1.

Current Ratio

The current ratio is a liquidity ratio that measures a company's ability to pay shortterm and long-term obligations. To gauge this ability, the current ratio considers the
current total assets of a company (both liquid and illiquid) relative to that companys
current total liabilities.
The formula for calculating a companys current ratio, then, is:
Current Ratio = Current Assets / Current Liabilities
The current ratio is called current because, unlike some other liquidity ratios, it
incorporates all current assets and liabilities.
The current ratio is also known as the working capital ratio.

BREAKING DOWN 'Current Ratio'

The current ratio is mainly used to give an idea of the company's ability to pay back its
liabilities (debt and accounts payable) with its assets (cash,
marketable securities, inventory, accounts receivable). As such, current ratio can be
used to take a rough measurement of a companys financial health. The higher the
current ratio, the more capable the company is of paying itsobligations, as it has a larger
proportion of asset value relative to the value of its liabilities.
A ratio under 1 indicates that a companys liabilities are greater than its assets and
suggests that the company in question would be unable to pay off its obligations if they
came due at that point. While a current ratio below 1 shows that the company is not in
good financial health, it does not necessarily mean that it will go bankrupt. There are
many ways for a company to access financing, and this is particularly so if a company
has realistic expectations of future earnings against which it might borrow. For example,
if a company has a reasonable amount of short-term debt but is expecting
substantial returns from a project or other investment not too long after its debts are due,
it will likely be able to stave off its debt. All the same, a current ratio below 1 is usually
not a good sign.
On the other hand, a high ratio (over 3) does not necessarily indicate that a company is
in a state of financial well-being either. Depending on how the companys assets are
allocated, a high current ratio may suggest that that company is not using its current
assets efficiently, is not securing financing well or is not managing its working capital
well. To better assess whether or not these issues are present, a liquidity ratio more
specific than the current ratio is needed.

An example: assume that Big-Sale Stores has $2 billion in cash, $1 billion in securities,
$4 billion in inventory, $2 billion in accounts receivable and $6 billion in liabilities. To
calculate Big-Sales current ratio, you would take the sum of its various assets and divide
them by its liabilities, for a current ratio of 1.5 (($2B + $1B + $4B + $2B) / $6B = $9B /
$6B = 1.5). Big-Sale Stores, then, appears to have healthy financials.
The current ratio can give a sense of the efficiency of a company's operating cycle or its
ability to turn its product into cash. Companies that have trouble getting paid on
their receivables or have long inventory turnover can run into liquidity problems because
they are unable to alleviate their obligations.

Limitations of 'Current Ratio'

No one ratio is a perfect gauge of a companys financial health or of whether or not
investing in a company is a wise decision. As such, when using them it is important to
understand their limitations, and the same holds true for the current ratio.
One limitation of using the current ratio emerges when using the ratio to compare
different companies with one another. Because business operations can differ
substantially between industries, comparing the current ratios of companies in different
industries with one another will not necessarily lead to any productive insight. For
example, while in one industry it may be common practice to take on a large amount of
debt through leverage, another industry may strive to keep debts to a minimum and pay
them off as soon as possible. Companies within these two industries, then, could
potentially have very different current ratios, though this would not necessarily indicate
that one is healthier than the other because of their differing business practices. As such,
it is always more useful to compare companies within the same industry.
Another drawback of using current ratios, briefly mentioned above, involves its lack of
specificity. Of all of the different liquidity ratios that exist, the current ratio is one of the
least stringent. Unlike many other liquidity ratios, it incorporates all of a companys
current assets, even those that cannot be easily liquidated. As such, a high current ratio
cannot be used to effectively determine if a company is inefficiently deploying its assets,
whereas certain other liquidity ratios can.

'Current Ratio' and Other Liquidity Ratios

Generally, liquidity ratios can be used to gauge a companys ability to pay off its debts.
However, there are a variety of different liquidity ratios that exist and that measure this in
different ways. When considering the current ratio, it is important to understand its
relationship to other popular liquidity ratios.

One popular ratio is the working capital ratio, which is the same as the current ratio.
Another class of liquidity ratios works in a similar way to the current ratio, but are more
specific as to the kinds of assets they incorporate. The cash asset ratio (or cash ratio),
for example, compares only a companys marketable securities and cash to its current
liabilities. The acid-test ratio (or quick ratio) compares a companys easily liquidated
assets (including cash, accounts receivable and short-term investments, excluding
inventory and prepaids) to its current liabilities. The operating cash flow ratio compares a
companies active cash flow from operations to its current liabilities. These liquidity ratios
have a more specific purpose than the current ratio, that is, to gauge a companys ability
to pay off short term debts.
Another similar liquidity ratio is the debt ratio, which is the opposite of the current ratio.
Debt ratio calculations take current liabilities as the numerator and current assets as the
denominator in an attempt to measure a companys leverage.
2. Quick Ratio

What is the 'Quick Ratio'

The quick ratio is an indicator of a companys short-term liquidity. The quick
ratio measures a companys ability to meet its short-term obligations with its most liquid
assets. For this reason, the ratio excludes inventories from current assets, and is
calculated as follows:
Quick ratio = (current assets inventories) / current liabilities, or
= (cash and equivalents + marketable securities + accounts receivable) / current
liabilities
The quick ratio measures the dollar amount of liquid assets available for each dollar of
current liabilities. Thus, a quick ratio of 1.5 means that a company has $1.50 of liquid
assets available to cover each $1 of current liabilities. The higher the quick ratio, the
better the company's liquidity position. Also known as the acid-test ratio" or "quick
assets ratio."

BREAKING DOWN 'Quick Ratio'

For example, consider a firm with the following current assets on its balance sheet:

Cash $5 million, marketable securities $10 million, accounts receivable $15 million,
inventories $20 million.
This is offset by current liabilities of $20 million.
The quick ratio in this case is 1.5 and the current ratio is 2.5.
The quick ratio is more conservative than the current ratio because it excludes
inventories from current assets. The ratio derives its name presumably from the fact that
assets such as cash and marketable securities are quick sources of cash. Inventories
generally take time to be converted into cash, and if they have to be sold quickly, the
company may have to accept a lower price than book value of these inventories. As a
result, they are justifiably excluded from assets that are ready sources of immediate
cash.
Whether accounts receivable is a source of ready cash is debatable, however, and
depends on the credit terms that the company extends to its customers. A firm that gives
its customers only 30 days to pay will obviously be in a better liquidity position than one
that gives them 90 days. But the liquidity position also depends on the credit terms the
company has negotiated from its suppliers. For example, if a firm gives its customers 90
days to pay, but has 120 days to pay its suppliers, its liquidity position may be
reasonable.
The other issue with including accounts receivable as a source of quick cash is that
unlike cash and marketable securities which can typically be converted into cash at
the full value shown on the balance sheet the total accounts receivable amount
actually received may be slightly below book value because of discounts for early
payment and credit losses.
To learn more about assessing a company's liquidity, check out How do you calculate
working capital?

3. Day of Sales Outstanding

Days sales outstanding (DSO) is a measure of the average number of days that a
company takes to collect revenue after a sale has been made. DSO is often determined
on a monthly, quarterly or annual basis and can be calculated by dividing the amount

of accounts receivable during a given period by the total value of credit sales during the
same period, and multiplying the result by the number of days in the period measured.
The formula for calculating days sales outstanding can be represented with the following
formula:

A low DSO value means that it takes a company fewer days to collect its accounts
receivable. A high DSO number shows that a company is selling its product to customers
on credit and taking longer to collect money.
Days sales outstanding is also often referred to as days receivables and is an element
of the cash conversion cycle.

BREAKING DOWN 'Days Sales Outstanding - DSO'

Due to the high importance of cash in running a business, it is in a company's best
interest to collect outstanding receivables as quickly as possible. While companies can
most often expect with relative certainty that they will in fact receive outstanding
receivables, because of the time value of money principle, money that a company
spends time waiting to receive is money lost. By quickly turning sales into cash, a
company has a chance to put the cash to use again more quickly. Ideally, the company
will use it to reinvest and thereby generate more sales. A high DSO value may lead
to cash flow problems because of the long duration between the time of a sale and the
time the company receives payment. In this respect, the ability to determine the average
length of time that a companys outstanding balances are carried in receivables can in
some cases tell a great deal about the nature of the companys cash flow.
For example, suppose that during the month of July, Company A made a total of
$500,000 in credit sales and had $350,000 in accounts receivable. There are 31 days in
July, so Company As DSO for July can be calculated as:

($350,000 / $500,000) x 31 = 0.7 x 31 = 21.7

With a DSO of 21.7, Company has a very short average turnaround in converting its
receivables into cash. Generally speaking, a DSO under 45 is considered low; however,
what qualifies as a high or low DSO may often vary depending on business type and
structure. For example, a DSO of 40 may still cause cash flow problems for a small or
new business that has little available capital. Because of the lower earnings that often
accompany small or new businesses, such businesses often rely on obtaining their
accounts receivable quickly in order to cover startup costs, wages, overhead and other
expenses. If they cannot collect payments quickly enough, they may struggle to meet
these costs. On the other hand, a DSO of 60 may cause few issues for a large and wellestablished corporation with high available capital. Though the company could likely
improve its earnings by reducing its DSO and thereby maximize its potential to reinvest
earnings, it is unlikely that the company will need to trim salaries or cut other costs in
order to make ends meet.
Generally, a high DSO can suggest a few things, including that the companys customer
base has credit issues or that the company is deficient in its collection processes.
Conversely, a very low DSO ratio may suggest that the company is too strict with regard
to its credit policy, which could alienate customers and thus hurt sales as well.
It is important to remember that the formula for calculating DSO only accounts for credit
sales. While cash sales may be considered to have a DSO of 0, they are not factored
into DSO calculations because they represent no time between a sale and the
companys receipt of payment. If they were factored into DSO, they would decrease DSO
values and companies with a high proportion of cash sales would have lower DSOs than
those with a high proportion of credit sales.

Uses of 'Days Sales Outstanding - DSO'

Days sales outstanding has a wide variety of applications. It can indicate the amount of
sales a company has made during a specific time period, how quickly customers are
paying, if the companys collections department is working well, if the company is
maintaining customer satisfaction or if credit is being given to customers that are not
credit worthy.
While looking at an individual DSO value for a company can provide a good benchmark
for quickly assessing a companys cash flow, trends in DSO are much more useful than

an individual DSO value. If a companys DSO is increasing, it may indicate a few things.
It may be that customers are taking more time to pay their expenses, suggesting either
that customer satisfaction is declining, that salespeople within the company are offering
longer terms of payment to drive increased sales or that the company is allowing
customers with poor credit to make purchases. Additionally, too sharp of an increase in
DSO can cause a company serious cash flow problems. If a company is accustomed to
paying its expenses at a certain rate on the basis of consistent payments on its accounts
receivable, a sharp rise in DSO can disrupt this flow and force the company to make
drastic changes.
Generally, when looking at a given companys cash flow, it is helpful to track that
companys DSO over time to determine if its DSO is trending in any particular direction
or if there are any patterns in the companys cash flow history. DSO may often vary on a
monthly basis, particularly if the company is affected by seasonality. If a company has a
volatile DSO, this may be cause for concern, but if a companys DSO dips during a
particular season each year, this is often less of a reason to worry.

Limitations of 'Days Sales Outstanding - DSO'

Like any metric attempting to gauge the efficiency of a business, days sales outstanding
comes with a set of limitations that are important for any investor to consider before
using it.
Most simply, when using DSO to compare the cash flows of multiple companies, one
should compare companies within the same industry, ideally when they have
similar business models and revenue numbers as well. As mentioned above, companies
of different size often have very different capital structures, which can greatly influence
DSO calculations, and the same is often true of companies in different industries. DSO is
not particularly useful in comparing companies with significant differences in the
proportion of sales that are credit, as determining the DSO of a company with a low
proportion of credit sales does not indicate much about that companys cash flow.
Comparing such companies with those that have a high proportion of credit sales also
does not usually indicate much of importance.
Furthermore, DSO is not a perfect indicator of a companys accounts receivable
efficiency, as fluctuating sales volumes can affect DSO, with increase sales frequently
lowering the DSO value. DDSO is a good alternative for credit collection assessment for

use alongside DSO. Like any metric measuring a companys performance, DSO should
not be considered alone, but instead should be considered with other metrics as well.
For more on DSO and how to lower it, read Understanding The Cash Conversion Cycle.

4. Inventory Turnover

What is 'Inventory Turnover'

Inventory turnover is a ratio showing how many times a company's inventory is sold and
replaced over a period of time. The days in the period can then be divided by the
inventory turnover formula to calculate the days it takes to sell the inventory on hand. It is
calculated as sales divided by average inventory.

BREAKING DOWN 'Inventory Turnover'

Inventory turnover measures how fast a company is selling inventory and is generally
compared against industry averages. A low turnover implies weak sales and, therefore,
excess inventory. A high ratio implies either strong sales and/or large discounts.
The speed with which a company can sell inventory is a critical measure of business
performance. It is also one component of the calculation for return on assets (ROA); the
other component is profitability. The return a company makes on its assets is a function
of how fast it sells inventory at a profit. As such, high turnover means nothing unless the
company is making a profit on each sale.

Inventory Turnover Example

Inventory turnover is calculated as sales divided by average inventory. Average inventory
is calculated as: (beginning inventory + ending inventory)/2. Using average inventory
accounts for any seasonality effects on the ratio. Inventory turnover is also calculated
using the cost of goods sold (COGS), which is the total cost of inventory. Analysts divide
COGS by average inventory instead of sales for greater accuracy in the calculation of
inventory turnover. This is because sales include a markup over cost. Dividing sales by
average inventory inflates inventory turnover.

Approach 1: Sales Divided By Average Inventory

As an example, assume company A has $1 million in sales. The COGS is only

$250,000. The average inventory is $25,000. Using the first equation, the company has
inventory turnover of $1 million divided by $25,000, or 40. Translate this into days by
dividing 365 by inventory days. The answer is 9.125 days. This means under the first
approach, inventory turns 40 times a year, and is on hand approximately nine days.

Approach 2: COGS Divided By Average Inventory

Using the second approach, inventory turnover is calculated as the cost of goods sold
divided by average inventory, which in this example is $250,000 divided by $25,000, or
10. The number of inventory days is calculated by dividing 365 by 10, which is 36.5.
Using the second approach, inventory turns over 10 times a year and is on hand for
approximately 36 days.

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5. Total Asset Turnover

Asset turnover ratio is the ratio of the value of a companys sales or revenues generated
relative to the value of its assets. The Asset Turnover ratio can often be used as
an indicator of the efficiency with which a company is deploying its assets in generating
revenue.

Asset Turnover = Sales or Revenues / Total Assets

Generally speaking, the higher the asset turnover ratio, the better the company
is performing, since higher ratios imply that the company is generating more revenue per
dollar of assets. Yet, this ratio can vary widely from one industry to the next. As such,
considering the asset turnover ratios of an energy company and
a telecommunications company will not make for an accurate comparison. Comparisons
are only meaningful when they are made for different companies within the same sector.

BREAKING DOWN 'Asset Turnover Ratio'

Asset turnover is typically calculated over an annual basis using either
the fiscal or calendar year. The total assets number used in the denominator can be
calculated by taking the average of assets held by a company at the beginning of the
year and at the years end.
For example, suppose company X has an asset base of $400 million at the beginning of
a given year and $500 million at the end of the same year, and suppose that company X
generated $900 million in revenues over the course of that year. The asset turnover ratio
for company X is therefore:
$900 million / [($500 million + $400 million) / 2] =
$900 million / [$900 million / 2] =
$900 million / $450 million =

2.00

The asset turnover ratio tends to be higher for companies in certain sectors than in
others. Retail, for example, is the sector that most often yields the highest asset turnover
ratios, scoring a 2.05 in 2014. Both it and consumer staples have relatively small asset
bases but have high sales volume.
Conversely, firms in sectors like utilities and telecommunications, which have large asset
bases, will have lower asset turnover. The financial sector, for example, often trails in its
asset turnover ratio, scoring a 0.08 in 2014.

Using the Asset Turnover Ratio

Consider the asset turnover ratio for Wal-Mart Stores Inc. (WMT). When the fiscal year
ended on January 31, 2014, Wal-Mart had total revenues of $476 billion. Wal-Marts total

assets were $203 billion at the beginning of that fiscal year and $205 billion at fiscal
year-end, for an average of $204 billion. Wal-Marts asset turnover ratio was therefore
2.36 ($476 billion/ $204 billion).
In contrast, AT&T Inc. (T) had total revenues of $132 billion when the fiscal year ended
on December 31, 2014. Total assets at the beginning and end of the 2014 fiscal year
were $278 billion and $293 billion respectively, for an average asset base of $287 billion.
AT&Ts asset turnover ratio in 2014 was therefore 0.46 ($132 billion / $287 billion).
Clearly, it would not make much sense to compare the asset turnover ratios for Wal-Mart
and AT&T, since they operate in very different industries. But comparing the asset
turnover ratios for AT&T and Verizon Communications Inc. (VZ), for instance, may
provide a clearer picture of asset use efficiency for these telecom companies. In the
same fiscal year as in the AT&T example above, Verizon had total revenues of $127
billion. Total assets at the beginning and end of the year were $274 billion and $232
billion, respectively, for an average asset base of $253 billion. As such, in 2014 Verizons
asset turnover ratio was 0.50 ($127 billion / $253 billion), about 9% higher than AT&Ts in
the same year.
Yet, this kind of comparison does not necessarily paint the clearest possible picture. It is
possible that a companys asset turnover ratio in any single year differs substantially
from previous or subsequent years. For example, while AT&Ts asset turnover ratio was
0.30 in 2006, it rose nearly a full fifty percent to reach 0.44 in 2007, the following year.
For any specific company, then, one would do well to review the trend in the asset
turnover ratio over a period of time to check whether asset usage is improving or
deteriorating.
Many other factors can affect a companys asset turnover ratio in a given year, such as
whether or not an industry is cyclical. (For more, see: Cyclical Versus Non-Cyclical
Stocks.)

History
The Asset Turnover ratio is a key component of DuPont analysis, a system that
the DuPont Corporation began using during the 1920s. DuPont analysis breaks
down Return on Equity (ROE) into three parts, one of which is asset turnover, the other
two being profit margin and financial leverage. In splitting ROE into distinct components,
this form of analysis allows one to analyze the nuances of a high or low ROE, to attempt

to determine what causes may be contributing to a companys ROE performance and to

compare the components of ROE with those of other companies.

6. Working Capital Turnover

What is the 'Working Capital Turnover'

Working capital turnover is a measurement comparing the depletion of working
capital used to fund operations and purchase inventory, which is then converted into
sales revenue for the company. The working capital turnover ratio is used to analyze the
relationship between the money that funds operations and the sales generated from
these operations. For example, a company with current assets of $10 million and current
liabilities of $9 million has $1 million in working capital, which may be used
in fundamental analysis.

BREAKING DOWN 'Working Capital Turnover'

The working capital turnover ratio measures how well a company is utilizing its working
capital for supporting a given level of sales. Because working capital is current assets
minus current liabilities, a high turnover ratio shows that management is being very
efficient in using a companys short-term assets and liabilities for supporting sales. In
contrast, a low ratio shows a business is investing in too many accounts receivable (AR)
and inventory assets for supporting its sales. This may lead to an excessive amount of
bad debts and obsolete inventory.

Calculating Working Capital Turnover

When calculating a companys working capital turnover ratio, the amount of net sales is
divided by the amount of working capital. The calculation is typically made on an annual
or trailing 12-month basis and uses the average working capital during that time period.
For example, Company A has $12 million of net sales over the past 12 months. The
average working capital during that time was $2 million. The calculation of its working
capital turnover ratio is $12,000,000/$2,000,000 = 6.

Pros and Cons of High Working Capital Turnover

A high working capital turnover ratio shows a company is running smoothly and has
limited need for additional funding. Money is coming in and flowing out on a regular
basis, giving the business flexibility to spend capital on expansion or inventory. A high
ratio may also give the business a competitive edge over similar companies.
However, an extremely high ratio, typically over 80%, may indicate a business does not
have enough capital supporting its sales growth. Therefore, the company may become
insolvent in the near future. The indicator is especially strong when the accounts payable
(AP) component is very high, indicating that management cannot pay its bills as they
come due. For example, gold mining and silver mining have average working capital
turnover ratios of approximately 82%. Gold and silver mining requires ongoing capital
investment for replacing, modernizing and expanding equipment and facilities, as well as
finding new reserves. An excessively high turnover ratio may be discovered by
comparing the ratio for a specific business to ratios reported by other companies in the
industry.

7. Gross Profit Margin

What is 'Gross Profit Margin'

Gross profit margin is a financial metric used to assess a company's financial health and
business model by revealing the proportion of money left over from revenues after
accounting for the cost of goods sold (COGS). Gross profit margin, also known as gross
margin, is calculated by dividing gross profit by revenues. Also known as "gross margin."
Calculated as:

Where: COGS = Cost of Goods Sold

BREAKING DOWN 'Gross Profit Margin'

There are several layers of profitability that analysts monitor to assess the performance
of a company, including gross profit, operating profit and net income. Each level provides
information about a company's profitability. Gross profit, the first level of profitability, tells
analysts how good a company is at creating a product or providing a service compared
to its competitors. Gross profit margin, calculated as gross profit divided by revenues,
allows analysts to compare business models with a quantifiable metric.

Gross Profit Margin

Without an adequate gross margin, a company is unable to pay for its operating
expenses. In general, a company's gross profit margin should be stable unless there
have been changes to the company's business model. For example, when companies
automate certain supply chain functions, the initial investment may be high; however, the
cost of goods sold is much lower due to lower labor costs.
Gross margin changes may also be driven by industry changes in regulation or even
changes in a company's pricing strategy. If a company sells its products at a premium in
the market, all other things equal, it has a higher gross margin. The conundrum is if the
price is too high, customers may not buy the product.

Gross Margin Example

Gross profit margin is used to compare business models with competitors. More efficient
or higher premium companies see higher profit margins. That is, if you have two
companies that both make widgets and one company can make the widgets for a fifth of
the cost and in the same amount of time, that company has the edge on the market. The
company has figured out a way to reduce the costs of goods sold by five times its
competitor. To make up for the loss in gross margin, the competitor counters by doubling
the price of its product, which should increase sales. Unfortunately, it increased the sales
price but decreased demand, as customers did not want to pay double for the product.
The competitor lost gross margin and market share in the process.
Suppose ABC company earns $20 million in revenue from producing widgets and incurs
$10 million in COGS-related expenses. ABC's gross profit is $20 million minus $10
million. The gross margin is calculated as gross profit divided by $20 million, which is
0.50, or 50%. This means ABC earns 50 cents on the dollar in gross margin.

8. Net Profit Margin

Net profit margin is the ratio of net profits to revenues for a company or business
segment . Typically expressed as a percentage, net profit margins show how much of
each dollar collected by a company as revenue translates into profit. The equation to
calculate net profit margin is: net margin = net profit / revenue.

BREAKING DOWN 'Net Profit Margin'

Net margins vary from company to company, and certain ranges can be expected in
certain industries, as similar business constraints exist in each distinct industry. Low
profit margins don't necessarily equate to low profits. For example, Wal-Mart Stores Inc.
has delivered high returns for its shareholders while operating on net margins less than
5% annually. In fact, in the first quarter of 2016, Walmart's profit margin was 2.66%. In
contrast, a business with very small operating budget such as an independent contractor
working as a freelance writer has a very small overhead and as a result, most of its
revenue is tied to profits. However, although freelance writing may have a high profit
margin, its annual profits may seem low when compared to a multinational corporation
such as Walmart.
Most publicly traded companies report their net margins both quarterly
during earnings releases and in their annual reports. Companies that are able to expand
their net margins over time are generally rewarded with share price growth, as share
price growth leads directly to higher levels of profitability.

How to Calculate Net Profit Margin?

To calculate net profit margin, find the company's revenue, which consists of all the
sales, fees or other money the business has collected through the period. To ascertain
profits, subtract operating expenses, cost of goods sold (COGS), interest and tax from
revenue. If the business pays stock dividends, also subtract those payments from
revenue when calculating profit, but do not take common stock dividends into account.
Then, simply divide net profit by revenue, and to convert that number into a percent,
multiply it by 100.

To illustrate, imagine a business has $100,000 in revenue, but it also has $20,000 in
operating costs, $10,000 in COGS and $14,000 in tax liability. Its net profits are $56,000.
Profits divided by revenue equals .56 or 56%. A 56% profit margin indicates the
company earns 56 cents in profit for every dollar it collects.

The Importance of Net Profit Margins

Net profit margin is one of the most important indicators of a business's financial health.
It can give a more accurate view of how profitable a business is than its cash flow, and
by tracking increases and decreases in its net profit margin, a business can assess
whether or not current practices are working. Additionally, because net profit margin is
expressed as a percentage rather than a dollar amount, as net profit is, it makes it
possible to compare the profitability of two or more businesses regardless of their
differences in size. Finally, a business can use its net profit margin to forecast profits
based on revenues.
9. Return on Total Capital

Return on total capital is a profitability ratio. It is a measure of the return

an investment generates for those who contribute capital, i.e. bondholders and
stockholders. Return on total capital signifies how effective a company is at turning
capital into profits.
HOW IT WORKS (EXAMPLE):

The general equation for return on total capital is: (Net income - Dividends) /
(Debt + Equity)
Return on total capital is also called "return on invested capital (ROIC)" or "return on
capital."
Looking at an example, Manufacturing Company MM has $100,000 in net income,
$500,000 in total debt and $100,000 in shareholder equity. Its operations are
straightforward -- MM makes and sells widgets.
We can calculate MM's return on total capital with the given equation: (Net income Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%
Note that for some companies, net income may not be the most useful profitability
measure to use. You want to make sure that the profit metric you put in the
numerator provides a genuine measure of profitability.

Return on total capital is most useful when you're trying to determine the returns
generated by the business operation itself, not the short-lived results from one-time
events. Gains/losses from foreigncurrency fluctuations and other one-time events
are included in the net income listed on the bottom line, but they do not result from
business operations. Try to think of what your business "does" and only
consider income related to fundamental business operations.
As an example, let's say, Conglomerate CC shows $100,000 as net income,
$500,000 in total debt and $100,000 in shareholder equity. But when you look at
CC's income statement, you see a lot of extra line-items, like "gains from foreign
currency transactions" and "gains from one-time transactions."
In the case of CC, if you use the net income number, you are not using a specific
measure as to where the returns are being generated. Were they from strong
business results? Were they from fluctuations in the foreign currency markets? Did
CC sell a subsidiary?
For CC, it is better to use an income measure called net operating profits after tax
(NOPAT) as the numerator. It's not found on the income statement, but you can
calculate it yourself using the following equation:
NOPAT = Earnings before Interest & Taxes * (1 - Tax Rate)
Using NOPAT in the equation will tell you the return for both its bondholders and
stockholders the company generated with its operations.
WHY IT MATTERS:

A firm's return on total capital can be an outstanding indicator of the size and
strength of its moat. If a company is able to generate returns of 15-20% year after
year, it has a great system for converting investor capital into profits.
Return on total capital is especially useful for companies that invest lots of capital,
like oil and gas firms, computer hardware companies, and even big box stores. As an
investor, it's imperative to know that if a company uses your money, you'll get a
respectable return on your investment.

10. Return on Common Equity

Return on equity (ROE) is the amount of net income returned as a percentage
of shareholders equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money shareholders have
invested.

ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income/Shareholder's Equity
Net income is for the full fiscal year (before dividends paid to common stock holders but
after dividends to preferred stock.) Shareholder's equity does not include preferred
shares.
Also known as "return on net worth" (RONW).

BREAKING DOWN 'Return On Equity - ROE'

The ROE is useful for comparing the profitability of a company to that of other firms in
the same industry.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above
by subtracting preferred dividends from net income and subtracting preferred equity from
shareholders' equity, giving the following: return on common equity (ROCE) = net
income - preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income
by average shareholders' equity. Average shareholders' equity is calculated by adding
the shareholders' equity at the beginning of a period to the shareholders' equity at
period's end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the
shareholders' equity figure from the beginning of a period as a denominator to determine
the beginning ROE. Then, the end-of-period shareholders' equity can be used as the
denominator to determine the ending ROE. Calculating both beginning and ending ROEs
allows an investor to determine the change in profitability over the period.
Things to Remember

If new shares are issued then use the weighted average of the
number of shares throughout the year.

For high growth companies you should expect a higher ROE.

Averaging ROE over the past 5 to 10 years can give you a better
idea of the historical growth.

For more on return on equity (ROE) read Are companies with a negative return on equity
(ROE) always a bad investment? and ROA And ROE Give Clear Picture Of Corporate
Health

11. Debt to Equity Ratio

What is the 'Debt/Equity Ratio'

Debt/Equity Ratio is a debt ratio used to measure a company's financial leverage,
calculated by dividing a companys total liabilities by its stockholders' equity. The D/E
ratio indicates how much debt a company is using to finance its assets relative to the
amount of value represented in shareholders equity.
The formula for calculating D/E ratios can be represented in the following way:
Debt - Equity Ratio = Total Liabilities / Shareholders' Equity
The result may often be expressed as a number or as a percentage.
This form of D/E may often be referred to as risk or gearing.
2. This ratio can be applied to personal financial statements as well as corporate ones, in
which case it is also known as the Personal Debt/Equity Ratio. Here, equity refers not
to the value of stakeholders shares but rather to the difference between the total value of
a corporation or individuals assets and that corporation or individuals liabilities. The
formula for this form of the D/E ratio, then, can be represented as:
D/E = Total Liabilities / (Total Assets - Total Liabilities)

BREAKING DOWN 'Debt/Equity Ratio'

1. Given that the debt/equity ratio measures a companys debt relative to the total value
of its stock, it is most often used to gauge the extent to which a company is taking on

debts as a means of leveraging (attempting to increase its value by using borrowed

money to fund various projects). A high debt/equity ratio generally means that a
company has been aggressive in financing its growth with debt. Aggressive leveraging
practices are often associated with high levels of risk. This may result in volatile earnings
as a result of the additional interest expense.
For example, suppose a company has a total shareholder value of $180,000 and has
$620,000 in liabilities. Its debt/equity ratio is then 3.4444 ($620,000 / $180,000), or
344.44%, indicating that the company has been heavily taking on debt and thus has high
risk. Conversely, if it has a shareholder value of $620,000 and $180,000 in liabilities, the
companys D/E ratio is 0.2903 ($180,000 / $620,000), or 29.03%, indicating that the
company has taken on relatively little debt and thus has low risk.
If a lot of debt is used to finance increased operations (high debt to equity), the company
could potentially generate more earnings than it would have without this outside
financing. If this were to increase earnings by a greater amount than the debt cost
(interest), then the shareholders benefit as more earnings are being spread among the
same amount of shareholders. However, if the cost of this debt financing ends up
outweighing the returns that the company generates on the debt through investment and
business activities, stakeholders share values may take a hit. If the cost of debt
becomes too much for the company to handle, it can even lead to bankruptcy, which
would leave shareholders with nothing.
2. The personal debt/equity ratio is often used in financing, as when an individual
or corporation is applying for a loan. This form of D/E essentially measures the dollar
amount of debt an individual or corporation has for each dollar of equity they have. D/E
is very important to a lender when considering a candidate for a loan, as it can greatly
contribute to the lenders confidence (or lack thereof) in the candidates financial stability.
A candidate with a high personal debt/equity ratio has a high amount of debt relative to
their available equity, and will not likely instill much confidence in the lender in the
candidates ability to repay the loan. On the other hand, a candidate with a low personal
debt/equity ratio has relatively low debt, and thus poses much less risk to the lender
should the lender agree to provide the loan, as the candidate would appear to have a
reasonable ability to repay the loan.

Limitations of 'Debt/Equity Ratio'

1. Like with most ratios, when using the debt/equity ratio it is very important to consider
the industry in which the company operates. Because different industries rely on different
amounts of capital to operate and use that capital in different ways, a relatively high D/E
ratio may be common in one industry while a relatively low D/E may be common in
another. For example,capital-intensive industries such as auto manufacturing tend to
have a debt/equity ratio above 2, while companies like personal computer manufacturers
usually are not particularly capital intensive and may often have a debt/equity ratio of
under 0.5. As such, D/E ratios should only be used to compare companies when those
companies operate within the same industry.
Another important point to consider when assessing D/E ratios is that the Total
Liabilities portion of the formula may often be determined in a variety of ways by
different companies, some of which are not actually the sum of all of the companys
liabilities. In some cases, companies will only incorporate debts (like loans and debt
securities) into the liabilities portion of the formula, while omitting other kinds of liabilities
(unearned revenue, etc.). In other cases, companies may calculate D/E in an even more
specific way, including only long-term debts and excluding short-term debts and other
liabilities. Yet, long-term debt here is not necessarily a term with a consistent meaning.
It may include all long-term debts, but it may also exclude long-term debts
nearing maturity, which are then categorized as short-term debts. Because of these
differentiations, when considering a companys D/E ratio one should try to determine
how the ratio was calculated and should be sure to consider other ratios and
performance metrics as well.

12. Interest Coverage

The interest coverage ratio is a debt ratio and profitability ratio used to determine how
easily a company can pay interest on outstanding debt. The interest coverage ratio may
be calculated by dividing a company's earnings before interest and taxes (EBIT) during a
given period by the amount a company must pay in interest on its debts during the same
period.
The method for calculating interest coverage ratio may be represented with the following
formula:

or

Interest coverage ratio is also often called times interest earned.

BREAKING DOWN 'Interest Coverage Ratio'

Essentially, the interest coverage ratio measures how many times over a company could
pay its current interest payment with its available earnings. In other words, it measures
the margin of safety a company has for paying interest during a given period, which a
company needs in order to survive future (and perhaps unforeseeable) financial
hardship should it arise. A companys ability to meet its interest obligations is an aspect
of a companys solvency, and is thus a very important factor in
the return for shareholders.
To provide an example of how to calculate interest coverage ratio, suppose that a
companys earnings during a given quarter are $625,000 and that it has debts upon
which it is liable for payments of $30,000 every month. To calculate the interest coverage
ratio here, one would need to convert the monthly interest payments into quarterly
payments by multiplying them by three. The interest coverage ratio for the company is
then 6.94 [$625,000 / ($30,000 x 3) = $625,000 / $90,000 = 6.94].
Staying above water with paying interest is a critical and ongoing concern for any
company. As soon as a company struggles with this, it may have to borrow further or dip
into its cash, which is much better used to invest in capital assets or held as reserves for
emergencies.
The lower a companys interest coverage ratio is, the more its debt expenses burden the
company. When a company's interest coverage ratio is 1.5 or lower, its ability to meet
interest expenses may be questionable. 1.5 is generally considered to be a bare
minimum acceptable ratio for a company and a tipping point below which lenders will

likely refuse to lend the company more money, as the companys risk for default is too
high.
Moreover, an interest coverage ratio below 1 indicates the company is not generating
sufficient revenues to satisfy its interest expenses. If a companys ratio is below 1, it will
likely need to spend some of its cash reserves in order to meet the difference or borrow
more, which will be difficult for reasons stated above. Otherwise, even if earnings are low
for a single month, the company risks falling into bankruptcy.
Generally, an interest coverage ratio of 2.5 is often considered to be a warning sign,
indicating that the company should be careful not to dip further.
Even though it creates debt and interest, borrowing has the potential to positively affect a
companys profitability through the development of capital assets according to the costbenefit analysis. But a company must also be smart in its borrowing. Because interest
affects a companys profitability as well, a company should only take a loan if it knows it
will have a good handle on its interest payments for years to come. A good interest
coverage ratio would serve as a good indicator of this circumstance, and potentially as
an indicator of the companys ability to pay off the debt itself as well. Large corporations,
however, may often have both high interest coverage ratios and very large borrowings.
With the ability to pay off large interest payments on a regular basis, large companies
may continue to borrow without much worry.
Businesses may often survive for a very long time while only paying off their interest
payments and not the debt itself. Yet, this is often considered a dangerous practice,
particularly if the company is relatively small and thus has low revenue compared to
larger companies. Moreover, paying off the debt helps pay off interest down the road, as
with reduced debt the interest rate may be adjusted as well.

Uses of 'Interest Coverage Ratio'

While looking at a single interest coverage ratio may tell a good deal about a companys
current financial position, analyzing interest coverage ratios over time will often give a
much clearer picture about a companys position and trajectory. By analyzing interest
coverage ratios on a quarterly basis for the past five years, for example, trends may
emerge and give an investor a much better idea of whether a low current interest
coverage ratio is improving or worsening, or if a high current interest coverage ratio is

stable. The ratio may also be used to compare the ability of different companies to pay
off their interest, which can help when making an investment decision.
Generally, stability in interest coverage ratios is one of the most important things to look
for when analyzing the interest coverage ratio in this way. A declining interest coverage
ratio is often something for investors to be wary of, as it indicates that a company may be
unable to pay its debts in the future.
Overall, interest coverage ratio is a very good assessment of a companys shortterm financial health. While making future projections by analyzing a companys interest
coverage ratio history may be a good way of assessing an investment opportunity, it is
difficult to accurately predict a companys long-term financial health with any ratio
or metric.

Variations of 'Interest Coverage Ratio'

There are a couple of somewhat common variations of interest coverage ratio that are
important to consider before studying the ratios of companies. These variations come
from alterations to EBIT in the numerator of interest coverage ratio calculations.
One such variation uses earnings before interest, taxes, depreciation and amortization
(EBITDA) instead of EBIT in calculating the interest coverage ratio. Because this
variation excludes depreciation and amortization, the numerator in calculations using
EBITDA will often be higher than those using EBIT. Because the interest expense will be
the same in both cases, calculations using EBITDA will produce a higher interest
coverage ratio than calculations using EBIT will.
Another variation uses earnings before interest after taxes (EBIAT) instead of EBIT in
interest coverage ratio calculations. This has the effect of deducting tax expenses from
the numerator in an attempt to render a more accurate picture of a companys ability to
pay its interest expenses. Because taxes are an important financial element to consider,
for a clearer picture of a companys ability to cover its interest expenses one might use
EBIAT in calculating interest coverage ratios instead of EBIT.
All of these variations of calculating the interest coverage ratio use interest expenses in
the denominator. Generally speaking, these three variants increase in conservatism, with
those using EBITDA being the most liberal, those using EBIT being more conservative,
and those using EBI being the most stringent.

Limitations of 'Interest Coverage Ratio'

Like any metric attempting to gauge the efficiency of a business, the interest coverage
ratio comes with a set of limitations that are important for any investor to consider before
using it.
For one, it is important to note that interest coverage is highly variable, both when
measuring companies in different industries and even when measuring companies within
the same industry. For established companies in certain industries, like a utility company,
an interest coverage ratio of 2 is often an acceptable standard. Even though this is a low
number, a well-established utility will likely have very consistent production and revenue,
particularly due to government regulations, so even with a relatively low interest
coverage ratio it may be able to reliably cover its interest payments. Other industries, like
many kinds of manufacturing, are much more volatile and may often have a higher
minimum acceptable interest coverage ratio, like 3. These kinds of companies generally
see greater fluctuation in business. For example, during the recession of 2008, car sales
dropped substantially, hurting the auto manufacturing industry. A workers strike is
another example of an unexpected event that may hurt interest coverage ratios. Because
these industries are more prone to these fluctuations, they must rely on a greater ability
to cover their interest in order to account for periods of low earnings. Because of wide
variations like these, when comparing companies interest coverage ratios one should be
sure to only compare companies in the same industry, and ideally when the companies
have similar business models and revenue numbers as well.
While all debt is important to take into account when calculating the interest coverage
ratio, companies may choose to isolate or exclude certain types of debt in their interest
coverage ratio calculations. As such, when considering a companys self-published
interest coverage ratio, one should try to determine if all debts were included, or should
otherwise calculate interest coverage ratio independently.
To understand more on the importance of this ratio, read Why Interest Coverage Matters
To Investors and Debt Ratios: Interest Coverage Ratio.