This essay sample on Corporate Finance Solutions provides all necessary basic info on this matter, including the most common “for and against” arguments. Below are the introduction, body and conclusion parts of this essay.
Liquidity Ratios Liquidity ratios measure a ability to pay its bills as they come due. Three commonly used liquidity ratios are the current ratio, the quick ratio and the cash ratio. The current ratio is found by dividing current assets by current liabilities. A ratio of 1 means the business has just enough current assets to pay current liabilities, Ratios above 1 mean a firm has more current assets than current liabilities; ratios below 1 mean more current liabilities than current assets. Investors typically prefer a lower current ratio because it shows that a assets are working to grow the business.
The quick ratio, also called the acid test, subtracts inventory from current assets before viding them by current liabilities. The acid test gives a more accurate view of the short-tern liquidity than the current ratio because it removes inventory that the firm may not be able to sell from the equation. The cash ratio excludes all assets except cash and marketable securities such as stocks and bonds. It gives the best indication of a ability to pay, should current creditors demand immediate payment. Financial Leverage Ratios Financial leverage ratios measure a use Of long-term debt.
The debt ratio is total debt divided by total assets. A ratio above 1 means a firm as more debt than assets, below I means more assets than debt and I means equal debt and assets. The debt-to-equity ratio divides total debt by total equity (the investment). It indicates how a firm is financed. A ratio above 1 indicates the use of more debt than equity, while a ratio below 1 indicates the use of more equity. A high-debt firm is, all things being equal, weaker financially than one using more equity because it is more susceptible to interest rate increases.
Corporate Finance Solutions
Investors generally prefer firms with lower debt. Profitability Ratios Profitability ratios measure a ability to generate profits. Gross profit margin, return on assets and return on equity are three commonly used ratios. Gross profit margin, also know as gross margin, indicates the percentage of net sales (sales minus cost of goods sold) going toward profit and fixed costs. Investors prefer high gross margins because they mean more money to cover fixed costs and more profit. Return on assets reveals how well a firm uses its assets to generate income.
It is found by dividing net income by total assets Investors prefer a high return on assets. Return on equity measures the return on each dollar invested in a stock. It is found by dividing net income y shareholder equity. As with other profitability ratios, higher is better. Http://sanguineness. Chronic. Certification-ratios-used-institutors-eggs. Thorn IS Financial Ratios Every Investor Should Else Financial ratios can help to make sense of the overwhelming amount of information that can be found in a company’s financial statements.
Knowing how to pick out small bits of important information. Combine them with other small bits of information and interpret the resulting number is more of an art than a science. But it’s undoubtedly one of the most important arts that an investor should practice. To start your journey into ratio analysis, you’ll need a company’s consolidated financial statements, found in a company’s 10-K and available for free on the SEC website. The three most important financial statements are the income statement, balance sheet and cash flow statement. Track these down before proceeding further.
While there are quite a few financial ratios, investors use a handful of them over and over again, These IS ratios are indispensable tools that should be a part of every investor’s research process. Price Ratios Price ratios are used to get an idea of whether a stock’s price is reasonable or to, They are easy to use and generally pretty intuitive, but do not forget this major caveat: Price ratios are “relative” metrics, meaning they are useful only when comparing one company’s ratio to another company’s ratio, a company’s ratio to itself over time, or a company’s ratio to a benchmark. ) Price-to-Earnings Ratio (PIE) What you need: Income Statement, Most Recent Stock Price The formula: PIE Ratio = Price per Share / Earnings Per Share What it means: Think Of the price-to-earnings ratio as the price you’ll pay for SSL of earnings. A very, very general rule Of thumb is that shares trading at a “low” PIE are a value, though the benefiting of “low” varies from industry to industry. [Investigators Feature: The PIE Ratio -A True Measure of Profits? 2) PEG Ratio PEG Ratio (PIE Ratio) / Projected Annual Growth in Earnings per Share What it means: The PEG ratio uses the basic format of the PIE ratio for a numerator and then divides by the potential growth for PEPS, which you’ll have to estimate. The two ratios may seem to be very similar but the PEG ratio is able to take into account future earnings growth. A very generally rule thumb is that any PEG ratio below I is considered to be a good value 3) price-to-Sales Ratio Price-to-Sales Ratio price per Share / Annual Sales per Share What it means: Much like PIE or P/B, think of P/S as the price you’ll pay for $1 of sales.
If you are comparing two different firms and you see that one firm’s PIPS ratio is xx and the other is ax, it makes sense to figure out why investors are willing to pay more for the company with a PIPS of xx_ The PIPS ratio is a great tool because sales figures are considered to be relatively reliable while other income statement items, like earnings, can be easily manipulated by using different accounting rules. 4) Price- to-Book Ratio (P/B) What you need: Balance Sheet, Most Recent Stock Price
The formula: P/B Ratio = Price per Share / Book Value per Share What it Book value (BE) is already listed on the balance sheet, it’s just under means: a different name: shareholder equity. Equity is the portion of the company that owners (i. E. Shareholders) own free and clear. Dividing book value by the number of shares outstanding gives you book value per share. Like PIE, the P,’ B ratio is essentially the number of dollars you’ll have to pay for $1 of equity. And like PIE, there are different criteria for what makes a P/B ratio “high” or “low. [Investigators Feature: Don’t Be Misled By the PIE Ratio] 5) Dividend Yield Dividend Yield = Dividend per Share Price per Share What it means: Dividends are the main way companies return money to their shareholders. If a firm pays a dividend, it will be listed on the balance sheet, right above the bottom line. Dividend yield is used to compare different dividend-paying stocks. Some people prefer to invest in companies with a steady dividend, even if the dividend yield is low, while others prefer to invest in stocks with a high dividend yield. Investigators Feature: Decoding the Dividend Yield r-ormolu] 6) Dividend Payout Ratio What you need: Income Statement Dividend Payout Ratio = Dividend Net Income What it means: The percentage Of profits distributed as a dividend is called the dividend payout ratio. Some companies maintain a steady payout ratio, while Other try to maintain a steady number Of dollars paid out each year (Which means the payout ratio Will fluctuate). Each company sets its own dividend policy according to What it thinks is in the best interest Of its shareholders.
Income investors should keep an especially close eye on changes in dividend policy. Profitability ratios tell you how good a company is at converting business operations into profits. Profit is a key driver of stock price, and it is undoubtedly one of the most closely followed metrics in business, finance and investing, 7) Return on Assets (ROAR) What you need: Income Statement, Balance Sheet Return on Assets – Net Income / Average Total Assets What it means: A company buys assets (factories, equipment, etc,) in order to conduct its business.
ROAR tells you how good the company is at using its assets to make money. For example, if Company A reported 510,000 of net income and owns $100,000 in assets, its ROAR is 10%. For ever $1 of assets it owns, it can generate SC, 10 in profits each year. With ROAR, higher is better, 8) Return on Equity (ROE) The formula: Return on Equity = Net Income / Average Stockholder Equity What it means: Equity is another overdo for ownership. ROE tells you how good a company is at rewarding its shareholders for their investment.
For example, if Company B reported $10,000 of net income and its shareholders have $200,000 in equity, its ROE is Poor every $1 of equity shareholders own, the company generates $0. 05 in profits each year. As with ROAR, higher is better. 9) Profit Margin The formula: Profit Margin = Net Income / Sales What it means: Profit margin calculates how much of a company’s total sales flow wrought to the bottom line. As you can probably tell, higher profits are better for shareholders, as is a high (and/or increasing) profit margin. Liquidity Ratios Liquidity ratios indicate how capable a business is of meeting its short-term obligations.
Liquidity is important to a company because when times are tough, a company without enough liquidity to pay its short-term debts could be forced to make unfavorable decisions in order to raise money (sell assets at a low price, borrow at high interest rates, sell part of the company to a vulture investor, etc. ). 10) Current Ratio What you need: Balance Sheet The formula: Current Ratio = Current Assets / Current Liabilities What it means: The current ratio measures a company’s ability to pay its short-term liabilities with its short-term assets. If the ratio is over I . 0, the firm has more short-term assets than short-term debts.
But it the current ratio is less than 1. 0, the opposite is true and the company could be vulnerable to unexpected bumps in the economy or business climate. 11) Quick Ratio The formula: Quick Ratio = (Current Assets – Inventory) / Current Liabilities What it means: The quick ratio (also known as the acid-test ratio) is similar to the kick ratio in that it’s a measure of how well a company can meet its short-term financial liabilities. However, it takes the concept one Step further. The quick ratio backs out inventory because it assumes that selling inventory would take several weeks or months.
The quick ratio only takes into account those assets that could be used to pay short-term debts today. Debt Ratios These ratios concentrate on the long-term health of a business, particularly the effect of the capital and finance structure on the business: 12) Debt to Equity Ratio The formula: Debate-Equity Ratio – Total Liabilities Total Shareholder Equity What it means: Total liabilities and total shareholder equity are both found on the balance sheet. The debt-to-equity ratio measures the relationship between the amount of capital that has been borrowed (i. E. Debt) and the amount of capital contributed by shareholders (i. . Equity). Generally speaking, as a firm’s debt-to-equity ratio increases, it becomes more risky because if it becomes unable to meet its debt obligations, it will be forced into bankruptcy. 13) Interest Coverage Ratio The formula: Interest Coverage Ratio = BIT / Interest Expense What it means: Both BIT (aka, operating income) and interest expense are found on the income tenement. The interest coverage ratio, also known as times interest earned (TIE), is a measure of how well a company can meet its interest payment obligations. If a company can’t make enough to make interest payments, it Avail be forced into bankruptcy.
Anything lower than 1. 0 is usually a sign of trouble. Efficiency Ratios These ratios give investors insight into how efficiently a business is employing resources invested in fixed assets and working capital. It’s can also be a reflection Of how effective a company’s management is. 14) Asset Turnover Ratio Whatnot need: Income Statement, Balance Sheet The formula: Asset Turnover Ratio = Sales / Average Total Assets What it means: Like return on assets (ROAR), the asset turnover ratio tells you how good the company is at using its assets to make products to sell.