inside of his store but needs a loan in order to afford it. After giving his financial
statements to the bank, the loan officer calculates Quinn's fixed charge coverage ratio.
According to Quinn's income statement, he has \$300,000 of income before interest and taxes and interest
expense of \$30,000. Quinn's current lease payment is \$2,000 a month or \$24,000 a year. Here is how
Quinn's ratio is calculated:

As you can see, Quinn's ratio is six. That means that Quinn's income is 6 times greater than his interest
and lease payments. This is a healthy ratio and he should be able to receive his loan from the bank.

## Return on Assets Ratio - ROA

The return on assets ratio, often called the return on total assets, is a profitability ratio that measures the
net income produced by total assets during a period by comparing net income to the average total assets.
In other words, the return on assets ratio or ROA measures how efficiently a company can manage its
assets to produce profits during a period.
Since company assets' sole purpose is to generate revenues and produce profits, this ratio helps both
management and investors see how well the company can convert its investments in assets into profits.
You can look at ROA as a return on investment for the company since capital assets are often the biggest
investment for most companies. In this case, the company invests money into capital assets and the return
is measured in profits.
In short, this ratio measures how profitable a company's assets are.
Formula

The return on assets ratio formula is calculated by dividing net income by average total assets.

This ratio can also be represented as a product of the profit margin and the total asset turnover.
Either formula can be used to calculate the return on total assets. When using the first formula, average
total assets are usually used because asset totals can vary throughout the year. Simply add the beginning
and ending assets together on the balance sheet and divide by two to calculate the average assets for the
year. It might be obvious, but it is important to mention that average total assets is the historical cost of the
assets on the balance sheet without taking into consideration the accumulated depreciation.
The net income can be found on the income statement.
Analysis

The return on assets ratio measures how effectively a company can turn earn a return on its investment in
assets. In other words, ROA shows how efficiently a company can covert the money used to purchase
assets into net income or profits.
Since all assets are either funded by equity or debt, some investors try to disregard the costs of acquiring
the assets in the return calculation by adding back interest expense in the formula.
It only makes sense that a higher ratio is more favorable to investors because it shows that the company is
more effectively managing its assets to produce greater amounts of net income. A positive ROA ratio
usually indicates an upward profit trend as well. ROA is most useful for comparing companies in the same
industry as different industries use assets differently. For instance, construction companies use large,
expensive equipment while software companies use computers and servers.
Example

Charlie's Construction Company is a growing construction business that has a few contracts to build
storefronts in downtown Chicago. Charlie's balance sheet shows beginning assets of \$1,000,000 and an
ending balance of \$2,000,000 of assets. During the current year, Charlie's company had net income of
\$20,000,000. Charlie's return on assets ratio looks like this.

As you can see, Charlie's ratio is 1,333.3 percent. In other words, every dollar that Charlie invested in
assets during the year produced \$13.3 of net income. Depending on the economy, this can be a healthy
return rate no matter what the investment is.
Investors would have to compare Charlie's return with other construction companies in his industry to get a
true understanding of how well Charlie is managing his assets.

## Return on Equity Ratio

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate
profits from its shareholders investments in the company. In other words, the return on equity ratio shows
how much profit each dollar of common stockholders' equity generates.
So a return on 1 means that every dollar of common stockholders' equity generates 1 dollar of net income.
This is an important measurement for potential investors because they want to see how efficiently a
company will use their money to generate net income.
ROE is also and indicator of how effective management is at using equity financing to fund operations and
grow the company.
Formula

The return on equity ratio formula is calculated by dividing net income by shareholder's equity.

Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not
included in the calculation because these profits are not available to common stockholders. Preferred
dividends are then taken out of net income for the calculation.
Also, average common stockholder's equity is usually used, so an average of beginning and ending equity
is calculated.
Analysis

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits
and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the
investor's point of viewnot the company. In other words, this ratio calculates how much money is made
based on the investors' investment in the company, not the company's investment in assets or something
else.
That being said, investors want to see a high return on equity ratio because this indicates that the
company is using its investors' funds effectively. Higher ratios are almost always better than lower ratios,
but have to be compared to other companies' ratios in the industry. Since every industry has different

levels of investors and income, ROE can't be used to compare companies outside of their industries very
effectively.
Many investors also choose to calculate the return on equity at the beginning of a period and the end of a
period to see the change in return. This helps track a company's progress and ability to maintain a positive
earnings trend.
Example

Tammy's Tool Company is a retail store that sells tools to construction companies across the country.
Tammy reported net income of \$100,000 and issued preferred dividends of \$10,000 during the year.
Tammy also had 10,000, \$5 par common shares outstanding during the year. Tammy would calculate her
return on common equity like this:

As you can see, after preferred dividends are removed from net income Tammy's ROE is 1.8. This means
that every dollar of common shareholder's equity earned about \$1.80 this year. In other words,
shareholders saw a 180 percent return on their investment. Tammy's ratio is most likely considered high
for her industry. This could indicate that Tammy's is a growing company.
An average of 5 to 10 years of ROE ratios will give investors a better picture of the growth of this company.
Company growth or a higher ROE doesn't necessarily get passed onto the investors however. If the
company retains these profits, the common shareholders will only realize this gain by having an
appreciated stock.

## Earnings Per Share

Earning per share, also called net income per share, is a market prospect ratio that measures the amount
of net income earned per share of stock outstanding. In other words, this is the amount of money each
share of stock would receive if all of the profits were distributed to the outstanding shares at the end of the
year.
Earnings per share is also a calculation that shows how profitable a company is on a shareholder basis.
So a larger company's profits per share can be compared to smaller company's profits per share.
Obviously, this calculation is heavily influenced on how many shares are outstanding. Thus, a larger
company will have to split its earning amongst many more shares of stock compared to a smaller
company.
Formula

Earnings per share or basic earnings per share is calculated by subtracting preferred dividends from net
income and dividing by the weighted average common shares outstanding. The earnings per share
formula looks like this.

You'll notice that the preferred dividends are removed from net income in the earnings per share
calculation. This is because EPS only measures the income available to common stockholders. Preferred
dividends are set-aside for the preferred shareholders and can't belong to the common shareholders.
Most of the time earning per share is calculated for year-end financial statements. Since companies often
issue new stock and buy back treasury stock throughout the year, the weighted average common shares
are used in the calculation. The weighted average common shares outstanding is can be simplified by
adding the beginning and ending outstanding shares and dividing by two.
Analysis

Earning per share is the same as any profitability or market prospect ratio. Higher earnings per share is
always better than a lower ratio because this means the company is more profitable and the company has
more profits to distribute to its shareholders.
Although many investors don't pay much attention to the EPS, a higher earnings per share ratio often
makes the stock price of a company rise. Since so many things can manipulate this ratio, investors tend to
look at it but don't let it influence their decisions drastically.
Example

Quality Co. has net income during the year of \$50,000. Since it is a small company, there are no preferred
shares outstanding. Quality Co. had 5,000 weighted average shares outstanding during the year. Quality's
EPS is calculated like this.

As you can see, Quality's EPS for the year is \$10. This means that if Quality distributed every dollar of
income to its shareholders, each share would receive 10 dollars.

## Price Earnings P/E Ratio

The price earnings ratio, often called the P/E ratio or price to earnings ratio, is a market prospect ratio that
calculates the market value of a stock relative to its earnings by comparing the market price per share by
the earnings per share. In other words, the price earnings ratio shows what the market is willing to pay for
a stock based on its current earnings.
Investors often use this ratio to evaluate what a stock's fair market value should be by predicting future
earnings per share. Companies with higher future earnings are usually expected to issue higher dividends
or have appreciating stock in the future.
Obviously, fair market value of a stock is based on more than just predicted future earnings. Investor
speculation and demand also help increase a share's price over time.
The PE ratio helps investors analyze how much they should pay for a stock based on its current earnings.
This is why the price to earnings ratio is often called a price multiple or earnings multiple. Investors use
this ratio to decide what multiple of earnings a share is worth. In other words, how many times earnings
they are willing to pay.
Formula

The price earnings ratio formula is calculated by dividing the market value price per share by the earnings
per share.

This ratio can be calculated at the end of each quarter when quarterly financial statements are issued. It is
most often calculated at the end of each year with the annual financial statements. In either case, the fair
market value equals the trading value of the stock at the end of the current period.
The earnings per share ratio is also calculated at the end of the period for each share outstanding. A
trailing PE ratio occurs when the earnings per share is based on previous period. A leading PE ratios
occurs when the EPS calculation is based on future predicted numbers. A justified PE ratio is calculated
by using the dividend discount analysis.
Analysis

The price to earnings ratio indicates the expected price of a share based on its earnings. As a company's
earnings per share being to rise, so does their market value per share. A company with a high P/E ratio
usually indicated positive future performance and investors are willing to pay more for this company's
shares.
A company with a lower ratio, on the other hand, is usually an indication of poor current and future
performance. This could prove to be a poor investment.
In general a higher ratio means that investors anticipate higher performance and growth in the future. It
also means that companies with losses have poor PE ratios.

An important thing to remember is that this ratio is only useful in comparing like companies in the same
industry. Since this ratio is based on the earnings per share calculation, management can easily
manipulate it with specific accounting techniques.
Example

The Island Corporation stock is currently trading at \$50 a share and its earnings per share for the year is 5
dollars. Island's P/E ratio would be calculated like this:

As you can see, the Island's ratio is 10 times. This means that investors are willing to pay 10 dollars for
every dollar of earnings. In other words, this stock is trading at a multiple of ten.
Since the current EPS was used in this calculation, this ratio would be considered a trailing price earnings
ratio. If a future predicted EPS was used, it would be considered a leading price to earnings ratio.

## Dividend Payout Ratio

The dividend payout ratio measures the percentage of net income that is distributed to shareholders in the
form of dividends during the year. In other words, this ratio shows the portion of profits the company
decides to keep to fund operations and the portion of profits that is given to its shareholders.
Investors are particularly interested in the dividend payout ratio because they want to know if companies
are paying out a reasonable portion of net income to investors. For instance, most start up companies and
tech companies rarely give dividends at all. In fact, Apple, a company formed in the 1970s, just gave its
first dividend to shareholders in 2012.
Conversely, some companies want to spur investors' interest so much that they are willing to pay out
unreasonably high dividend percentages. Inventors can see that these dividend rates can't be sustained
very long because the company will eventually need money for its operations.
Formula

The dividend payout formula is calculated by dividing total dividend by the net income of the company.

This calculation will give you the overall dividend ratio. Both the total dividends and the net income of the
company will be reported on the financial statements.
You can also calculate the dividend payout ratio on a share basis by dividing the dividends per share by
the earnings per share.
Obviously, this calculation requires a little more work because you must figure out the earnings per
share as well as divide the dividends by each outstanding share. Both of these formulas will arrive at the
Analysis

Since investors want to see a steady stream of sustainable dividends from a company, the dividend payout
ratio analysis is important. A consistent trend in this ratio is usually more important than a high or low
ratio.
Since it is for companies to declare dividends and increase their ratio for one year, a single high ratio does
not mean that much. Investors are mainly concerned with sustainable trends. For instance, investors can
assume that a company that has a payout ratio of 20 percent for the last ten years will continue giving 20
percent of its profit to the shareholders.
Conversely, a company that has a downward trend of payouts is alarming to investors. For example, if a
company's ratio has fallen a percentage each year for the last five years might indicate that the company
can no longer afford to pay such high dividends. This could be an indication of poor operating
performance.
Generally, more mature and stable companies tend to have a higher ratio than newer start up companies.
Example

Joe's Kitchen is a restaurant change that has several shareholders. Joe reported \$10,000 of net income
on his income statement for the year. Joe's issued \$3,000 of dividends to its shareholders during the year.
Here is Joe's dividend payout ratio calculation.

As you can see, Joe is paying out 30 percent of his net income to his shareholders. Depending on Joe's
debt levels and operating expenses, this could be a sustainable rate since the earnings appear to support
a 30 percent ratio.

## Dividend Yield Ratio

The dividend yield is a financial ratio that measures the amount of cash dividends distributed to common
shareholders relative to the market value per share. The dividend yield is used by investors to show how

their investment in stock is generating either cash flows in the form of dividends or increases in asset
value by stock appreciation.
Investors invest their money in stocks to earn a return either by dividends or stock appreciation. Some
companies choose to pay dividends on a regular basis to spur investors' interest. These shares are often
called income stocks. Other companies choose not to issue dividends and instead reinvest this money in
the business. These shares are often called growth stocks.
Investors can use the dividend yield formula to help analyze their return on investment in stocks.
Formula

The dividend yield formula is calculated by dividing the cash dividends per share by the market value per
share.

Cash dividends per share are often reported on the financial statements, but they are also reported as
gross dividends distributed. In this case, you'll have to divide the gross dividends distributed by the
average outstanding common stock during that year.
The shares' market value is usually calculated by looking at the open stock exchange price as of the last
day of the year or period.
Analysis

Investors use the dividend yield formula to compute the cash flow they are getting from their investment in
stocks. In other words, investors want to know how much dividends they are getting for every dollar that
the stock is worth.
A company with a high dividend yield pays its investors a large dividend compared to the fair market value
of the stock. This means the investors are getting highly compensated for their investments compared with
lower dividend yielding stocks.
A high or low dividend yield is relative to the industry of the company. As I mentioned above, tech
companies rarely give dividends at all. So even a small dividend might produce a high dividend yield ratio
for the tech industry. Generally, investors want to see a yield as high as possible.
Example

Stacy's Bakery is an upscale bakery that sells cupcakes and baked goods in Beverly Hills. Stacy's is listed
on a smaller stock exchange and the current market price per share is \$15. As of last year, Stacy paid
\$15,000 in dividends with 1,000 shares outstanding. Stacy's yield is computed like this.

As you can see, Stacy's yield is one dollar. This means that Stacy's investors receive 1 dollar in dividends
for every dollar they have invested in the company. In other words, the investors are getting a 100 percent
return on their investment every year Stacy maintains this dividend level.

## Accounts Receivable Turnover Ratio/

Average Collection Period
Accounts receivable turnover is anefficiency ratio or activity ratio that measures how many times a
business can turn its accounts receivable into cash during a period. In other words, the accounts
receivable turnover ratio measures how many times a business can collect its average accounts
receivable during the year.
A turn refers to each time a company collects its average receivables. If a company had \$20,000 of
average receivables during the year and collected \$40,000 of receivables during the year, the company
would have turned its accounts receivable twice because it collected twice the amount of average
receivables.
This ratio shows how efficient a company is at collecting its credit sales from customers. Some companies
collect their receivables from customers in 90 days while other take up to 6 months to collect from
customers.
In some ways the receivables turnover ratio can be viewed as a liquidity ratio as well. Companies are
more liquid the faster they can covert their receivables into cash.
Formula

Accounts receivable turnover is calculated by dividing net credit sales by the average accounts receivable
for that period.

The reason net credit sales are used instead of net sales is that cash sales don't create receivables. Only
credit sales establish a receivable, so the cash sales are left out of the calculation. Net sales simply refers
to sales minus returns and refunded sales.

The net credit sales can usually be found on the company's income statement for the year although not all
companies report cash and credit sales separately. Average receivables is calculated by adding the
beginning and ending receivables for the year and dividing by two. In a sense, this is a rough calculation
of the average receivables for the year.
Analysis

Since the receivables turnover ratio measures a business' ability to efficiently collect itsreceivables, it only
makes sense that a higher ratio would be more favorable. Higher ratios mean that companies are
collecting their receivables more frequently throughout the year. For instance, a ratio of 2 means that the
company collected its average receivables twice during the year. In other words, this company is collecting
is money from customers every six months.
Higher efficiency is favorable from a cash flow standpoint as well. If a company can collect cash from
customers sooner, it will be able to use that cash to pay bills and other obligations sooner.
Accounts receivable turnover also is and indication of the quality of credit sales and receivables. A
company with a higher ratio shows that credit sales are more likely to be collected than a company with a
lower ratio. Since accounts receivable are often posted as collateral for loans, quality of receivables is
important.
Example

Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers accounts to all of his main
customers. At the end of the year, Bill's balance sheet shows \$20,000 in accounts receivable, \$75,000 of
gross credit sales, and \$25,000 of returns. Last year's balance sheet showed \$10,000 of accounts
receivable.
The first thing we need to do in order to calculate Bill's turnover is to calculate net credit sales and average
accounts receivable. Net credit sales equals gross credit sales minus returns (75,000 25,000 = 50,000).
Average accounts receivable can be calculated by averaging beginning and ending accounts receivable
balances ((10,000 + 20,000) / 2 = 15,000).
Finally, Bill's accounts receivable turnover ratio for the year can be like this.

As you can see, Bill's turnover is 3.33. This means that Bill collects his receivables about 3.3 times a year
or once every 110 days. In other words, when Bill makes a credit sale, it will take him 110 days to collect
the cash from that sale.

## Days Sales Outstanding / Average

Collection Period

The days sales outstanding calculation, also called the average collection period or days' sales in
receivables, measures the number of days it takes a company to collect cash from its credit sales. This
calculation shows the liquidity and efficiency of a company's collections department.
In other words, it shows how well a company can collect cash from its customers. The sooner cash can be
collected, the sooner this cash can be used for other operations. Both liquidity and cash flows increase
with a lower days sales outstanding measurement.

Formula
The ratio is calculated by dividing the ending accounts receivable by the total credit sales for the period
and multiplying it by the number of days in the period. Most often this ratio is calculated at year-end and
multiplied by 365 days.

Accounts receivable can be found on the year-end balance sheet. Credit sales, however, are rarely
reported separate from gross sales on the income statement. The credit sales figure will most often have
to be provided by the company.
This formula can also be calculated by using the accounts receivable turnover ratio

Analysis
The days sales outstanding formula shows investors and creditors how well companies' can collect cash
from their customers. Obviously, sales don't matter if cash is never collected. This ratio measures the
number of days it takes a company to convert its sales into cash.
A lower ratio is more favorable because it means companies collect cash earlier from customers and can
use this cash for other operations. It also shows that the accounts receivables are good and won't be
A higher ratio indicates a company with poor collection procedures and customers who are unable or
unwilling to pay for their purchases. Companies with high days sales ratios are unable to convert sales
into cash as quickly as firms with lower ratios.

Example
Devin's Long Boards is a retailer that offers credit to customers. Devin often selling inventory to customers
on account with the agreement that these customers will pay for the merchandise within 30 days. Some
customers promptly pay for their goods, while others are delinquent. Devin's year-end financial statements
list the following accounts:

## Accounts Receivable: \$15,000

Net Credit Sales: \$175,000

## Devin's days sales is calculated like this:

As you can see, it takes Devin approximately 31 days to collect cash from his customers on average. This
is a good ratio since Devin is aiming for a 30 day collection period.

## Gross Margin Ratio / Net Profit

Margin
Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales.
This ratio measures how profitable a company sells its inventory or merchandise. In other words, the
gross profit ratio is essentially the percentage markup on merchandise from its cost. This is the pure profit
from the sale of inventory that can go to paying operating expenses.
Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different.
Gross margin ratio only considers the cost of goods sold in its calculation because it measures the
profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.

Formula
Gross margin ratio is calculated by dividing gross margin by net sales.

The gross margin of a business is calculated by subtracting cost of goods sold from net sales. Net sales
equals gross sales minus any returns or refunds. The broken down formula looks like this:

Analysis
Gross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It
only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their
inventory at a higher profit percentage.
High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can
get a bigpurchase discount when they buy their inventory from the manufacturer or wholesaler, their gross
margin will be higher because their costs are down.
The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has
to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.
A company with a high gross margin ratios mean that the company will have more money to pay operating
expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also

measures the percentage of sales that can be used to help fund other parts of the business. Here is
another great explaination.

Example
Assume Jack's Clothing Store spent \$100,000 on inventory for the year. Jack was able to sell this
inventory for \$500,000. Unfortunately, \$50,000 of the sales were returned by customers and refunded.
Jack would calculate his gross margin ratio like this.

As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel industry. This means that
after Jack pays off his inventory costs, he still has 78 percent of his sales revenue to cover his operating
costs.
FoxManufacturingCompany
RatioAnalysis
IndustryAverage
2006
Currentratio
2.35
Quickratio
0.87
Inventoryturnover
4.55times
Averagecollectionperiod
35.8days
Totalassetturnover
1.09
Debtratio
0.30
Timesinterestearned
12.3
Grossprofitmargin
20.2%
Operatingprofitmargin
13.5%
Netprofitmargin
9.1%
Returnontotalassets(ROA)
9.9%
Returnoncommonequity(ROE)
16.7%
Earningspershare
\$3.10

Actual
2006
1.84
0.75
5.61times
20.5days
1.47
0.55
8.0
?%
?%
?%
?%
23.4%
\$2.15

Liquidity:Thecurrentandquickratiosshowaweakerpositionrelativetotheindustryaverage.
Activity:Allactivityratiosindicateafasterturnoverofassetscomparedtotheindustry.Furtheranalysisis
necessarytodeterminewhetherthefirmisinaweakerorstrongerpositionthantheindustry.Ahigher
inventoryturnoverratiomayindicatelowinventory,resultinginstockoutsandlostsales.Ashorteraverage
collectionperiodmayindicateextremelyefficientreceivablesmanagement,anoverlyzealouscredit
department,orrestrictivecredittermswhichprohibitgrowthinsales.
Debt:Thefirmusesmoredebtthantheaveragefirm,resultinginhigherinterestobligationswhichcould
reduceitsabilitytomeetotherfinancialobligations.
Profitability:Thefirmhasahighergrossprofitmarginthantheindustry,indicatingeitherahighersales
priceoralowercostofgoodssold.Theoperatingprofitmarginisinlinewiththeindustry,butthenetprofit
marginislowerthanindustry,anindicationthatexpensesotherthancostofgoodssoldarehigherthanthe
industry.Mostlikely,thedamagingfactorishighinterestexpensesduetoagreaterthanaverageamountof