# 2. Common Ratios

## b. classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios;

## c. describe relationships among ratios and evaluate a company using ratio analysis;

For the ratios on this page, don’t worry about memorizing them all. Mostly memorize what they are for. “The analyst’s primary focus should be the relationships indicated by the ratios, not the details of their calculations.”

What are Activity Ratios? Activity ratios describe the relationship between the company’s level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

What is the activity ratio “receivables turnover”? What is the formula? - Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash. - \(receivables\ turnover = \frac{revenue}{average\ receivables}\)

What is the formula for Days Sales Outstanding (DSO)? \(days\ sales\ outstanding\ (DSO) = \frac{number\ of\ days\ in\ the\ period}{receivables\ turnover}\)

What is the activity ratio for “inventory turnover”? What is the formula? - Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold. - \(inventory\ turnover = \frac{COGS}{average\ inventory}\)

What is the formula for Days of Inventory On hand (DOH)? \(days\ of\ inventory\ on\ hand (DOH) = \frac{number\ of\ days\ in\ period}{inventory\ turnover}\)

What is the activity ratio of “payable turnover”? What is the formula? - Payable turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers. - \(payables\ turnover = \frac{purchases}{average\ trade\ payables}\)

What is the formula for number of days payable? \(number\ of\ days\ payable = \frac{number\ of\ days\ in\ period}{payables\ turnover}\)

What is the activity ratio for “working capital turnover”? What is the formula? - Working capital turnover measures how efficiently a company generates revenue with its working capital. Working capital is defined as current assets minus current liabilities. - \(working\ capital\ turnover = \frac{revenue}{average\ working\ capital}\)

What is the activity ratio for “total asset turnover”? What is the formula? - Total asset turnover is a measure of how many dollars of sales are generated by a dollar of assets. - \(total\ asset\ turnover = \frac{revenue}{average\ total\ assets}\)

What is the activity ratio for “fixed asset turnover”? What is the formula? - Fixed asset turnover is a measure of a company’s utilization of fixed assets. - \(fixed\ asset\ turnover = \frac{revenue}{average\ net\ fixed\ assets}\)

How is “net assets” calculated?
`net assets = gross fixed assets - depreciation on fixed assets`

What are liquidity ratios? Liquidity ratios measure the ability of a company to meet short-term obligations.

What is the liquidity ratio of “defensive interval ratio”? What is the formula? - The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. - \(defensive\ interval\ ratio = \frac{cash + short\ term\ marketable\ investments + receivables}{daily\ cash\ expenditures}\)

What is the liquidity ratio for “cash conversion cycle”? What is the formula? - The cash conversion cycle is the time period that exists from when the company pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the company’s finished goods. In short, it measures the number of days the company’s cash is tied up in the business. - \(Cash\ Conversion\ Cycle = DOH + DSO - Number\ of\ Days\ of\ Payables\)

What are solvency ratios? Solvency ratios measure the ability of a company to meet long-term obligations.

What is the solvency coverage ratio for “interest coverage ratio”? What is the formula? - Interest coverage ratio measures how many times over a company could pay its interest out of earnings. The higher the ratio, the less likely that the company cannot meet its interest payments, and consequently, the lower the financial risk. - \(interest\ coverage = \frac{EBIT}{interest\ expense}\)

What is the solvency coverage ratio for “fixed charge coverage”? What is the formula? - Fixed charge coverage measures a company’s ability to meet all fixed payment obligations, including interest payment on debt, entire lease payments (not limited to the interest component), and dividends on preferred stock. - \(fixed\ charge\ coverage = \frac{EBIT + lease\ payments}{interest\ payments + lease\ payments}\)

What are profitability ratios? Profitability ratios measure the ability of a company to generate profits from revenue and assets.

What is the return on sales profitability ratio for “operating profit margin”? What is the formula? - Operating profit margin relates a company’s operating income to its net sales. - \(operating\ profit\ margin = \frac{operating\ income}{revenue}\)

What is another term often used in place of “operating profit”? What is the formula for operating profit?
- EBIT = earnings before interest and taxes
- `EBIT = gross profit - SG&A (sales general administrative)`

What is the formula for return on sales profitability ratio of “pre-tax margin”? \(pre\ tax\ margin = \frac{EBT\ (earnings\ before\ tax)}{revenue}\)

What is the return on investment profitability ratio “ROA”? What is the formula? - ROA measures the return earned by a company on its assets - \(ROA = \frace{net\ income}{average\ total\ assets}\)

What is the formula for the return on investment profitability ratio of “Operating ROA”? \(Operating\ ROA = \frac{operating\ income}{average\ total\ assets}\)

What is the formula for the return on investment profitability ratio of “return on total capital”? What is the formula? - Return on total capital indicates a company’s return on all the capital employed (debt, preferred stock, and common stock). It measures return on all sources of funding. - \(return\ on\ total\ capital = \frac{EBIT}{average\ total\ capital}\)

How is “total capital” determined?
`total capital = debt + equity`

What is the return on investment profitability ratio for “ROE” (return on equity)? What is the formula? - ROE (Return on equity) measures return on total equity capital only. This includes both preferred and common equity owners. - \(return\ on\ equity = \frac{net\ income}{average\ total\ equity}\)

What is the formula for the return on investment profitability ratio of “return on common equity”? \(return\ on\ common\ equity = \frac{net\ income - preferred\ dividends}{average\ common\ equity}\)

##### Source:

CFA

##### Graph:

- 115.040.06 Financial Analysis - Reading 24. Financial Analysis Techniques to 115.040.06.02 Financial Analysis - Reading 24 - 2. Common Ratios