Financial Ratio

Topics: Generally Accepted Accounting Principles, Financial ratios, Financial ratio Pages: 8 (1799 words) Published: December 7, 2012
Tests of Profitability
Profitability is a primary measure of the overall success of a company and is necessary for a company’s survival. Several test of profitability focus on measuring the adequacy of income by comparing it to other items reported on the financial statements.

1) Return on Equity:

One of the most important profitability ratios is return on equity (ROE). ROE is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. The return on equity ratio is computed as follows:

Return on Equity =| Net Income|
| Average Shareholder's Equity|

Simply, ROE indicates know how well management is employing the shareholders’ capital invested in the company. A business that has a high return on equity is more likely to be capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better.

2) Return on Assets:
Return on Assets is an indicator of how profitable a company is relative to its total assets. ROA shows how efficient management is at using its assets to generate earnings.

Return on Assets =| Net Income + Interest Expense|
| Average Total Assets|

ROA gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment.

3) Financial Leverage Percentage:

Financial Leverage Percentage is obtained by subtracting the return on assets from the return on equity. The ratio represents the advantage or disadvantage that occurs when a company’s ROE differs from its ROA. Ratios will vary greatly between companies, but in general, a company wants to have positive leverage, regardless of the how high or low the ratio. Financial Leverage Percentage = Return on Equity - Return on Assets

4) Earnings per Share (EPS):

Earnings per Share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. EPS serves as an indicator of a company's profitability.

Earnings Per Share (EPS) =| Net Income|
| Average Number of Shares of Common Stock Outstanding|

5) Quality of Income:

This ratio indicates the proportion of income that has been realized in cash. High levels for this ratio are desirable.

Quality of Income =| Cash Flows from Operating Activities| | Net Income|

A higher quality of income ratio indicates greater ability to finance operations and other cash needs from operating cash inflows. A higher ratio also indicates that it is less likely that the company is using aggressive revenue recognition policies to increase net income.

6) Profit Margin:

Net profit margin measures how much profit a company makes for every one dollar it creates in revenue. Net profit margin can be calculated by dividing net income after taxes by revenue.

Profit Margin =| Net Income|
| Net Sales Revenue|

Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.

7) Fixed Assets Turnover Ratio

The fixed-asset turnover ratio measures a company's ability to generate net sales from fixed-asset investments - specifically property, plant and equipment (PP&E) - net of depreciation.

Fixed Assets Turnover Ratio =| Net Sales Revenue|
| Average Net Fixed Assets|

A higher fixed-asset turnover ratio shows that the company has been more effective in using investments in fixed assets to generate revenues.

Tests of Liquidity

Liquidity is a company’s ability to meet its current maturing debts. Tests of liquidity measure a company’s ability to pay its current liabilities with current assets. Tests of liquidity...
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