Links Between Financial Statements
Current Ratio = Current Assets / Current Liabilities
Ability of the firm to cover its short term debts
Quick Ratio = Cash + cash equiv + receivables / Curent Liabilities
Ability of the firm to cover its immediate short term debts
Cash Ratio = Cash + Cash Equivalents / Curent Liabilities
Measures cash available to pay short term debts
Working capital :
Margin of safety to pay current obligations
Current assets – current liabilities
Free Cash Flow for a project or a firm:
= Earnings Before Interest and Taxes (EBIT)
x (1- tax rate)
- Changes in working capital (without cash)
- Replacement Investments (Capex)
(+ Receipt from asset sale)
(Note: you can also get free cash flows from operating cash flows + investing cash flows – interest (1-tax%) and adjustment for dividends).
Times Interest Earned = Net Income + Interest Exp. +Tax Exp. / Interest Exp.
Shows the firm’s ability to pay the cost of financing
Debt-to-Equity Ratio = Total Liabilities / Shareholder's Equity
Proportion of debt for each “dollar” invested by shareholders
Profit Margin =
Net Income / Sales Revenue
% of each “dollar” of sales that remains as net income.
Quality of Income =
Cash Flow from Operating Activities / Net Income
Compares the cash flows earned (real) to net income declared (accounting principles!)
Fixed Assets Turnover =
Net Sales Revenue / Average Net Fixed Assets
Shows the ability of the firm to use its fixed assets to generate revenue.
Return on Equity =
Net Income / Average Shareholders’ Equity
How much income was earned for every “dollar” invested by owners?
Structure of Income Statement
Return on Asset Ratios
Profit Margin = EBIT x (1-tax) / Net Sales
Asset Turnover = Net Sales / Average Assets
= Profit margin x Asset turnover
= EBIT x (1-tax) / Average Assets
ROCE (return on capital employed) = EBIT x (1 – tax) / Capital Employed
= Total assets – short term liabilities OR
= Long term liabilities + Equity
Financial leverage: ROE – ROA
Shows the relationship between the return on assets (all forms of funding) and the return on equity (only shareholder’s investment).
Should be positive (indicates that the company creates a bigger return than the cost of borrowing).
When return on capital employed is more than the expected return on investment => Value Creation
EPS = Net Income* /Average Number of Shares Outstanding For The Period
Measures return on investment for shareholders.
*If there are preferred dividends, the amount is subtracted from net income.
Price-to-earnings ratio = Current Market Price Per Share / Earnings Per Share
Measures the relationship between the current share price and the earnings per share. Indicates market expectations.