Financial Ratio Analysis: Performance, Efficiency, and Growth

Market Value Performance Measures

• Market Value Added (MVA): Market Capitalization (Number of shares × Price per share) - Equity.
• Market-to-Book Ratio: Measures value added per dollar invested by shareholders. Calculated as: Market Value of Equity / Book Value of Equity (Total Shareholders' Equity).

Measuring Profitability

• Economic Value Added (EVA): Profit after deducting all costs, including the cost of capital. Formula: [After-tax operating income] - [Cost of Capital × Total Capitalization at start of year (Long-term debt + Total equity)].
• Return on Equity (ROE): Net Income / Equity (start of year).
• Return on Assets (ROA): [(1 - Tax Rate) × Interest Expense + Net Income] / Total Assets (start of year).
• Return on Capital (ROC): [(1 - Tax Rate) × Interest Expense + Net Income] / (Long-term Debt + Equity at start of year).

Measuring Efficiency

Efficiency refers to how effectively a business utilizes its assets regarding liquidity, profitability, and performance.

• Asset Turnover Ratio: Sales / Total Assets (start of year).
• Inventory Turnover Ratio: Measures how many times inventory is sold annually. Formula: COGS / Inventory (start of year).
• Average Days in Inventory: Average days inventory sits before sale. Formula: Inventory (start of year) / (COGS / 365).
• Receivables Turnover: Speed of collecting credit accounts. Formula: Sales / Receivables (start of year).
• Average Collection Period: Average days to collect credit sales. Formula: Receivables (start of year) / (Sales / 365).

Analyzing Return on Assets: DuPont System

• Profit Margin: Net Income / Sales.
• Operating Profit Margin: [(1 - Tax Rate) × Interest Paid + Net Income] / Sales. Indicates income available to shareholders per dollar of sale.
• ROA: Measures asset utilization efficiency. Formula: [(1 - Tax Rate) × Interest Expense + Net Income] / Assets. Also calculated as: Asset Turnover × Operating Profit Margin.

Measuring Leverage

• Long-Term Debt Ratio: Long-Term Debt / (Long-Term Debt + Equity).
• Long-Term Debt-to-Equity Ratio: Long-Term Debt / Equity.
• Total Debt Ratio: Total Liabilities / Total Assets.
• Times Interest Earned (Interest Coverage Ratio): EBIT / Interest Payment.
• Cash Coverage Ratio: (EBIT + Depreciation) / Interest Payment.

Extended DuPont System

ROE (Shareholders' investment return) can be calculated as: Leverage Ratio × Assets Turnover × Operating Profit Margin × Debt Burden.

Measuring Liquidity

Measures the ability to pay short-term obligations using available assets.

• Net Working Capital (NWC): Current Assets - Current Liabilities.
• NWC to Total Assets Ratio: NWC / Total Assets.
• Current Ratio: Current Assets / Current Liabilities.
• Quick Ratio (Acid-Test Ratio): (Cash + Accounts Receivable) / Current Liabilities.
• Cash Ratio: Cash / Current Liabilities.

Sustainable Growth

• Payout Ratio: Dividends / Net Income.
• Plowback Ratio: (Net Income - Dividends) / Net Income.
• Sustainable Growth Rate: Plowback Ratio × ROE.