A Basic Set of Financial Ratios
Annual Income Statement Data ∗
Ratios will be an important part of our financial analysis. One problem is that there are literally
hundreds of financial ratios in use. Which ones are best? The answer differs depending on the context,
but here is a minimum core set of ratios that is appropriate for almost all businesses except for financial
institutions. This basic set will address the major areas without creating a large computational burden.
Undoubtedly there will be times during the course (and your business career) when you will find it useful
to augment this set with additional computations. That is fine, but make sure that the ratios identified
below are always computed for each period for which we have data.
We also will standardize with specific definitions for each ratio. It is not that all of the other
definitions are conceptually wrong; it simply facilitates class discussion to standardize.
Thus, for this course only the definitions below will be considered correct. Here are a few general
comments about the ratios.
• Use ending balance sheet values, not average.
• Typically, income statements only show net sales. If both net and gross sales are provided, use
net sales in the calculations.
• Assume a 365-day year.
• If income statement data are not annual, some of the ratios will need adjustment. There is a
reading assigned later in the course that explains these adjustments.
• Note how ratios combine items that are similar. For example, the average collection period
combines accounts receivable with sales because receivables are at the selling price. On the
other hand, inventory days uses inventory and cost of goods sold because inventory is valued at
cost.
• If credit sales are not available, use total sales for the average collection period.
• When computing the debt-to-equity ratio use all debt. That means everything except the equity
accounts. Accounts such as accounts payable and accruals are part of total debt.
• The fixed asset turnover should include land, plant, equipment, and capitalized lease assets.
• Use the following formatting standards:
o Round days to the nearest day (e.g., average collection period = 37),
o Turnovers to the nearest tenth (e.g., total asset turnover = 2.7), and
o Profit ratios to the nearest tenth of a percent (e.g., net profit margin = 10.3%).
• Ratios will vary by the nature of a company and this makes it difficult to generalize about a
ratio’s value. For example, you will sometimes hear that a current ratio of 2.0 and a quick ratio
of 1.0 are the accepted standards. This is not correct for many businesses so we will not use
those numbers as standards. It will be much more effective to think about why the ratio has a
particular value and what the implications are for the specific business.
∗
Peter C. Eisemann. No portion of this document may be reproduced without the express written consent of the
author.
Liquidity
Ending current assets
Current ratio =
Ending current liabilities
Ending current assets − ending inventory
Quick ratio or acid test =
Ending current liabilities
Ending accounts payable x 365
Accounts payable days =
Annual credit purchases (if available , otherwise CGS )
Profitability
Annual net income
Return on equity =
Ending total equity
Annual net income
Return on assets =
Ending total assets
The next three ratios can be taken from your common-size income statements. Remember to use
net sales as the base number when doing a common-size income statement rather than gross sales
when both are provided.
Annual gross profit
Gross profit margin =
Annual net sales
Annual earnings before interest and taxes
Operating margin =
Annual net sales
Annual net income
Net profit margin =
Annual net sales
Efficiency
Annual net sales
Total asset turnover =
Ending total assets
Average collection period or days sales outstanding =
Ending accounts receivable x 365
Annual credit sales (if available, otherwise total sales )
2
If the income statement shows both gross sales and net sales, use net sales for the average collection
period and all other ratios using sales.
Ending inventory x 365
Inventory days =
Annual cost of goods sold
Annual net sales
Fixed asset turnover =
Ending net fixed assets
Leverage
Debt Ending total debt
=
Equity Ending total equity
Total debt means all debt including items such as accounts payable and accruals. Compute it by
either adding up all debt or subtracting total equity from total assets.
Annual earnings before interest and taxes
Times interest earned =
Annual interest
Other
Annual common dividends
Dividend payout =
Annual earnings available to common
Net sales in year 2
Sales growth = − 1 x 100
Net sales in year 1
Summary
DuPont analysis:
Debt
Return on equity = Net profit margin x Total asset turnover x 1 +
Equity
The purpose of DuPont analysis is not to compute ROE. That can be done more simply by dividing
net income by total equity. In fact, no computations are necessary because you have already
computed the return on equity, net profit margin, total asset turnover, and debt-to-equity ratio as
part of your standard set of ratios. Instead, use DuPont analysis to look at the three components of
return on equity to determine how the firm is generating its return. You should be able to gain some
insight into performance from the components.
