1. Liquidity and Efficiency
Ratio Analysis P3
Liquidity and Efficiency
Solvency
Profitability
Market Prospects
On the next three slides we will present financial information from Norton Corporation’s 2012 and 2013 financial statements. We will use this information to prepare a ratio analysis for the company. You may want to print these three screens so you can refer to them as we compute the ratios.
Let’s use the following financial statements for Norton Corporation for our ratio analysis.
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2. Liquidity Ratios
PowerPoint Slides 61

3. Solvency Ratios
PowerPoint Slides 61

4. Profitability Ratios
PowerPoint Slides 61

5. Ratio Analysis Liquidity and EfficiencyP3
Current
Ratio
Inventory Turnover
Acid-Test
Ratio
Days’ Sales Uncollected
Accounts Receivable Turnover
Now that we have the basic information we need, let’s calculate some of the company’s important ratios. On the next slide, we provide supplemental information that we will need.
Days’ Sales in Inventory
Total Asset Turnover
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6. Ratio Analysis Liquidity and EfficiencyP3
Use this information to calculate the liquidity and efficiency ratios for Norton Corporation.
We will turn our attention to ratios that provide measures of the liquidity and efficiency for Norton Corporation. Some additional information is provided to help us complete this analysis.
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7. This ratio measures the short-term debt-paying ability of the company.
Current Ratio P3
Current
ratio
Current assets
Current liabilities =
Current
ratio
$65,000 $42,000 =
1.55 : 1
Perhaps the most significant measure of a company’s ability to pay current obligations is the current ratio. It is merely current assets divided by current liabilities.
At Norton, the current ratio is 1.55 to 1.
As a short-term creditor, you would be vitally interested in a company’s current ratio. If the ratio continues to decrease over time, you may be less likely to be paid in full.
This ratio measures the short-term debt-paying ability of the company.
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8. Quick assets Current liabilities
Acid-Test Ratio P3
Quick assets Current liabilities =
Acid-test
ratio
Quick assets are Cash, Short-Term Investments, and Current Receivables.
$50,000
$42,000 =
1.19 : 1
Acid-test
ratio
The acid-test ratio is a more stringent measure than the current ratio. We calculate the ratio by dividing quick assets by current liabilities. Quick assets include cash, short-term investments, and current receivables. You can see that Norton’s only quick assets are cash and accounts receivable.
The acid-test ratio at Norton is 1.19 to 1. The acid-test ratio is generally lower than the current ratio because we have reduced the numerator. We have removed accounts from the numerator that generally require a period of time to convert into cash. For example, for some companies inventories may take a significant amount of time to be converted into cash.
This ratio is like the current
ratio but excludes current assets such as inventories and prepaid expenses that may take time to covert into cash or may expire over time and not be converted into cash at all.
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9. Accounts Receivable TurnoverP3
Net sales
Average accounts receivable/net
Accounts receivable
turnover =
= times
$494,000
($17,000 + $20,000) ÷ 2
Accounts receivable
turnover =
We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is yet another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator.
At Norton, accounts receivable turnover is 26.7 times. This means that, on average, accounts receivable turns over completely about 27 times per year.
This ratio helps us get a feel for the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable.
This ratio measures how many times a company converts its receivables into cash each year.
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10. Inventory Turnover Cost of goods sold Average inventory InventoryP3
Cost of goods sold
Average inventory
Inventory
turnover =
= times
$140,000
($10,000 + $12,000) ÷ 2 =
Inventory
turnover
Like receivables turnover, we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory.
At Norton, inventory turnover is times. So, inventory is turned over about 13 times per year.
The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items.
This ratio measures the number
of times merchandise is sold and
and replaced during the year.
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11. Total Asset Turnover Total asset turnover = Net sales
P 3
Total asset turnover =
Net sales
Average total assets
= 1.53 times
$494,000
($300,000 + $346,390) ÷ 2 =
Total asset
turnover
Total asset turnover is equal to net sales divided by average total assets. At Norton, asset turnover was 1.53 times. Asset turnover is a measure of how efficiently management is using the available assets to generate sales.
This ratio measures the efficiency of assets in producing sales.
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12. Ratio Analysis Solvency Ratios
P 3
Debt
Ratio
Equity
Ratio
Debt-to-Equity Ratio
Let’s focus now on solvency ratios.
Times Interest Earned
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13. Solvency
P 3
Use this information to calculate the solvency ratios for Norton Corporation.
This screen contains some new supplemental information that will help us calculate the ratios that follow. One quick note; income before interest and taxes is often referred to as net operating income.
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14. Debt Ratio Total liabilities = Debt ratio Total assets $112,000P3
Total liabilities =
Total assets
Debt ratio
$112,000 =
$346,390
Debt ratio
= 32.3%
The debt ratio is determined by dividing total liabilities of the company by total assets.
At Norton, the debt ratio is 32.3%. This means that just over $0.30 of every $1 of assets was provided by creditors of the company.
This ratio measures what portion of a company’s assets are contributed by creditors.
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15. Equity Ratio Total equity Equity ratio = Total assets $234,390P3
Total equity =
Total assets
Equity ratio
$234,390 =
$346,390
Equity ratio
= 67.7%
The equity ratio is determined by dividing total equities of the company by total assets.
At Norton, the equity ratio is 67.7%. This means that about $0.68 of every $1 of assets was contributed by owners of Norton.
This ratio measures what portion of a company’s assets are contributed by owners.
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16. Debt-to-Equity Ratio Debt-to-equity ratio Total liabilities =P3
Debt-to-equity ratio
Total liabilities =
Total equity
$112,000 $346,390 =
Debt-to-equity ratio
The debt-to-equity ratio is designed to measure the solvency of a company. A calculation above 1 or 100% indicates the company has more liabilities than equity. The lower the calculation, the more solvency the company has.
= 32%
This ratio measures the solvency of companies.
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17. Income before interest expense
Times Interest Earned P3
Times interest earned
Income before interest expense
and income taxes
Interest expense =
Times interest earned
$84,000
$7,300 = =
Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that would be important to you. The ratio is calculated by dividing income before interest and taxes by interest expense for the period.
At Norton, interest was earned 11.5 times during the year.
This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.
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18. Ratio Analysis Profitability
Margin
Basic Earnings per Share
Gross Margin
Book Value per Common Share
The next category of ratios deals with profitability measures.
Return on Total Assets
Return on Common Stockholders’ Equity
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19. Profitability P3
Use this information to calculate the profitability ratios for Norton Corporation.
Here is some supplemental information about Norton that we will need to calculate our profitability ratios.
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20. Profit Margin Profit margin Net income Net sales = = 10.87% Profit
$53,690
$494,000 =
Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined by dividing net income by net sales.
At Norton, after all expenses and taxes have been paid, the company was able to produce a profit margin of 10.87%.
This ratio describes a company’s ability to earn a net income from sales.
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21. Net sales - Cost of sales
Gross Margin P3
Gross
margin
Net sales - Cost of sales
Net sales =
= 71.66%
Gross
margin
$494,000 - $140,000
$494,000 =
Our gross margin percentage is an extremely important measure in business. The percentage indicates how much of each sales dollar is left to cover operating expenses, taxes, and profit.
Gross margin is equal to net sales less cost of goods sold divided by net sales for the period.
At Norton, the gross margin is 71.66%. This is a relatively high margin and indicates that, with effective cost control, the company will be able to produce net income.
This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales.
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22. Return on Total Assets Return on total assets Net incomeP3
Return on
total assets
Net income
Average total assets =
= 16.61%
$53,690
($300,000 + $346,390) ÷ 2 =
Return on total assets
We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period.
Norton is able to earn a return on its total assets of 16.61%. Please spend a few minutes going over the calculation of this ratio. Return on total assets measures how well assets have been employed by the management of Norton.
This ratio is generally considered
the best overall measure of a
company’s profitability.
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23. Return on Common Stockholders’ EquityP3
Return on common
stockholders’ equity
Net income - Preferred dividends Average common stockholders’ equity =
= 25.9%
$53,690 - $0
($180,000 + $234,390) ÷ 2 =
Return on common stockholders’ equity
We may calculate the return on common stockholders’ equity. The numerator is net income available to common shareholders, that is net income less preferred dividends, divided by average common stockholders’ equity.
The return on common stockholders’ equity at Norton is 25.9%. The return on equity is higher than the return on total assets.
This measure indicates how well the company employed the owners’ investments to earn income.
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24. Book Value per Common Share
Shareholders’ equity applicable to common shares
Number of common shares outstanding =
Book value per share is calculated by dividing common stockholders’ equity by the number of common shares outstanding. Remember, we are including only common stockholders’ equity in the numerator. If your company has preferred shares outstanding, the total dollar amount will be removed to determine the stockholders’ equity relating to the common shareholders.
This ratio measures liquidation at reported amounts.
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25. Basic Earnings per Share
Net income - Preferred dividends
Weighted-average common shares outstanding =
Basic earnings
per
share
$53,690 - $0
27,400 =
= $1.96 per share
Earnings per share is equal to net income less preferred stock dividends divided by the weighted-average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders.
Earnings per share is $1.96 per common share. Notice that we had no preferred dividends to impact our numerator.
Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. As an investor, we will want to track this ratio carefully.
This measure indicates how much
income was earned for each share of common stock outstanding.
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26. Market Prospects P3
Use this information to calculate the market ratios for Norton Corporation.
As a shareholder, we often need information about the market prospects of our investment. Good ratios to look at for this purpose are the price-earnings ratio and the dividend yield.
Here is some supplemental information we will need to calculate the market prospect ratios. The supplemental information includes information about the closing market price of the common stock and the annual cash dividend.
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27. Price-Earnings Ratio Market price per common share =
Earnings per share =
Price-earnings
ratio
$15.00
$1.96 =
= 7.65 times
Once we know the earnings per share, we can calculate the price-earnings ratio, or PE ratio. We will divide the closing market price of the Norton’s common stock by earnings per share.
For Norton, the PE ratio is 7.65 times. This means that the stock is selling for 7.65 times its current earnings per share.
This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.
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28. Annual cash dividends per share
Dividend Yield P3
Dividend
yield
Annual cash dividends per share
Market price per share =
$2.00
$15.00
= 13.3%
If you are an investor who requires current income; you will want to look for companies with high dividend payout ratios. If you believe that a company can invest its funds and earn a higher return than you would be able to earn, you might look for a company with high growth and a low payout ratio.
To determine the dividend yield ratio, we divide the annual cash dividend per share by the closing market price per share of the company’s common stock.
At Norton, the dividend yield is 13.3%. This means that if we purchase the stock today for $15 per share and receive an annual dividend of $2, we will earn a return of 13.3% on our investment.
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
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