INVESTMENT STRATEGIES - Business Evaluation Ratios.

Business Evaluation Ratios.


• Current Assets = Cash + Accounts Receivable (Debtors) + Inventory (Stock)
• Current Liabilities = Money owed to Creditors, due within 1 year
• Working Capital = Current Assets – Current Liabilities
• Net Worth = Shareholders’ Equity = Balance Sheet difference between
Assets and Liabilities
• Total Assets = Current Assets + Fixed (Long-term) Assets
• Accounts Receivable = Money owed to the company by Debtors


Liquidity Ratios (firm’s ability to pay its debts)

Current Ratio = Current Assets (Cash + Debtors + Stock) / Current Liabilities.
Best is 2:1. Low ratio suggests inability to pay bills on time. High suggests too much liquidity is tied up.

Quick Ratio (Acid Test) = Cash + Debtors / Current Liabilities.
Some analysts reduce Debtors by 25% for bad debt provision. Best is 1:1.
Good Current Ratio/poor Quick Ratio suggests slow-moving Inventory.

Working Capital Ratio (Turnover of Cash) = Net Sales / Working Capital.
Best is 5 to 6*. Low ratio means too much cash; high means may have difficulty in
paying some creditors.

Debt to Equity Ratio = Total Debt (i.e. Total Liabilities) / Equity
(i.e. Net Worth or Shareholders’ Equity or Total Assets less Total Liabilities).
Current Liabilities / Equity should not exceed 80%.
Long-term Debt / Equity should not exceed 50%.
Companies with no debt can be too conservative, missing the
potential profit that gearing brings - i.e. borrowing cheaply and
earning a higher rate of return on sales. Gearing works against the company
in a sales slump.

Profitability Ratios (measure returns on sales, assets, and investment)

Rate of Return on Sales Ratio = Operating Income (i.e. Net Profit) / Net Sales.
The higher, the better. Industries differ on acceptable levels
e.g. supermarkets low.

Rate of Return on Assets (ROA) Ratio = Income before Taxes / Total Assets.
Variations are Return on Current Assets and Return on Fixed Assets.
Look out for the distorting effect of a large amount of intangible assets.

Rate of Return on Investment (ROI) or Return on Equity (ROE) Ratio = Income
before Taxes / Shareholders’ Equity (i.e. Net Worth). Variation is EBIT / Shareholders’ Equity.
Look for 15%+ which allows company to fund growth through its operating
income.
A high ratio could mean that a company is under-capitalised with minimal
long-term debt.
Efficiency Ratios

Average Debt Collection Period Ratio = Accnts. Rec. (Debtors) * Days / Net Sales.
This is the average number of days to collect cash from credit sales.
Best if within 10 to 15 days of normal collection period, which is 30 days.
A high figure may be due to bad accounts or using credit to generate sales.
Excessive debtors lowers ROCE and may cause liquidity problems.

Average Creditors’ Payment Period = Creditors / Purchases (Cost of Sales) * 365.
Delaying payment can be an indication of cash problems.

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory.
Av. Inventory is beginning stock + ending stock / 2.
This figure measures how many times a company’s stock is replaced in
one year.
The rule of thumb is 6 to 7*. A good figure increases cash flow and
reduces costs.
A low figure could be the result of obsolete items or over-stocking.
A high figure suggests fast-moving stock or perhaps lack of stock.
A small business should not carry more than 100% of its working capital
figure in inventory.

Fixed Asset Turnover Ratio (Net Sales to fixed Assets Ratio)
= Net Sales / Fixed Assets.
This measures the effectiveness in generating sales from fixed assets.
Best between 3 and 5*. A low figure suggests too many assets chasing too
few sales.
A high figure indicates greater profitability. The figure can be distorted
if assets areheavily depreciated. Comparisons with firms and industry
need to be based on similar asset figures.

Interest Cover = Profit before Tax and Interest / Interest Paid.
Should be at least 5*.

Basic Market Ratios

Earnings per Share (EPS) = Net Earnings (i.e. Net Income) /Average shares outstanding.
A decline raises questions about future growth and profitability.

Price to Earnings Ratio = Market Price / EPS.

Dividend Yield =Dividends per share / Market Price.
A reduced payout generally leads to a decline in Market Price.

Dividend Cover = Shareholders’ Profit / Dividend.