Microsoft Office Tutorials and References

In Depth Information

The Average Collection Period is generally compared against the company's credit terms. If the company allows

30 days for its customers to pay and the Average Collection Period is greater than 30 days, it can indicate a

problem with the company's credit policies or collection efforts.

The efficiency with which the company uses its inventory can be similarly computed. Inventory Turnover di-

vides cost of sales by average inventory:

=Cost_of_Goods_Sold/((Inventory+LastYear_Inventory)/2)

The Average Age of Inventory tells how many days inventory is in stock before it is sold:

=365/Inventory_turnover

By adding the Average Collection Period to the Average Age of Inventory, the total days to convert inventory

into cash can be computed. This is the Operating Cycle and is computed as follows:

=Average_collection_period+Average_age_of_inventory

Solvency ratios

Whereas
liquidity ratios
compute a company's ability to pay short-term debt,
solvency ratios
compute its ability

to pay long-term debt. The Debt Ratio compares total assets with total liabilities:

=Total_Assets/(Total_Current_Liabilities+Long_Term_Debt)

The Debt-to-Equity Ratio divides total liabilities by total equity. It's used to determine whether a company is

primarily equity financed or debt financed:

=(Total_Current_Liabilities+Long_Term_Debt)/(Com-

mon_Stock+Additional_Paid_in_Capital+Retained_Earnings)

The Times Interest Earned Ratio computes how many times a company's profit would cover its interest expense:

=(Net_Income__Loss+Interest_Expense)/Interest_Expense

Profitability ratios

As you might guess,
profitability ratios
measure how much profit a company makes. Gross Profit Margin and

Net Profit Margin can be seen on the earlier common size financial statements because they are both ratios com-

puted relative to sales. The formulas for Gross Profit Margin and Net Profit Margin are

=Gross_Margin/Revenue

=Net_Income__Loss/Revenue

The Return on Assets computes how well a company uses its assets to produce profits:

=Net_Income__Loss/((Total_Assets+LastYear_Total_Assets)/2)

The Return on Equity computes how well the owners' investments are performing: