Ratio Analysis Best

Financial Ratio Analysis
Working Capital
The excess of current assets over

current liabilities is known as
working capital.
Working capital is not

free. It must be
financed with long-
term debt and equity.
2
Working Capital
December 31
This Year
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
3
Current Ratio
Current Current Assets

=
Ratio Current Liabilities
The current ratio measures a

company’s short-term debt paying
ability.
A declining ratio may be a

sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
4
Current Ratio
Current Current Assets

=
Current $65,000
= = 1.55
Ratio $42,000
The picture can't be displayed.
5
Quick or Acid-Test Ratio
• The quick or acid-test ratio is a measure of liquidity

that compares only the most liquid assets with current
liabilities.
• Excluded from the quick ratio are non-liquid current
assets such as inventories.
• The numerator of the quick ratio includes only the most
liquid assets (cash, marketable securities, and accounts
receivable).
6
Acid-Test (Quick) Ratio
Acid-Test Quick Assets

=
Acid-Test $50,000
= = 1.19
Ratio $42,000
Quick assets include Cash,

Marketable Securities, Accounts Receivable, and
current Notes Receivable.
This ratio measures a company’s ability to meet
obligations without having to liquidate inventory.
7
Calculating the Current Ratio and
the Quick (or Acid-Test) Ratio
Information:
Bordner Company has current assets equal to $120,000. Of these,
$15,000 is cash, $30,000 is accounts receivable, and the remainder is
inventories. Current liabilities total $50,000.
Required:
1. Calculate the current ratio.
2. Calculate the quick ratio (acid-test ratio).
Solution:
1. Current ratio = Current assets/Current liabilities
= $120,000/$50,000
= 2.4
2. Quick ratio = (Cash + Marketable securities + Accounts Receivable)
/ Current liabilities
= ($15,000 + 0 + $30,000)/ $50,000
= 0.90
8
Classification System
Liquidity Ratios
Current assets
Current ratio =
Current liabilities
Current assets - Inventory
Quick ratio =
Current liabilities
Current assets - Current liabilities
Net working capital to =
Total assets
total assets
9
Ratio Analysis – The Long–Term
Creditor
Long-term creditors are concerned with a
company’s ability to repay its loans over the
long-run.
NORTON CORPORATION
This Year
Earnings before interest
expense and income taxes $ 84,000
Interest expense 7,300
Total stockholders' equity 234,390
This is also referred
Total liabilities 112,000
to as net operating
income.
10
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
This ratio indicates the relative proportions

of debt to equity on a company’s balance
sheet.
Stockholders like a lot of Creditors prefer less debt

debt if the company can and more equity because
take advantage of positive equity represents a buffer
financial leverage. of protection.
11
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Ratio
Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio
12
Times Interest Earned Ratio
Earnings before Interest Expense
Times and Income Taxes
Interest = Interest Expense
Earned
Times
$84,000
Interest = = 11.51 times
$7,300
Earned
This is the most common
measure of a company’s ability
to provide protection for its long-
term creditors. A ratio of less
than 1.0 is inadequate.
13
Debt Ratio
• What percentage of the firm’s assets are

financed by debt?
• Total debt/Total assets
Example
Debt ratio =
$591M / $2,672M = .221 or 22.1%
14
Fixed Payment Coverage
Ratio (FPC)
Earnings Before Interest &
Fixed Payment Taxes + Lease Payments
Coverage FPC=
Interest + Lease Payments
Ratio (FPC) +{(Grossed up Principal
Payments + Preferred Stock
Dividends)
15
Debt-utilization Ratios
Long - term debt

Long-term debt to equity =
Stockholders' equity
Total debt to total assets Total debt
=
Total assets
Times interest earned =
Income before interest & taxes
Interest
Fixed charge coverage =

Income before fixed charges & taxes
Fixed charges 16
How Is Management Doing Creating
Shareholder Value?
• These ratios indicate what investors think

of management’s past performance and
future prospects. Two approaches:
• Price/Earnings ratio
• Price/Book ratio
17
The Price-Earning Ratio
(1)
Price per share
P/E ratio = Earnings per share (2)
 Ultimately P/E ratio is set by investors

 Bid price up or down in relation to
earnings
(1) Today’s price

(2) Latest 12-month earnings per share
18
Common Stock Valuation – P/E
Ratios
• Hi P/E ratios Indicates positive expectations

of the future
• Lo P/E ratios Indicates negative expectations

of the future
19
Factors Affecting P/E Ratio
• Investors’ expectation of EPS

• Expected growth in EPS
• Historical analysis
• Overall conditions in the stock market
• Growth prospects in the economy
• Inflation inversely related to P/E ratio
• CPI goes down P/E ratio goes up
• CPI goes up P/E ratio goes down
20
Price-Earnings Ratio
Price-Earnings Market Price Per Share
=
Ratio Earnings Per Share
Price-Earnings $20.00
= = 8.26 times
Ratio $2.42
A higher price-earnings ratio means that

investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.
21
Earnings Per Share
Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding
Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.
Earnings form the basis for dividend payments

and future increases in the value of shares of
stock.
22
Earnings Per Share
Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding
Earnings per Share = $53,690 – $0 = $2.42

($17,000 + $27,400)/2
This measure indicates how much

income was earned for each share of
common stock outstanding.
23
Dividend Payout Ratio
Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share
Dividend $2.00
= = 82.6%
Payout Ratio $2.42
This ratio gauges the portion of current

earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).
24
Dividend Yield Ratio
Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share
Dividend $2.00
= = 10.00%
Yield Ratio $20.00
This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.
25
A Complete Ratio Analysis
• DuPont System of Analysis

• DuPont System of Analysis is an integrative
approach used to dissect a firm's financial
statements and assess its financial
condition
• It ties together the income statement and
balance sheet to determine two summary
measures of profitability, namely ROA and
ROE
26
DuPont System of Analysis
• The firm's return is broken into three

components:
• A profitability measure (net profit margin)
• An efficiency measure (total asset
turnover)
• A leverage measure (financial leverage
multiplier)
27
Return on Equity (ROE)
Dupont Analysis
Shows the relationship between

income statement & balance sheet
If ROE is unsatisfactory, the Du Pont

Analysis helps locate which part of the
business is underperforming
Age of assets must be considered
28
Du Pont analysis
29
7-29
Return of Wal-Mart versus May Department
Stores using the Du Pont method of analysis
30
30
Compute the firm's return on equity,
using the DuPont formula
Current Assets $ 1,000 INCOME STATEMENT (000’s)
Fixed Assets 5,000 Net Sales $12,000
Total Assets $ 6,000 COGS -7,100
Gross Profit 4,900
Current Liabilities $ 600 Operating Expense -3,000
Long-term Liabilities 1,500 Operating Profit 1,900
Common stock (at par) 2,000
Paid-in Capital 1,000 Interest -200
Retained Earnings 900 Net Profit Before Taxes 1,700
Total Liabilities/Equity $6,000
Taxes (40%) -680
Net Profit $ 1,020
31
Solution
ROE= Net Profit Margin X Total Assets Turnover X Financial Leverage
= Net Profit Sales Total Assets

Sales Total Assets Stockholder's Equity
$ 1,020 $12,000 $ 6,000
= X X = .085 x 2.0 x 1.538 =.2615
$12,000 $ 6,000 $ 3,900
ROE = 26.15%
OR Net Profit $1,020
ROE = = = .2615 = 26.15%
Stockholder's Equity 3,900
32
Importance of Ratios
Which ratio is most important?

It depends on your perspective.
• Suppliers and banks (lenders) are most
interested in liquidity ratios.
• Stockholders are most interested in
profitability ratios.
• A long-run trend analysis over a 5-10 year
period is usually performed by an analyst.
33
33
Seven Basic Profitability
Measures
Gross Profits
GPM=
Sales
Gross Profit Margin (GPM)
Operating Profits (EBIT)
OPM =
Operating Profit Margin (OPM) Sales
Net Profit After Taxes

Net Profit Margin (NPM) NPM=
Sales
Return on Total Assets (ROA) ROA=
Total Assets
Return On Equity (ROE) ROE=
Earnings Available for
Earnings Per Share (EPS) Common Stockholder’s
EPS =
Number of Shares of Common
Stock Outstanding
Price/Earnings (P/E) Ratio Market Price Per Share of
Common Stock
P/E = 34
Earnings Per Share
Five Important Activity Measures
Cost of Goods Sold
Inventory Turnover (IT) IT =
Inventory
Average Collection Period Accounts Receivable

(ACP) ACP =
Annual Sales/360
Accounts Payable
Average Payment Period APP=
(APP) Annual Purchases/360
Sales
FAT =
Fixed Asset Turnover (FAT) Net Fixed Assets
Sales
TAT =
Total Asset Turnover (TAT) Total Assets
35
Four Important Debt Measures
Total Liabilities
Debt Ratio DR=
Total Assets
(DR)
Long-Term Debt
Debt-Equity Ratio DER=
(DER)
Earnings Before Interest
& Taxes (EBIT)
Times Interest Earned TIE=
Interest
Ratio (TIE)
Earnings Before Interest &
Taxes + Lease Payments
Fixed Payment Coverage FPC= Interest + Lease Payments
Ratio (FPC) +{(Principal Payments +
Preferred Stock Dividends)
X [1 / (1 -T)]} 36
Rules for Memorizing Ratios
• There can be an infinite number of
financial ratios, but knowing a few basic
rules will help you to memorize the
formulas: The basic rule is that the name
tells you how to calculate the ratio.
• Any ‘margin’ ratio is something divided by
sales
• Any ‘turnover’ ratio is sales (or a variation of
sales) divided by something
• Any ‘return on’ ratio is net income (or a
variation of net income) divided by something 37
Using Financial Ratios
• Calculating ratios is pointless unless you
know how to use them
• The most basic rule is: a single ratio
provides very little information and may be
misleading
• With that in mind, there are at least 4 uses of
ratios:
• Trend analysis (internal and external)
• Comparison to industry averages (internal and
external)
• Setting and evaluating company goals (internal)
38
• Restrictive debt covenants (external)
P-1 Griffey Junior Wear, Inc., has $800,000 in
assets and $200,000 of debt. It reports net
income of $100,000.
• a. What is the return on assets?
Net income
Return on Assets (Investment) =
Total assets
$100,000
= 12.5%
$800,000
P-1 Griffey Junior Wear, Inc., has $800,000 in assets and
$200,000 of debt. It reports net income of $100,000.
• b. What is the return on stockholders' equity?

Net income
Return on equity =
Stockholders' equity = total assets − total debt

= $800,000 − $200,000 = $600,000
Net income $100,000

= = 16.67%
Stockholder' s equity $600,000
P-2 Sharpe Razor Company has total assets of $2,500,000 and
current assets of $1,000,000. It turns over its fixed assets 5
times a year. It has $700,000 of debt. Its return on sales is 3
percent. What is its return on stockholders' equity?
Part A: Determine the Sales & Stockholder’s Equity
Total Assets $2,500,000
– Current Assets 1,000,000
Fixed Assets $1,500,000
Sales = Fixed Assets x Fixed Asset Turnover =
$1,500,000 x 5 = $7,500,000
Total assets $ 2,500,000
- Debt - 700,000
Stockholders' Equity $1,800,000
P-2 Sharpe Razor Company has total assets of $2,500,000 and
current assets of $1,000,000. It turns over its fixed assets 5
times a year. It has $700,000 of debt. Its return on sales is 3
percent. What is its return on stockholders' equity?
Part B: Determine the Return on Stockholder Equity
Net income = Sales x Profit margin =
$7,500,000 x 3% = $225,000
Net income
Return on stockholders' equity =
$225,000
= = 12.5%
$1,800,000
P-3 Martin Electronics has an accounts receivable turnover
equal to 15 times. If accounts receivable are equal to $80,000,
what is the value for average daily credit sales?
• Average daily credit sales

• To determine credit sales, multiply accounts
receivable by accounts receivable turnover.
• $80,000 x 15 = $1,200,000
• Average daily credit sales
$1,200,000
= = $3,333
360
P-4) As of Jan ‘05, Status Quo total assets were $500k, of which
$300k consisted of depreciable fixed assets. Status Quo uses St.-line
depreciation, over a period of 10 years. After-tax income has been
$26k/year each of the last 10 years. Other assets have not changed.
A) Compute return on assets at year-end for ‘05, ‘07, ‘10,

‘12 & ‘14. (Use $26k in the numerator for each year.)
Fixed Assets Book values at year-end are as follows:
• 2005 = $270,000;
• 2007 = $210,000;
• 2010 = $120,000;
• 2012 = $60,000;
• 2014 = -0-
P-4 As of Jan ‘05, Status Quo total assets were $500k, of which
A> Return on Assets (Investment)

Income after taxes
=
Current assets + Fixed assets
P-4 As of Jan ‘05, Status Quo total assets were $500k, of which
A> Return on Assets (Investment)

Income after taxes
=
Current assets + Fixed assets
• 2005 = $26,000/$470,000 = 5.53%

• 2007 = $26,000/$410,000 = 6.34%
• 2010 = $26,000/$320,000 = 8.13%
• 2012 = $26,000/$260,000 = 10.00%
• 2014 = $26,000/200,000 = 13.00%
P-4>To what do you attribute the phenomenon shown in part a?
• The increasing return on assets over time is due

solely to the fact that annual depreciation charges
reduce the amount of investment. The increasing
return is in no way due to operations.
• Financial analysts should be aware of the effect of

overall asset age on the return-on-investment ratio
and be able to search elsewhere for indications of
operating efficiency when ROI is very high or very
low.
P-4 C>Now assume income increased by 10 percent
each year. What effect would this have on your above
answers?
As income rises, return on assets will be higher

than in part (b) and would indicate an
increase in return partially from more
profitable operations.
Ratios
If a firm finances with only debt and common
equity, and if its equity multiplier is 3.0, then its
debt ratio must be _____?
Equity multiplier = Assets/Equity = 3.0,

So Equity/Assets = 1/3 = 0.333.
By definition, Equity/Assets + Debt/Assets = 1.00,
So 0.333 + Debt/Assets = 1.0.
Therefore, Debt/Assets = 1.0 - 0.333 = 0.667.
7-49
Ratios
The key here is to recognize that if the CR is greater than 1.0,

then a given increase in both current assets and current
liabilities would lead to a decrease in the CR. The reverse
would hold if the initial CR were less than 1.0. Here the
initial CR is greater than 1.0, so borrowing on a short-term
basis to build the cash account would lower the CR.
7-50
Ratios
Original New Old New
CA/CL Plus $1 CA/CL CR CR
3/2 1/1 4/3 1.50 1.33 CR falls if initial CR is greater
than 1.0
2/3 1/1 3/4 0.67 0.75 CR rises if initial CR is less than
1.0
7-51
Ratios
Bostian, Inc. has total assets of $625,000. Its total debt
outstanding is $185,000. The Board of Directors has directed the
CFO to move towards a debt-to-assets ratio of 55%.
How much debt must the company add or subtract to achieve the
target debt ratio?
Total assets $625,000
Present debt $185,000
Target debt ratio 55%
Target amount of debt $343,750
Change in amount of debt $158,750
outstanding
7-52
Ratios
Last year Central Chemicals had sales of $205,000, assets of $127,500, a profit margin of
5.3%, and an equity multiplier of 1.2. The CFO believes that the company could reduce its
assets by $21,000 without affecting either sales or costs. Had it reduced its assets in this
amount, and had the debt-to-assets ratio, sales, and costs remained constant, by how much
would the ROE have changed?
Old New
Sales $205,000 $205,000
Original assets $127,500
Reduction in assets $ 21,000
New assets $106,500
TATO 1.61 1.92
Profit margin 5.30% 5.30%
Equity multiplier 1.20 1.20
ROE 10.23% 12.24%
Change in ROE 2.02%
7-53
Ratios
Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and
its year-end assets were $210,000. The firm's total-debt-to-total-assets ratio was
42.5%. Based on the DuPont equation, what was Vaughn's ROE
Sales $315,000
Assets $210,000
Net income $17,832
Debt ratio 42.5%
Debt $89,250
Equity $120,750
Profit margin 5.66%
TATO 1.50
Equity multiplier 1.74
ROE 14.77%
7-54
Challenge Problem
Mario & Mark, Inc. has projected its requirement for funds next
year to be $15,000. The pro forma balance sheet summaries
are as follows:
Current Assets $30,000 Current Liabilities $12,000
Fixed Assets 60,000 Long-Term Debt 20,000
______ Common Equity 43,000
$90,000 $75,000
Management would like to finance the $15,000 shortfall

($90,000 - $75,000) primarily with short- term borrowing, but
will borrow long-term and sell common stock if necessary.
A restriction in the indenture in their last bond issue limits M &
M's ability to borrow. The indenture requires a minimum
current ratio of 2.25 and a maximum debt ratio of .40. Given
these restrictions, create a financing plan for Mario & Mark,
Inc.
SOLUTION **
1. Current ratio minimum is 2.25, so determine the maximum short-
term borrowing possible.
$30,000 ; x = $13,333
2.25 =
x
$13,333 - $12,000 = $1,333 short-term borrowing capacity remaining
2. Debt ratio maximum is .40, so, determine the maximum total
borrowing
.40 = x ; x = $36,000
$90,000
$36,000 - ($20,000 + $13,333) = $2,667 long-term borrowing capacity
Determine equity financing needed
$15,000 - ($1,333 + $2,667) = $11,000
Financing Plan: Short-Term Borrowing $ 1,333

Long-Term Borrowing $ 2,667
Common Stock $11,000
Total $15,000
INTRO COST OF MONEY
Chapter 6
DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
Interest Rates
Cost of Money and Interest Rate Levels
Determinants of Interest Rates
The Term Structure and Yield Curves
Using Yield Curves to Estimate Future Interest Rates
6-57
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.
INTRO COST OF MONEY DETERMINANTS TERM STRUCTURE EST. FUTURE RATES
What four factors affect the level of interest

rates?
• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
6-58
“Nominal” vs. “Real” Rates
r = represents any nominal rate

r* = represents the “real” risk-free rate of
interest. Like a T-bill rate, if there was no
inflation. Typically ranges from 1% to 4%
per year.
rRF = represents the rate of interest on Treasury
securities.
6-59
Determinants of Interest Rates
r = r* + IP + DRP + LP + MRP
r = required return on a debt security

r* = real risk-free rate of interest
IP = inflation premium
DRP = default risk premium
LP = liquidity premium
MRP = maturity risk premium
6-60
Figure 6.3 – Relationship between Annual Inflation Rates
and Long-Term Interest Rates, 1972-2015
6-61
Premiums Added to r* for Different Types of Debt
IP MRP DRP LP
S-T Treasury 
L-T Treasury  
S-T Corporate   
L-T Corporate    
6-62
Yield Curve and the Term Structure of Interest

Rates
Yield Curve for March 2015
• Term structure:
relationship between
interest rates (or yields)
and maturities.
• The yield curve is a
graph of the term
structure.
• The March 2015
Treasury yield curve is
shown at the right.
6-63
Constructing the Yield Curve: Inflation
• Step 1: Find the average expected inflation

rate over Years 1 to N:
N
∑ INFL t
IPN = t =1
N
6-64
Constructing the Yield Curve: Inflation
Assume inflation is expected to be 5% next year,

6% the following year, and 8% thereafter.
IP1 = 5% / 1 = 5.00%
IP10 = [5% + 6% + 8%(8)] / 10 = 7.50%
IP20 = [5% + 6% + 8%(18)] / 20 = 7.75%
Must earn these IPs to break even vs. inflation;

these IPs would permit you to earn r* (before
taxes).
6-65
Constructing the Yield Curve:

Maturity Risk
• Step 2: Find the appropriate maturity risk

premium (MRP). For this example, the
following equation will be used to find a
security’s appropriate maturity risk premium.
MRPt = 0.1% (t – 1)
6-66
Constructing the Yield Curve:

Maturity Risk
Using the given equation:
MRP1 = 0.1% × (1 − 1) = 0.0%

MRP10 = 0.1% × (10 − 1) = 0.9%
MRP20 = 0.1% × (20 − 1) = 1.9%
Notice that since the equation is linear, the

maturity risk premium is increasing as the time to
maturity increases, as it should be.
6-67
Add the IPs and MRPs to r* to Find the

Appropriate Nominal Rates
Step 3: Adding the premiums to r*.

rRF, t = r* + IPt + MRPt
Assume r* = 3%,
rRF,1 = 3% + 5% + 0.0% = 8.0%

rRF,10 = 3% + 7.5% + 0.9% = 11.4%
rRF,20 = 3% + 7.75% + 1.9% = 12.65%
6-68
Hypothetical Yield Curve
Interest
Rate (%)
• An upward-sloping
15
yield curve.
Maturity risk premium
• Upward slope due to
an increase in
10 Inflation premium expected inflation and
increasing maturity
risk premium.
5
Real risk-free rate

Years to
0 Maturity
1 10 20
6-69
Figure 6.2 – Long- and Short-Term Interest Rates,
1972-2015
6-70
Figure 6.4 – U.S. Treasury Bond Interest Rates on
Different Dates
6-71
Figure 6.5 – Illustrative Treasury Yield Curves
6-72
Relationship Between Treasury Yield Curve and

Yield Curves for Corporate Issues
• Corporate yield curves are higher than that of

Treasury securities, though not necessarily
parallel to the Treasury curve.
• The spread between corporate and Treasury
yield curves widens as the corporate bond
rating decreases.
• Since corporate yields include a default risk
premium (DRP) and a liquidity premium (LP),
the corporate bond yield spread can be
calculated as:
Corporate bond
= Corporate bond yield − Treasury bond yield
yield spread
= DRP + LP
6-73
Illustrating the Relationship Between Corporate

and Treasury Yield Curves
6-74
Pure Expectations Theory
• The pure expectations theory contends that the

shape of the yield curve depends on investors’
expectations about future interest rates.
• If interest rates are expected to increase, L-T
rates will be higher than S-T rates, and vice-
versa. Thus, the yield curve can slope up,
down, or even bow.
6-75
Assumptions of Pure Expectations
• Assumes that the maturity risk premium for

Treasury securities is zero.
• Long-term rates are an average of current and
future short-term rates.
• If the pure expectations theory is correct, you
can use the yield curve to “back out” expected
future interest rates.
6-76
An Example: Observed Treasury Rates and

Pure Expectations
Maturity Yield
1 year 6.0%
2 years 6.2
3 years 6.4
4 years 6.5
5 years 6.5
If the pure expectations theory holds, what does

the market expect will be the interest rate on one-
year securities, one year from now? Three-year
securities, two years from now?
6-77
One-Year Forward Rate

6.0 x%
%
0 1 2
6.2
%
(1.062)2 = (1.060) (1 + X)
1.12784/1.060 = (1 + X)
6.4004% = X
• The pure expectations theory says that one-year
securities will yield 6.4004%, one year from now.
• Notice, if an arithmetic average is used, the answer
is still very close. Solve: 6.2% = (6.0% + X)/2, and
the result will be 6.4%.
6-78
Three-Year Security, Two Years from Now

6.2 x%
%
0 1 2 3 4
5
6.5
%
(1.065)5 = (1.062)2 (1 + X)3
1.37009/1.12784 = (1 + X)3
6.7005% = X
• The pure expectations theory says that three-
year securities will yield 6.7005%, two years from
now.
6-79
Conclusions About Pure Expectations
• Some would argue that the MRP ≠ 0, and

hence the pure expectations theory is
incorrect.
• Most evidence supports the general view that
lenders prefer S-T securities, and view L-T
securities as riskier.
– Thus, investors demand a premium to persuade
them to hold L-T securities (i.e., MRP > 0).
6-80
Macroeconomic Factors That Influence

Interest Rate Levels
• Federal reserve policy

• Federal budget deficits or surpluses
• International factors
• Level of business activity
6-81

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Financial Ratio Analysis

The excess of current assets over

Working capital is not

Current Current Assets

The current ratio measures a

A declining ratio may be a

Current Current Assets

• The quick or acid-test ratio is a measure of liquidity

Acid-Test Quick Assets

Quick assets include Cash,

This ratio indicates the relative proportions

Stockholders like a lot of Creditors prefer less debt

• What percentage of the firm’s assets are

Long - term debt

Fixed charge coverage =

• These ratios indicate what investors think

 Ultimately P/E ratio is set by investors

(1) Today’s price

• Hi P/E ratios Indicates positive expectations

• Lo P/E ratios Indicates negative expectations

• Investors’ expectation of EPS

A higher price-earnings ratio means that

Net Income – Preferred Dividends

Whenever a ratio divides an income statement

Earnings form the basis for dividend payments

Earnings per Share = $53,690 – $0 = $2.42

This measure indicates how much

Dividend Dividends Per Share

This ratio gauges the portion of current

Dividend Dividends Per Share

This ratio identifies the return, in terms

• DuPont System of Analysis

• The firm's return is broken into three

Shows the relationship between

If ROE is unsatisfactory, the Du Pont

Net Profit $ 1,020

ROE= Net Profit Margin X Total Assets Turnover X Financial Leverage

= Net Profit Sales Total Assets

Which ratio is most important?

Net Profit After Taxes

Average Collection Period Accounts Receivable

• b. What is the return on stockholders' equity?

Stockholders' equity = total assets − total debt

Net income $100,000

• Average daily credit sales

A) Compute return on assets at year-end for ‘05, ‘07, ‘10,

A> Return on Assets (Investment)

A> Return on Assets (Investment)

• 2005 = $26,000/$470,000 = 5.53%

• The increasing return on assets over time is due

• Financial analysts should be aware of the effect of

As income rises, return on assets will be higher

Equity multiplier = Assets/Equity = 3.0,

The key here is to recognize that if the CR is greater than 1.0,

Management would like to finance the $15,000 shortfall

Financing Plan: Short-Term Borrowing $ 1,333

Cost of Money and Interest Rate Levels

Determinants of Interest Rates

The Term Structure and Yield Curves

Using Yield Curves to Estimate Future Interest Rates

What four factors affect the level of interest

r = represents any nominal rate