Cash Conversion CycleCash conversion cycle is an efficiency ratio which measures the number of days for which a companys cash is tied up in inventories and accounts receivable. It is aimed at assessing how effectively a company is managing its working capital.A typical business purchases raw materials (mostly on credit), converts them to finished products, sell those products (mostly on credit), recovers cash from customers and reuses the cash to purchase raw materials for further production and so on.We defined cash conversion cycle as the time for which cash is tied up in working capital (i.e. inventories and receivables). The days for which cash is tied up in receivables is measured bydays sales outstanding (DSO)and the number of days it takes to sell inventories is measured bydays inventories outstanding (DIO). The sum of these two ratios is the companys operating cycle. However, since raw materials consumed in production of inventories is purchased on credit, and hence paid after the relevant raw materials have been used in production, the actual days for which cash is tied up in inventories equals days it takes to sell inventories minus days for which the amount payable against those raw materials remained outstanding, i.e.days payable outstanding (DPO).The following timeline shows the relationship between operating cycle, cash conversion cycle, DSO, DIO and DPO:

FormulaCash Conversion Cycle = DSO + DIO DPOWhere,DSO isdays sales outstanding= Average Accounts Receivable 365 Credit SalesDIO isdays inventory outstanding= Average Inventories 365 Cost of Goods SoldDPO isdays payables outstanding= Average Accounts Payable 365 Cost of Goods SoldAlternatively, it can also be calculated using the following formula if we know the operating cycle:Cash conversion cycle =operating cycleDPOThe figures for credit sales, cost of goods sold, average accounts receivable, average inventories and average accounts payable can be obtained from the companys financial statements.AnalysisCash conversion cycle is an important ratio, particularly for companies that carry significant inventories and have large receivables, because it highlights how effectively the company is managing its working capital.Cash conversion is most useful in conducting trend analysis for companies in the same industry. Generally, short cash conversion cycle is better because it tells that the companys management is selling inventories and recovering cash from those sales as quickly as possible while at the same time paying the suppliers as late as possible.ExampleCalculate and analyze the cash conversion cycle for Hewlett-Packard (NYSE: HPQ) and Apple, Inc. (NYSE: AAPL) based on the information given below (as obtained from Morningstar):201220132014

HPQ

Days Sales Outstanding52.5152.4648.65

Days Inventory27.2726.1226.81

Days Payables Outstanding55.5157.8264.37

AAPL

Days Sales Outstanding19.0125.6630.51

Days Inventory3.264.376.3

Days Payables Outstanding74.3974.5485.45

SolutionCash conversion cycle for HPQ for 2012 = 52.51 + 27.27 55.51 = 24.27The following table shows cash conversion cycle for both companies for the three years.201220132014

HPQ24.2720.7611.09

AAPL-52.12-44.51-48.64

AAPL has negative cash conversion cycle of 44 to 52 days during the three-year period which suggests an exceptionally good working capital management. It means that AAPL could sell and receive cash from its sales even 44 to 52 days before it actually made payments against its production inputs, which is impressive.HPQ on the other hand drastically improved its cash conversion over the three years i.e. from 24.27 in 2012 to 11.09 in 2014, which suggests significant improvement in efficiency of the company. Still HPQs working capital management is not as good as AAPL. AAPL has been able to leverage its very strong market position to receive generous credit terms from suppliers.Cash Conversion CycleThe cash conversion cycle is a cash flow calculation that attempts to measure the time it takes a company to convert its investment in inventory and other resource inputs into cash. In other words, the cash conversion cycle calculation measures how long cash is tied up in inventory before the inventory is sold and cash is collected from customers.The cash cycle has three distinct parts. The first part of the cycle represents the current inventory level and how long it will take the company to sell this inventory. This stage is calculated by using the days inventory outstanding calculation.The second stage of the cash cycle represents the current sales and the amount of time it takes to collect the cash from these sales. This is calculated by using the days sales outstanding calculation.The third stage represents the current outstanding payables. In other words, this represents how much a company owes its current vendors for inventory and goods purchases and when the company will have to pay off its vendors. This is calculated by using the days payables outstanding calculation.FormulaThe cash conversion cycle is calculated by adding the days inventory outstanding to the days sales outstanding and subtracting the days payable outstanding.

All three of these smaller calculations will have to be made before the CCC can be calculated.

AnalysisThe cash conversion cycle measures how many days it takes a company to receive cash from a customer from its initial cash outlay for inventory. For example, a typical retailer buys inventory on credit from its vendors. When the inventory is purchased, a payable is established, but cash isn't actually paid for some time.The payable is paid within 30 days and the inventory is marketed to customers and eventually sold to a customer on account. The customer then pays for the inventory within 30 days of purchasing it.The cash cycle measures the amount of days between paying the vendor for the inventory and when the retailer actually receives thecashfrom the customer.As with most cash flow calculations, smaller or shorter calculations are almost always good. A small conversion cycle means that a company's money is tied up in inventory for less time. In other words, a company with a small conversion cycle can buy inventory, sell it, and receive cash from customers in less time.In this way, the cash conversion cycle can be viewed as a sales efficiency calculation. It shows how quickly and efficiently a company can buy, sell, and collect on its inventory.ExampleTim's Tackle is a retailer that sells outdoor and fishing equipment. Tim buys its inventory from one main vendor and pays its accounts within 10 days in order to get a purchase discount. Tim has a fairly highinventory turnover ratiofor his industry and can collect accounts receivable from his customer within 30 days on average.Tim's days calculations are as follows:DIO represents days inventory outstanding: 15 daysDSO represents days sales outstanding: 2 daysDPO represents days payable outstanding: 12 daysTim's conversion cycle is calculated like this:

As you can see, Tim's cash conversion cycle is 5 days. This means it takes Tim 5 days from paying for his inventory to receive the cash from its sale. Tim would have to compare his cycle to other companies in his industry over time to see if his cycle is reasonable or needs to be improved.Cash RatioThe cash ratio or cash coverage ratio is a liquidity ratio that measures a firm's ability to pay off its current liabilities with only cash and cash equivalents. The cash ratio is much more restrictive than thecurrent ratioorquick ratiobecause no other current assets can be used to pay off current debt--only cash.This is why many creditors look at the cash ratio. They want to see if a company maintains adequate cash balances to pay off all of their current debts as they come due. Creditors also like the fact that inventory and accounts receivable are left out of the equation because both of these accounts are not guaranteed to be available for debt servicing. Inventory could take months or years to sell and receivables could take weeks to collect. Cash is guaranteed to be available for creditors.FormulaThe cash coverage ratio is calculated by adding cash and cash equivalents and dividing by the total current liabilities of a company.

Most companies list cash and cash equivalents together on their balance sheet, but some companies list them separately. Cash equivalents are investments and other assets that can be converted into cash within 90 days. These assets are so close to cash thatGAAPconsiders them an equivalent.Current liabilities are always shown separately from long-term liabilities on the face of the balance sheet.AnalysisThe cash ratio shows how well a company can pay off its current liabilities with only cash and cash equivalents. This ratio shows cash and equivalents as a percentage of current liabilities.A ratio of 1 means that the company has the same amount ofcashand equivalents as it has current debt. In other words, in order to pay off its current debt, the company would have to use all of its cash and equivalents. A ratio above 1 means that all the current liabilities can be paid with cash and equivalents. A ratio below 1 means that the company needs more than just its cash reserves to pay off its current debt.As with most liquidity ratios, a higher cash coverage ratio means that the company is more liquid and can more easily fund its debt. Creditors are particularly interested in this ratio because they want to make sure their loans will be repaid. Any ratio above 1 is considered to be a good liquidity measure.ExampleSophie's Palace is a restaurant that is looking to remodel its dining room. Sophie is asking her bank for a loan of $100,000. Sophie's balance sheet lists these items:Cash: $10,000Cash Equivalents: $2,000Accounts Payable: $5,000Current Taxes Payable: $1,000Current Long-term Liabilities: $10,000Sophie's cash ratio is calculated like this:

As you can see, Sophie's ratio is .75. This means that Sophie only has enough cash and equivalents to pay off 75 percent of her current liabilities. This is a fairly high ratio which means Sophie maintains a relatively high cash balance during the year.Obviously, Sophie's bank would look at other ratios before accepting her loan application, but based on this coverage ratio, Sophie would most likely be accepted.Days Sales in InventoryThe days sales in inventory calculation, also called days inventory outstanding or simply days in inventory, measures the number of days it will take a company to sell all of its inventory. In other words, the days sales in inventory ratio shows how many days a company's current stock of inventory will last.This is an important to creditors and investors for three main reasons. It measures value, liquidity, and cash flows. Both investors and creditors want to know how valuable a company's inventory is. Older, more obsolete inventory is always worth less than current, fresh inventory. The days sales in inventory shows how fast the company is moving its inventory. In other words, it shows how fresh the inventory is.This calculation also shows the liquidity of inventory. Shorter days inventory outstanding means the company can convert its inventory into cash sooner. In other words, the inventory is extremely liquid.Along the same line, more liquid inventory means the company's cash flows will be better.FormulaThe days sales inventory is calculated by dividing the ending inventory by the cost of goods sold for the period and multiplying it by 365.

Ending inventory is found on the balance sheet and the cost of goods sold is listed on the income statement. Note that you can calculate the days in inventory for any period, just adjust the multiple.Since this inventory calculation is based on how many times a company can turn its inventory, you can also use the inventory turnover ratio in the calculation. Just divide 365 by the inventory turnover ratioDays inventory usually focuses on ending inventory whereas inventory turnover focuses on average inventory.AnalysisThe dayssalesin inventory is a key component in a company's inventory management. Inventory is a expensive for a company to keep, maintain, and store. Companies also have to be worried about protecting inventory from theft and obsolescence.Management wants to make sure its inventory moves as fast as possible to minimize these costs and to increase cash flows. Remember the longer the inventory sits on the shelves, the longer the company's cash can't be used for other operations.Management strives to only buy enough inventories to sell within the next 90 days. If inventory sits longer than that, it can start costing the company extra money.It only makes sense that lower days inventory outstanding is more favorable than higher ratios.ExampleKeith's Furniture Company's management have been extremely happy with their sales staff because they have been moving more inventory this year than in any previous year. At the end of the year, Keith's financial statements show an ending inventory of $50,000 and a cost of good sold of $150,000. Keith's days sales in inventory is calculated like this:

As you can see, Keith's ratio is 122 days. This means Keith has enough inventories to last the next 122 days or Keith will turn his inventory into cash in the next 122 days. Depending on Keith's industry, this length of time might be short or long.Days Sales OutstandingThe days sales outstanding calculation, also called the average collection period or days' sales in receivables, measures the number of days it takes a company to collect cash from its credit sales. This calculation shows the liquidity and efficiency of a company's collections department.In other words, it shows how well a company can collect cash from its customers. The sooner cash can be collected, the sooner this cash can be used for other operations. Both liquidity and cash flows increase with a lower days sales outstanding measurement.FormulaThe ratio is calculated by dividing the ending accounts receivable by the total credit sales for the period and multiplying it by the number of days in the period. Most often this ratio is calculated at year-end and multiplied by 365 days.

Accounts receivable can be found on the year-endbalance sheet. Credit sales, however, are rarely reported separate from gross sales on theincome statement. The credit sales figure will most often have to be provided by the company.This formula can also be calculated by using the accounts receivable turnover ratioAnalysisThe days sales outstanding formula shows investors and creditors how well companies' can collect cash from their customers. Obviously,salesdon't matter if cash is never collected. This ratio measures the number of days it takes a company to convert its sales into cash.A lower ratio is more favorable because it means companies collect cash earlier from customers and can use this cash for other operations. It also shows that the accounts receivables are good and won't be written off asbad debts.A higher ratio indicates a company with poor collection procedures and customers who are unable or unwilling to pay for their purchases. Companies with high days sales ratios are unable to convert sales into cash as quickly as firms with lower ratios.ExampleDevin's Long Boards is a retailer that offers credit to customers. Devin often selling inventory to customers on account with the agreement that these customers will pay for the merchandise within 30 days. Some customers promptly pay for their goods, while others are delinquent. Devin's year-end financial statements list the following accounts:Accounts Receivable: $15,000Net Credit Sales: $175,000Devin's days sales is calculated like this:

As you can see, it takes Devin approximately 31 days to collect cash from his customers on average. This is a good ratio since Devin is aiming for a 30 day collection period.Debt RatioDebt ratio is asolvency ratiothat measures a firm's total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company's ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.This ratio measures thefinancial leverageof a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders.This helps investors and creditors analysis the overall debt burden on the company as well as the firm's ability to pay off the debt in future, uncertain economic times.FormulaThe debt ratio is calculated by dividing total liabilities by total assets. Both of these numbers can easily be found thebalance sheet. Here is the calculation:

Make sure you use the total liabilities and the total assets in your calculation. The debt ratio shows the overall debt burden of the companynot just the current debt.AnalysisThe debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets. As with many solvency ratios, a lower ratios is more favorable than a higher ratio.A lower debt ratio usually implies a more stable business with the potential of longevity because a company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but .5 is reasonable ratio.A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities. Or said a different way, this company's liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company's assets and the shareholders own the remainder of the assets.A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm. Once its assets are sold off, the business no longer can operate.The debt ratio is a fundamental solvency ratio because creditors are always concerned about being repaid. When companies borrow more money, their ratio increases creditors will no longer loan them money. Companies with higher debt ratios are better off looking to equity financing to grow their operations.ExampleDave's Guitar Shop is thinking about building an addition onto the back of its existing building for more storage. Dave consults with his banker about applying for a new loan. The bank asks for Dave's balance to examine his overalldebtlevels.The banker discovers that Dave has total assets of $100,000 and total liabilities of $25,000. Dave's debt ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as many assets as he has liabilities. This is a relatively low ratio and implies that Dave will be able to pay back his loan. Dave shouldn't have a problem getting approved for his loan.Debt Service Coverage RatioThe debt service coverage ratio is a financial ratio that measures a company's ability to service its current debts by comparing its net operating income with its total debt service obligations. In other words, this ratio compares a company's available cash with its current interest, principle, and sinking fund obligations.The debt service coverage ratio is important to both creditors and investors, but creditors most often analyze it. Since this ratio measures a firm's ability to make its current debt obligations, current and future creditors are particularly interest in it.Creditors not only want to know the cash position and cash flow of a company, they also want to know how much debt it currently owes and the available cash to pay the current and future debt.Unlike thedebt ratio, the debt service coverage ratio takes into consideration all expenses related to debt including interest expense and other obligations like pension and sinking fund obligation. In this way, the DSCR is more telling of a company's ability to pay its debt than the debt ratio.FormulaThe debt service coverage ratio formula is calculated by dividing net operating income by total debt service.

Net operating income is the income or cash flows that are left over after all of the operating expenses have been paid. This is often called earnings before interest and taxes or EBIT. Net operating income is usually stated separately on theincome statement.Total debt service refers to all costs related to servicing a company's debt. This often includes interest payments, principle payments, and other obligations. The debt service amount is rarely given in a set offinancial statements. Many times this is mentioned in the financial statement notes, however.AnalysisThe debt service coverage ratio measures a firm's ability to maintain its current debt levels. This is why a higher ratio is always more favorable than a lower ratio. A higher ratio indicates that there is more income available to pay for debt servicing.For example, if a company had a ratio of 1, that would mean that the company's net operating profits equals its debt service obligations. In other words, the company generates just enough revenues to pay for its debt servicing. A ratio of less than one means that the company doesn't generate enough operating profits to pay its debt service and must use some of its savings.Generally, companies with higher service ratios tend to have more cash and are better able to pay their debt obligations on time.ExampleBurton's Shoe Store is looking to remodel its storefront, but it doesn't have enough cash to pay for the remodel it self. Thus, Burton is talking with several banks in order to get a loan. Burton is a little worried that he won't get a loan because he already has several loans.According to his financial statements and documents, Burton's had the following:Net Operating Profits$150,000

Interest Expense$55,000

Principle Payments$35,000

Sinking Fund Obligations$25,000

Here is Burton's debt service coverage calculation:

As you can see, Burton has a ratio of 1.3. This means that Burton makes enough in operating profits to pay his current debt service costs and be left with 30 percent of his profits.DuPont AnalysisThe Dupont analysis also called the Dupont model is a financial ratio based on thereturn on equity ratiothat is used to analyze a company's ability to increase its return on equity. In other words, this model breaks down the return on equity ratio to explain how companies can increase their return for investors.The Dupont analysis looks at three main components of the ROE ratio.Profit MarginTotal Asset TurnoverFinancial LeverageBased on these three performances measures the model concludes that a company can raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively.The Dupont Corporation developed this analysis in the 1920s. The name has stuck with it ever since.FormulaThe Dupont Model equates ROE to profit margin, asset turnover, and financial leverage. The basic formula looks like this.

Since each one of these factors is a calculation in and of itself, a more explanatory formula for this analysis looks like this.

Every one of these accounts can easily be found on the financial statements. Net income and sales appear on the income statement, while total assets and total equity appear on the balance sheet.AnalysisThis model was developed to analyze ROE and the effects different business performance measures have on thisratio. So investors are not looking for large or small output numbers from this model. Instead, they are looking to analyze what is causing the current ROE. For instance, if investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.Once the problem area is found, management can attempt to correct it or address it with shareholders. Some normal operations lower ROE naturally and are not a reason for investors to be alarmed. For instance, accelerated depreciation artificially lowers ROE in the beginning periods. This paper entry can be pointed out with the Dupont analysis and shouldn't sway an investor's opinion of the company.ExampleLet's take a look at Sally's Retailers and Joe's Retailers. Both of these companies operate in the same apparel industry and have the same return on equity ratio of 45 percent. This model can be used to show the strengths and weaknesses of each company. Each company has the following ratios:RatioSallyJoe

Profit Margin30%15%

Total Asset Turnover.506.0

Financial Leverage3.0 .50

As you can see, both companies have the same overall ROE, but the companies' operations are completely different.

Sally's is generating sales while maintaining a lower cost of goods as evidenced by its higher profit margin. Sally's is having a difficult time turning over large amounts of sales.Joe's business, on the other hand, is selling products at a smaller margin, but it is turning over a lot of products. You can see this from its low profit margin and extremely high asset turnover.This model helps investors compare similar companies like these with similar ratios. Investorscan then apply perceived risks with each company's business model.Equity MultiplierThe equity multiplier is afinancial leverage ratiothat measures the amount of a firm's assets that are financed by its shareholders by comparing total assets with total shareholder's equity. In other words, the equity multiplier shows the percentage of assets that are financed or owed by the shareholders. Conversely, this ratio also shows the level of debt financing is used to acquire assets and maintain operations.Like allliquidity ratiosand financial leverage ratios, the equity multiplier is an indication of company risk to creditors. Companies that rely too heavily on debt financing will have high debt service costs and will have to raise more cash flows in order to pay for their operations and obligations.Both creditors and investors use this ratio to measure howleverageda company is.FormulaThe equity multiplier formula is calculated by dividing total assets by total stockholder's equity.

Both of these accounts are easily found on the balance sheet.AnalysisThe equity multiplier is a ratio used to analyze a company's debt andequityfinancing strategy. A higher ratio means that more assets were funding by debt than by equity. In other words, investors funded fewer assets than by creditors.When a firm's assets are primarily funded by debt, the firm is considered to be highly leveraged and more risky for investors and creditors. This also means that current investors actually own less of the company assets than current creditors.Lower multiplier ratios are always considered more conservative and more favorable than higher ratios because companies with lower ratios are less dependent on debt financing and don't have high debt servicing costs.The multiplier ratio is also used in theDuPont analysisto illustrate how leverage affects a firm's return on equity. Higher multiplier ratios tend to deliver higherreturns on equityaccording to the DuPont analysis.ExampleTom's Telephone Company works with the utility companies in the area to maintain telephone lines and other telephone cables. Tom is looking to bring his company public in the next two years and wants to make sure his equity multiplier ratio is favorable. According to Tom'sfinancial statements, he has $1,000,000 of total assets and $900,000 of totalequity. Tom's multiplier is calculated like this:

As you can see, Tom has a ratio of 1.11. This means that Tom's debt levels are extremely low. Only 10 percent of his assets are financed by debt. Conversely, investors finance 90 percent of his assets. This makes Tom's company very conservative as far as creditors are concerned.Tom's return on equity will be negatively affected by his low ratio, however.Equity RatioThe equity ratio is aninvestment leverageorsolvency ratiothat measures the amount of assets that are financed by owners' investments by comparing the total equity in the company to the total assets.The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets.The second component inversely shows how leveraged the company is with debt. The equity ratio measures how much of a firm's assets were financed by investors. In other words, this is the investors' stake in the company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that were financed by debt. Companies with higher equity ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.FormulaThe equity ratio is calculated by dividing total equity by total assets. Both of these numbers truly include all of the accounts in that category. In other words, all of the assets and equity reported on thebalance sheetare included in the equity ratio calculation.

AnalysisIn general, higher equity ratios are typically favorable for companies. This is usually the case for several reasons. Higher investment levels by shareholders shows potential shareholders that the company is worth investing in since so many investors are willing to finance the company. A higher ratio also shows potential creditors that the company is more sustainable and less risky to lend future loans.Equity financing in general is much cheaper than debt financing because of the interest expenses related to debt financing. Companies with higherequityratios should have less financing and debt service costs than companies with lower ratios.As with all ratios, they are contingent on the industry. Exact ratio performance depends on industry standards andbenchmarks.ExampleTim's Tech Company is a new startup with a number of different investors. Tim is looking for additional financing to help grow the company, so he talks to his business partners about financing options. Tim's total assets are reported at $150,000 and his total liabilities are $50,000. Based on the accounting equation, we can assume the totalequityis $100,000. Here is Tim's equity ratio.

As you can see, Tim's ratio is .67. This means that investors rather than debt are currently funding more assets. 67 percent of the company's assets are owned by shareholders and not creditors. Depending on the industry, this is a healthy ratio.Fixed Charge Coverage RatioThe fixed charge coverage ratio is a financialthat measures a firm's ability to pay all of its fixed charges or expenses with its income before interest and income taxes. The fixed charge coverage ratio is basically an expanded version of thetimes interest earned ratioor the times interest coverage ratio.The fixed charge coverage ratio is very adaptable for use with almost any fixed cost since fixed costs like lease payments, insurance payments, and preferred dividend payments can be built into the calculation.FormulaThe fixed charge coverage ratio starts with the times earned interest ratio and adds in applicable fixed costs. We will use lease payments for this example, but any fixed cost can be added in. This ratio would be calculated like this:

Note that any number offixed costscan be used in this formula. This coverage ratio is not limited to only one cost.AnalysisThe fixed charge coverage ratio shows investors and creditors a firm's ability to make its fixed payments. Like the times interest ratio, this ratio is stated in numbers rather than percentages.The ratio measures how many times a firm can pay its fixed costs with its income before interest and taxes. In other words, it shows how many times greater the firm's income is compared with its fixed costs.In a way, this ratio can be viewed as asolvency ratiobecause it shows how easily a company can pay its bills when they become due. Obviously, if a company can't pay its lease or rent payments, it will not be in business for much longer.Higher fixed cost ratios indicate a healthier and less risky business to invest in or loan to. Lower ratios show creditors and investors that the company can barely meet its monthly bills.ExampleQuinn's Harp Shop is an instrument retailer that specializes in selling and repairing harps. Quinn has been interest in remodeling the inside of his store but needs a loan in order to afford it. After giving his financial statements to the bank, the loan officer calculates Quinn's fixed charge coverage ratio.According to Quinn's income statement, he has $300,000 of income before interest and taxes and interest expense of $30,000. Quinn's current lease payment is $2,000 a month or $24,000 a year. Here is how Quinn's ratio is calculated:

As you can see, Quinn's ratio is six. That means that Quinn's income is 6 times greater than his interest and lease payments. This is a healthy ratio and he should be able to receive his loan from the bank.Gross margin ratio is aprofitability ratiothat compares the gross margin of a business to the net sales. This ratio measures how profitable a company sells its inventory or merchandise. In other words, the gross profit ratio is essentially the percentage markup on merchandise from its cost. This is the pure profit from the sale of inventory that can go to paying operating expenses.Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different. Gross margin ratio only considers the cost of goods sold in its calculation because it measures the profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.FormulaGross margin ratio is calculated by dividing gross margin by net sales.

The gross margin of a business is calculated by subtracting cost of goods sold from net sales. Net sales equals gross sales minus any returns or refunds. The broken down formula looks like this:AnalysisGross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory. It only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their inventory at a higher profit percentage.High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can get a bigpurchase discountwhen they buy their inventory from themanufactureror wholesaler, their gross margin will be higher because their costs are down.The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.A company with a high gross margin ratios mean that the company will have more money to pay operating expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also measures the percentage of sales that can be used to help fund other parts of the business.Hereis another great explaination.ExampleAssume Jack's Clothing Store spent $100,000 on inventory for the year. Jack was able to sell this inventory for $500,000. Unfortunately, $50,000 of the sales were returned by customers and refunded. Jack would calculate his gross margin ratio like this.

As you can see, Jack has a ratio of 78 percent. This is a high ratio in the apparel industry. This means that after Jack pays off his inventory costs, he still has 78 percent of his sales revenue to cover his operating costs.Operating Margin RatioThe operating margin ratio, also known as the operating profit margin, is a profitability ratio that measures what percentage of total revenues is made up by operating income. In other words, the operating margin ratio demonstrates how much revenues are left over after all the variable or operating costs have been paid. Conversely, this ratio shows what proportion of revenues is available to cover non-operating costs like interest expense.This ratio is important to both creditors and investors because it helps show how strong and profitable a company's operations are. For instance, a company that receives 30 percent of its revenue from its operations means that it is running its operations smoothly and this income supports the company. It also means this company depends on the income from operations. If operations start to decline, the company will have to find a new way to generate income.Conversely, a company that only converts 3 percent of its revenue to operating income can be questionable to investors and creditors. The auto industry made a switch like this in the 1990's. GM was making more money on financing cars than actually building and selling the cars themselves. Obviously, this did not turn out very well for them. GM is a prime example of why this ratio is important.FormulaThe operating margin formula is calculated by dividing the operating income by the net sales during a period.

Operating income, also called income from operations, is usually stated separately on theincome statementbefore income from non-operating activities like interest and dividend income. Many times operating income is classified as earnings before interest and taxes. Operating income can be calculated by subtracting operating expenses, depreciation, and amortization from gross income orrevenues.The revenue number used in the calculation is just the total, top-line revenue or net sales for the year.AnalysisThe operating profit margin ratio is a key indicator for investors and creditors to see how businesses are supporting their operations. If companies can make enough money from their operations to support the business, the company is usually considered more stable. On the other hand, if a company requires both operating and non-operating income to cover the operation expenses, it shows that the business' operating activities are not sustainable.A higher operating margin is more favorable compared with a lower ratio because this shows that the company is making enough money from its ongoing operations to pay for its variable costs as well as its fixed costs.For instance, a company with an operating margin ratio of 20 percent means that for every dollar of income, only 20 cents remains after the operating expenses have been paid. This also means that only 20 cents is left over to cover the non-operating expenses.ExampleIf Christie's Jewelry Store sells custom jewelry to celebrities all over the country. Christie reports the follow numbers on herfinancial statements:Net Sales:$1,000,000

Cost of Goods Sold:$500,000

Rent:$15,000

Wages:$100,000

Other Operating Expenses:$25,000

Here is how Christie would calculate her operating margin.

As you can see, Christie's operating income is $360,000 (Net sales all operating expenses). According to our formula, Christie's operating margin .36. This means that 74 cents on every dollar of sales is used to pay for variable costs. Only 36 cents remains to cover all non-operating expenses or fixed costs.It is important to compare this ratio with other companies in the same industry. Thegross margin ratiois a helpful comparison.Accounts Payable Turnover RatioThe accounts payable turnover ratio is a liquidity ratio that shows a company's ability to pay off its accounts payable by comparing net credit purchases to the average accounts payable during a period. In other words, the accounts payable turnover ratio is how many times a company can pay off its average accounts payable balance during the course of a year.This ratio helps creditors analyze the liquidity of a company by gauging how easily a company can pay off its current suppliers and vendors. Companies that can pay off supplies frequently throughout the year indicate to creditor that they will be able to make regular interest and principle payments as well.Vendors also use this ratio when they consider establishing a new line of credit or floor plan for a new customer. For instance, car dealerships and music stores often pay for their inventory with floor plan financing from their vendors. Vendors want to make sure they will be paid on time, so they often analyze the company's payable turnover ratio.FormulaThe accounts payable turnover formula is calculated by dividing the total purchases by the average accounts payable for the year.

The total purchases number is usually not readily available on anygeneral purpose financial statement. Instead, total purchases will have to be calculated by adding the ending inventory to the cost of goods sold and subtracting the beginning inventory. Most companies will have a record of supplier purchases, so this calculation may not need to be made.The averagepayablesis used because accounts payable can vary throughout the year. The ending balance might be representative of the total year, so an average is used. To find the average accounts payable, simply add the beginning and ending accounts payable together and divide by two.AnalysisSince the accounts payable turnover ratio indicates how quickly a company pays off its vendors, it is used by supplies and creditors to help decide whether or not to grant credit to a business. As with most liquidity ratios, a higher ratio is almost always more favorable than a lower ratio.A higher ratio shows suppliers and creditors that the company pays its bills frequently and regularly. It also implies that new vendors will get paid back quickly. A high turnover ratio can be used to negotiate favorable credit terms in the future.As with all ratios, the accounts payable turnover is specific to different industries. Every industry has a slightly different standard. This ratio is best used to compare similar companies in the same industry.ExampleBob's Building Suppliers buys constructions equipment and materials from wholesalers and resells this inventory to the general public in its retail store. During the current year Bob purchased $1,000,000 worth of construction materials from his vendors. According to Bob'sbalance sheet, his beginning accounts payable was $55,000 and his ending accounts payable was $958,000.Here is how Bob's vendors would calculate his payable turnover ratio:

As you can see, Bob's average accounts payable for the year was $506,500 (beginning plus ending divided by 2). Based on this formula Bob's turnover ratio is 1.97. This means that Bob pays his vendors back on average once every six months of twice a year. This is not a high turnover ratio, but it should be compared to others in Bob's industry.Profit Margin RatioThe profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit margin formula would indicate the expenses are too high and the management needs to budget and cut expenses.The return on sales ratio is often used by internal management to set performance goals for the future.FormulaThe profit margin ratio formula can be calculated by dividing net income by net sales.

Net sales is calculated by subtracting any returns or refunds from gross sales.Net incomeequals total revenues minus total expenses and is usually the last number reported on theincome statement.AnalysisThe profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.Since most of the time generating additionalrevenuesis much more difficult than cutting expenses, managers generally tend to reduce spending budgets to improve their profit ratio.Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.ExampleTrisha's Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the public. Last year Trisha had the best year in sales she has ever had since she opened the business 10 years ago. Last year Trisha's net sales were $1,000,000 and her net income was $100,000.Here is Trisha's return on sales ratio.

As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that with this year's numbers of $800,000 of net sales and $200,000 of net income.This year Trisha may have made less sales, but she cut expenses and was able to convert more of these sales into profits with a ratio of 25 percent.Retention RateThe retention rate, sometimes called the plowback ratio, is a financial ratio that measures the amount of earnings or profits that are added to retained earnings at the end of the year. In other words, the retention rate is the percentage of profits that are withheld by the company and not distributed as dividends at the end of the year.This is an important measurement because it shows how much a company is reinvesting in its operations. Without a steady reinvestment rate, company growth would be completely dependent on financing from investors and creditors.In a sense the retention ratio is the opposite of thedividend payout ratiobecause it shows how much money the company chooses to keep in its bank account; whereas, the dividend payout ratio computes the percentage of profits that a company choose to distribute to its shareholders. The plowback ratio increases retained earnings while the dividend payout ratio decreases retained earnings.FormulaThe retention rate is calculated by subtracting thedividendsdistributed during the period from the net income and dividing the difference by the net income for the year.

The numerator of this equation calculates the earnings that were retained during the period since all the profits that are not distributed as dividends during the period are kept by the company. You could simplify the formula by rewriting it as earnings retained during the period divided by net income.

AnalysisSince companies need to retain some portion of their profits in order to continue to operate and grow, investors value this ratio to help predict where companies will be in the future. Apple, for instance, only started paying dividends in the early 2010s. Up until then, the company retained all of its profits every year.This is true about most tech companies. They rarely give dividends because they want to reinvest and continue to grow at a steady rate. The opposite is true about established companies like GE. GE gives dividends every year to it shareholders.Higher retention rates are not always considered good for investors because this usually means the company doesn't give as much dividends. It might mean that the stock is continually appreciating because of company growth however. This ratio helps illustrate the difference between a growth stock and an earnings stock.ExampleTed's TV Company earned $100,000 of net income during the year and decided to distribute $20,000 of dividends to its shareholders. Here is how Ted would calculate his plowback ratio.

As you can see, Ted's rate of retention is 80 percent. In other words, Ted keeps 80 percent of his profits in the company. Only 20 percent of his profits are distributed to shareholders. Depending on his industry this could a standard rate or it could be high.Times Interest Earned RatioThe times interest earned ratio, sometimes called the interest coverage ratio, is a coverage ratio that measures the proportionate amount of income that can be used to cover interest expenses in the future.In some respects the times interest ratio is considered a solvency ratio because it measures a firm's ability to make interest and debt service payments. Since these interest payments are usually made on a long-term basis, they are often treated as an ongoing, fixed expense. As with most fixed expenses, if the company can't make the payments, it could go bankrupt and cease to exist. Thus, this ratio could be considered a solvency ratio.FormulaThe times interest earned ratio is calculated by dividing income before interest and income taxes by the interest expense.

Both of these figures can be found on theincome statement. Interest expense and income taxes are often reported separately from the normal operating expenses for solvency analysis purposes. This also makes it easier to find the earnings before interest and taxes or EBIT.AnalysisThe times interest ratio is stated in numbers as opposed to a percentage. The ratio indicates how many times a company could pay the interest with its before tax income, so obviously the larger ratios are considered more favorable than smaller ratios.In other words, a ratio of 4 means that a company makes enough income to pay for its totalinterest expense4 times over. Said another way, this company's income is 4 times higher than its interest expense for the year.As you can see, creditors would favor a company with a much higher times interest ratio because it shows the company can afford to pay its interest payments when they come due. Higher ratios are less risky while lower ratios indicate credit risk.ExampleTim's Tile Service is a construction company that is currently applying for a new loan to buy equipment. The bank asks Tim for his financial statements before they will consider his loan. Tim's income statement shows that he made $500,000 of income before interest expense and income taxes. Tim's overall interest expense for the year was only $50,000. Tim's time interest earned ratio would be calculated like this:

As you can see, Tim has a ratio of ten. This means that Tim's income is 10 times greater than his annual interest expense. In other words, Tim can afford to pay additional interest expenses. In this respect, Tim's business is less risky and the bank shouldn't have a problem accepting his loan.Working Capital RatioThe working capital ratio, also called thecurrent ratio, is aliquidity ratiothat measures a firm's ability to pay off its current liabilities with current assets. The working capital ratio is important to creditors because it shows the liquidity of the company.Current liabilities are best paid with current assets like cash, cash equivalents, and marketable securities because these assets can be converted into cash much quicker than fixed assets. The faster the assets can be converted into cash, the more likely the company will have the cash in time to pay its debts.The reason this ratio is called the working capital ratio comes from the working capital calculation. When current assets exceed current liabilities, the firm has enough capital to run its day-to-day operations. In other words, it has enough capital to work. The working capital ratio transforms the working capital calculation into a comparison between current assets and current liabilities.FormulaThe working capital ratio is calculated by dividing current assets by current liabilities.

Both of these current accounts are stated separately from their respective long-term accounts on thebalance sheet. This presentation gives investors and creditors more information to analyze about the company. Current assets and liabilities are always stated first on financial statements and then followed by long-term assets and liabilities.This calculation gives you a firm understanding what percentage a firm's current assets are of its current liabilities.AnalysisSince the working capital ratio measures current assets as a percentage of current liabilities, it would only make sense that a higher ratio is more favorable. A WCR of 1 indicates the current assets equal current liabilities. A ratio of 1 is usually considered the middle ground. It's not risky, but it is also not very safe. This means that the firm would have to sell all of its current assets in order to pay off its current liabilities.A ratio less than 1 is considered risky by creditors and investors because it shows the company isn't running efficiently and can't cover its current debt properly. A ratio less than 1 is always a bad thing and is often referred to as negative working capital.On the other hand, a ratio above 1 shows outsiders that the company can pay all of its current liabilities and still have current assets left over or positiveworking capital.ExampleSince the working capital ratio has two main moving parts, assets and liabilities, it is important to think about how they work together. In other words, how does the ratio change if a firm's current liabilities increase while the current assets stay the same? Here are the four examples of changes that affect the ratio:Current assets increase = increase in WCRCurrent assets decrease= decrease in WCRCurrent liabilities increase = decrease in WCRCurrent liabilities decrease = increase in WCRLet's take a look at an example. Kay's Machine Shop has several loans from banks for equipment she purchased in the last five years. All of these loans are coming due which is decreasing her working capital. At the end of the year, Kay had $100,000 of current assets and $125,000 of current liabilities. Here is her WCR:

As you can see, Kay's WCR is less than 1 because her debt is increasing. This makes her business more risky to new potential credits. If Kay wants to apply for another loan, she should pay off some of the liabilities to lower her working capital ratio before she applies.Compound Annual Growth Rate - CAGRCompound annual growth rate or CAGR is a financial investment calculation that measures the percentage an investment increases or decreases year over year. You can think of this as the annual average rate of return for an investment over a period of time. Since most investments annual returns vary from year to year, the CAGR calculation averages the good years and bad years returns into one return percentage that investors and management can use to make future financial decisions.Its important to remember that the compound annual growth rate percentage isnt the actual annual rate of return. Its an average of all the annual returns the investment has produced. It evens all the years rates out to make it easier compare the returns to other investment opportunities. For example, a company might fund a capital project that loses money for five straight years and makes a huge profit on the sixth year. This CAGR would even out first five years worth of negative returns with the sixth years positive return.FormulaCAGR formula is calculated by first dividing the ending value of the investment by the beginning value to find the total growth rate. This is then taken to the Nth root where the N is the number of years money has been invested. Finally, one is subtracted from product to arrive at the compound annual growth rate percentage. Heres what it looks like:

The equation might seem a little complex at first, but it really isnt after you use it in an example or two. Just remember that we are calculating the average return over the life of an investment, so you can think of the first part of the equation as measuring the total return. The second part of the equation annualizes the return over the life of the investment. After you understand that, its a pretty easy formula.ExampleSome of these financial ratios are easier to understand by looking at an example. Lets assume that Bills Auto Manufacturing plant invested $75,000 in new automated manufacturing equipment. Without considering saving the amount saved in labor costs, Bill was able to bring in an extra $25,000 of work over the past five years because of this capital investment. Thus, Bills ending value of his investment would be $100,000. His CAGR would be calculated like this:

As you can see, Bill made an average of 5.86% on his investment in new automated equipment. This means that if we could smooth out the earnings and make them equal over the five span, Bill would have made 5.86% every single year. Like I said before, we are trying to simplify the example, so we arent considering the effects of labor savings on the return.Now lets assume that Bill also put some of the companys profits into a stocks. He purchased $35,000 of stocks five years ago. Immediately after he bought the shares, the market dropped and his investment hovered around $20,000 for the next four years. During the fifth year, the economy rebounded and today the shares are worth $50,000. Bills compound annual growth rate for his stock investment would be calculated like this:

Even though Bill had four straight years of losses with his stock, he was able to achieve a growth rate of 7.39% year over year. Comparing the stock investment with the capital investment in machinery, Bill would have been better off investing all of the companys money into stock because he earned an additional 1.53% year over year with the stock purchases.AnalysisThe compound annual growth rate helps management and investors compare investments based on their returns. It doesnt matter what the investment is in or how much the original investment is. Management can use a CAGR calculator to compare a $1M capital investment in new machinery to a $500,000 investment in a new building. This makes the concept that much more powerful for managers and owners because it allows them to shift their money into investments that give them the highest possible return no matter what it is.Obviously, when comparing investments in unrelated activities, there has to be some cautions. For instance, if Bill pull all of the companys money into stock, his production processes might have suffered and could have missed orders and lost customers. A lot more goes into the decision making process than the compound annual growth rate, but it does give a good base line comparison for annual returns.As with any investment, management should seek opportunities that will yield the highest return rate. A larger CAGR percentage is always better than a lower percentage.EBITDAEBITDA, which stands for earnings before interest, taxes, depreciation, and amortization, is a financial calculation that measures a companys profitability before deductions that are often considered irrelevant in the decision making process. In other words, its the net income of a company with certain expenses like amortization, depreciation, taxes, and interest added back into the total. Investors and creditors often use EBITDA as a coverage ratio to compare big companies that either have significant amounts of debt or large investments in fixed assets because this measurement excludes the accounting effects of non-operating expenses like interest and paper expenses like depreciation. Adding these expenses back into net income allows us to analyze and compare the true operating cash flows of the businesses.FormulaThe EBITDA formula is calculated by subtracting all expenses except interest, taxes, depreciation, and amortization from total revenues.

Often the equation is calculated inversely by starting with net income and adding back the ITDA. Many companies use this measurement to calculate different aspects of their business. For instance, since it is a non-GAAP calculation, you can pick and choose what expenses are added back into net income. For example, its not uncommon for an investor to want to see how debt affects a companys financial position without the distraction of the depreciation expenses. Thus, the formula can be altered to exclude only taxes and depreciation.AnalysisSo what is EBITDA? It's a profitability calculation that measures how profitable a company is before paying interest to creditors, taxes to the government, and taking paper expenses like depreciation and amortization. This is not afinancial ratio. Instead, its a calculation of profitability that is measured in dollars rather than percentages.Like all profitability measurements, higher numbers are always preferred over lower numbers because higher numbers indicate the company is more profitable. Thus, an earnings before ITDA of $10,000 is better than one of $5,000. This means the first company still has $10,000 left over after all of its operating expenses have been paid to cover the interest and taxes for the year. In this sense, its more of a coverage or liquidity measurement than a profitability calculation.Since the earnings before ITDA only computes profits in raw dollar amounts, it is often difficult for investors and creditors to use this metric to compare different sized companies across an industry. A ratio is more effective for this type of comparison than a straight calculation.MarginThe EBITDA margin takes the basic profitability formula and turns it into a financial ratio that can be used to compare all different sized companies across and industry. The EBITDA margin formula divides the basic earnings before interest, taxes, depreciation, and amortization equation by the total revenues of the company-- thus, calculating the earnings left over after all operating expenses (excluding interest, taxes, dep, and amort) are paid as a percentage of total revenue. Using this formula a large company like Apple could be compared to a new start up in Silicon Valley.

The basic earnings formula can also be used to compute the enterprise multiple of a company. The EBITDA multiple ratio is calculated by dividing the enterprise value by the earnings before ITDA to measure how low or high a company is valued compared with it metrics. For instance a high ratio would indicate a company might be currently overvalued based on its earnings.ExampleLets look at an example and calculate both the adjusted EBITDA and margin for Jakes Ski House. Jake manufactures custom skis for both pro and amateur skiers. At the end of the year, Jake earned $100,000 in total revenues and had the following expenses.Salaries: $25,000Rent: $10,000Utilities: $4,000Cost of Goods Sold: $35,000Interest: $5,000Depreciation: $15,000Taxes: $3,000Jakesnet incomeat the end of the year equals $3,000. Jakes EBITDA is calculated like this:

As you can see, the taxes, depreciation and interest are added back into the net income for the year showing the amount of earnings Jake was able to generate to cover his interest and tax payments at the end of the year.If investor or creditors wanted to compare Jakes Ski shop with another business in the same industry, they could calculate his margin like this:

The EBITDA margin ratio shows that every dollar Jake generates in revenues results in 26 cents of profits before all taxes and interest is paid. This percentage can be used to compare Jakes efficiency and profitability to other companies regardless of size.Internal Rate of Return - IRRInternal rate of return or IRR is the minimum discount rate that management uses to identify what capital investments or future projects will yield an acceptable return and be worth pursuing. The IRR for a specific project is the rate that equates thenet present valueof future cash flows from the project to zero. In other words, if we computed the present value of future cash flows from a potential project using the internal rate as the discount rate and subtracted out the original investment, our net present value of the project would be zero.This sounds a little confusing at first, but its pretty simple. Think of it in terms of capital investing like the companys management would. They want to calculate what percentagereturnis required to break even on an investment adjusted for the time value of money. You can think of the internal rate of return as the interest percentage that company has to achieve in order to break even on its investment in new capital. Since management wants to do better thanbreak even, they consider this the minimum acceptable return on an investment.FormulaThe IRR formula is calculated by equating the sum of the present value of future cash flow less the initial investment to zero. Since we are dealing with an unknown variable, this is a bit of an algebraic equation. Heres what it looks like:

As you can see, the only variable in this equation that management wont know is the IRR. They will know how much capital is required to start the project and they will have a reasonable estimate of the future income of the investment. This means we will have solve for thediscount ratethat will make the NPV equal to zero.ExampleIt might be easier to look at an example than to keep explaining it. Lets look at Toms Machine Shop. Tom is considering purchasing a new machine, but he is unsure if its the best use of company funds at this point in time. With the new $100,000 machine, Tom will be able to take on a new order that will pay $20,000, $30,000, $40,000, and $40,000 in revenue. Lets calculate Toms minimum rate. Since its difficult to isolate the discount rate unless you use an excel IRR caclulator. You can start with an approximate rate and adjust from there. Lets start with 8 percent.

As you can see, our ending NPV is not equal to zero. Since its a positive number, we need to increase the estimatedinternal rate. Lets increase it to 10 percent and recalculate.

As you can see, Toms return rate on this project is 10 percent. He can compare this to other investing opportunities to see if it makes sense to spend $100,000 on this piece of equipment or investment the money in another venture.AnalysisRemember, IRR is the rate at which the net present value of the costs of an investment equals the net present value of the expected future revenues of the investment. Management can use this return rate to compare other investments and decide what capital projects should be funded and what ones should be scrapped.Going back to our machine shop example, assume Tom could purchase three different pieces of machinery. Each would be used for a slightly different job that brought in slightly different amounts of cash flow. Tom can calculate the internal rate of return on each machine and compare them all. The one with the highest IRR would be the best investment.Since this is an investment calculation, the concept can also be applied to any other investment. For instance, Tom can compare the return rates of investing the companys money in the stock market or new equipment. Now obviously the expected future cash flows arent always equal to the actual cash received in the future, but this represents a starting point for management to base their purchase and investment decisions on.Return on Investment - ROIReturn on investment or ROI is aprofitability ratiothat calculates the profits of an investment as a percentage of the original cost. In other words, it measures how much money was made on the investment as a percentage of the purchase price. It shows investors how efficiently each dollar invested in a project is at producing a profit. Investors not only use this ratio to measure how well an investment performed, they also use it to compare the performance of different investments of all types and sizes.For example, an investment in stock can be compared to one in equipment. It doesnt matter what the type of investment because the return on investment calculation only looks that the profits and the costs associated with the investment.That being said, the ROI calculation is one of the most common investment ratios because its simple and extremely versatile. Managers can use it to compare performance rates on capital equipment purchases while investors can calculate what stock purchases performed better.FormulaThe return on investment formula is calculated by subtracting the cost from the total income and dividing it by the total cost.

As you can see, the ROI formula is very simplistic and broadly defined. What I mean by that is the income and costs are not clearly specified. Total costs and total revenues can mean different things to different individuals. For example, a manager might use the net sales andcost of goods soldas therevenuesand expenses in the equation, where as an investor might look more globally at the equation and use gross sales and all expenses incurred to produce or sell the product including operating and non-operating costs.In this way, the ROI calculation can be very versatile, but it can also be very manipulative depending on what the user wants to measure or show. Its important to realize that there is no one standardized equation for return on investment. Instead, well look at the basic idea of recognizing profits as a percentage of income. To truly understand the return on an investment presented to you, you have to understand what revenues and costs are being used in the calculation.ExampleNow that you know that there isnt a standard equation, lets look at a basic version without getting into cost and revenue segments. Lets look at Keiths Brokerage House for example. Keith is a stockbroker who specializes in penny stocks. Keith made a somewhat risky investment in a liquid metals stock last year when he purchased 5,000 shares at $1 per share. Today, a year later, thefair market valueof per share is $3.50. Keith sells theshareand uses an ROI calculator to measure his performance.

As you can see, Keiths return on investment is 2.5 or 250 percent. This means that Keith made $2.50 for every dollar that he invested in the liquid metals company. This investment was extremely efficient because it increased 2.5 times.We can compare Keiths good choice of liquid metals with his other financial choice of investing in a medical equipment company. He purchased 1,000 shares at $1 per share and sold them for $1.25 per share.

Keiths return on this stock purchase was only .25 or 25 percent. Its still a goodreturn, but nothing compared to the other investment.AnalysisGenerally, any positive ROI is considered a good return. This means that the total cost of the investment was recouped in addition to some profits left over. A negative return on investment means that the revenues werent even enough to cover the total costs. That being said, higher return rates are always better than lower return rates.Going back to our example about Keith, the first investment yielded an ROI of 250 percent, where as his second investment only yielded 25 percent. The first stock out performed the second one ten fold. Keith would have been better off investing all of his money into the first stock.The ROI calculation is extremely versatile and can be used for any investment. Managers can use it to measure the return on invested capital. Investors can use it to measure the performance of their stock and individuals can use it to measure their return on assets like their homes.One thing to remember is that it does not take into consideration the time value of money. For a simple purchase and sale of stock, this fact doesnt matter all that much, but it does for calculation of a fixed asset like a building or house that appreciates over many years. This is why the original simplistic earnings portion of the formula is usually altered with a present value calculation.Gross Profit MarginGross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. In other words, it measures how efficiently a company uses its materials and labor to produce and sell products profitably. You can think of it as the amount of money from product sales left over after all of the direct costs associated with manufacturing the product have been paid. These direct costs are typically called cost of goods sold or COGS and usually consist ofraw materialsanddirect labor.The gross profit ratio is important because it shows management and investors how profitable the core business activities are without taking into consideration the indirect costs. In other words, it shows how efficiently a company can produce and sell its products. This gives investors a key insight into how healthy the company actually is. For instance, a company with a seemingly healthy net income on the bottom line could actually be dying. The gross profit percentage could be negative, and the net income could be coming from other one-time operations. The company could be losing money on every product they produce, but staying a float because of a one-time insurance payout.That is why it is almost always listed on front page of theincome statementin one form or another. Lets take a look at how to calculate gross profit and what its used for.FormulaThe gross profit formula is calculated by subtracting total cost of goods sold from total sales.

Both the total sales and cost of goods sold are found on the income statement. Occasionally, COGS is broken down into smaller categories of costs like materials and labor. This equation looks at the pure dollar amount of GP for the company, but many times its helpful to calculate the gross profit rate or margin as a percentage.The gross profit percentage formula is calculated by subtracting cost of goods sold from total revenues and dividing the difference by total revenues. Usually a gross profit calculator would rephrase this equation and simply divide the total GP dollar amount we used above by the total revenues. Both equations get the result.

ExampleMonica owns a clothing business that designs and manufactures high-end clothing for children. She has several different lines of clothing and has proven to be one of the most successful brands in her space. Heres what appears on Monicas income statement at the end of the year.Total sales: $1,000,000COGS: $350,000Rent: $100,000Utilities: $10,000Office expenses: $2,500Monica has an upcoming meeting with investors and wants to know how to find gross profit and what method to use. First, we can calculate Monicas overall dollar amount of GP by subtracting the $350,000 ofCOGSfrom the $1,000,000 of total sales like this:

As you can see, Monica has a GP of $650,000. This means the goods that she sold for $1M only cost her $350,000 to produce. Now she has $650,000 that can be used to pay for other bills like rent and utilities.Monica can also compute this ratio in a percentage using the gross profit margin formula. Simply divide the $650,000 GP that we already computed by the $1,000,000 of total sales.

Monica is currently achieving a 65 percent GP on her clothes. This means that for every dollar of sales Monica generates, she earns 65 cents in profits before other business expenses are paid.AnalysisThe gross profit method is an important concept because it shows management and investors how efficiently the business can produce and sell products. In other words, it shows how profitable a product is.The concept of GP is particularly important to cost accountants and management because it allows them to create budgets and forecast future activities. For instance, Monicas GP was $650,000. This means if she wants to be profitable for the year, all of her other costs must be less than $650,000. Conversely, Monica can also view the $650,000 as the amount of money that can be put toward other business expenses or expansion into new markets.Investors are typically interested in GP as a percentage because this allows them to compare margins between companies no matter their size or sales volume. For instance, an investor can see Monicas 65 percent margin and compare it to Ralph Laurens margin even though RL is a billion dollar company. It also allows investors a chance to see how profitable the companys core business activities are.General Motors is a good example of this back in the 1990s. GM had a low margin and wasnt making much money one each car they were producing, but GM was profitable. Why? Because GMs financing services were raking in the money. In other words, GM was making more money financing cars like a bank than they were producing cars like a manufacturer. Investors want to know how healthy the core business activities are to gauge the quality of the company.They also use a gross profit margin calculator to measure scalability. Monicas investors can run different models with her margins to see how profitable the company would be at different sales levels. For instance, they could measure the profits if 100,000 units were sold or 500,000 units were sold by multiplying the potential number of units sold by the sales price and the GP margin.Enterprise ValueEnterprise value is a business valuation calculation that measures the worth of a company by comparing its stock price, outstanding debt, and cash and equivalents in the event of a company sale. In other words, its a way to measure how much a purchasing company should pay to buy out another company. A lot of times this is called the takeover price because its amount of money required to purchase 100 percent of a business and take it over.In business there are generally two ways to grow a company. Some companies grow internally by developing new products and lines to reach new customers. While this strategy is great, it can be slow and costly. Developing new products and marketing to new customers isnt cheap. Thats why many companies choice a different growth strategy. They expand by acquisition. Rather than developing new products, they just find companies that are already successful in those spaces and purchase them. This is where business valuation methods are important.Traditionally, the market capitalization method is used to compute the value of company by multiplying the outstanding shares by the fair market value per share. This gives investors a good understanding of the company, but it doesnt take into accountother balance sheet itemslike debt and cash. Enterprise value, on the other hand, considers the entire economic value of a company using these other accounts. Thats how to value a company the right way.FormulaThe enterprise value formula is calculated by adding the outstanding debt and subtracting the current cash from the companys market capitalization. Heres what the basic equation looks like.

This is the simplified version of the enterprise value equation that only looks at debt and cash. A more sophisticated investor would also want to look at the impact of preferred shares, minority interests, cash equivalents, liquid inventory and other investments. This only makes sense. The purpose of the business valuation calculator is to measure the total economic worth of a business and come up with a takeover price. Investors typically use this more detailed equation.

ExampleLets take a look at an example. Bills Music is a local music store with a prime location. Bill has been running this store himself for ten years and has been approached by Guitar Center (GC) recently to acquire his business because of the great location and local market. Bill thinks his music store is worth $200,000 because thats how much he makes every year, but he has no idea how to do a true business valuation of his company. Heres what Bills balance sheet looks like:Cash: $50,000Inventory: $15,000Liabilities: $25,000Common Stock: $75,000Retained Earnings: $15,000

Using the enterprise value method, Guitar Center would calculate Bills Music to be worth $35,000. Since Guitar Center can use Bills inventory, its considered liquid and is treated as cash. The companys retained earnings isnt used in the computation because the stock price theoretically already reflects the retained earnings of the company. In other words, profitable companies with higher retained earnings will usually have higher stock prices and cash reserves.AnalysisAs you can see, this measurement is used to come up with a business valuation or take over price. GC would acquire all of Bills Music for $35,000. This includes the entire business and balance sheet. In other words, Guitar Center would receive all of the cash, inventory, and stock as well as take on all of Bills debt. That is why the enterprise value method is so much more accurate than the market capitalization method.If GC simply used the MC approach, it would value the Bills Music at $75,000 because thats the price of the outstanding common shares. Obviously, this would drastically understate the true cost of acquiring Bills firm because it doesnt take into account the fact that Bill owes his creditors $25,000 and GC would have to pay them back after it acquires Bill.The MC method is a good shorthand calculation because its easy to do and doesnt take much research. All you need to do is look at the equity section of the balance sheet and compute the value of outstanding common shares, but this is not how to value a business completely. As with any company, there are manymoving partsand each section of balance sheet should be examined in the estimated purchase price.Weighted Average Cost of Capital - WACCThe weighted average cost of capital, also called the WACC, is afinancial ratiothat calculates a companys cost of financing and acquiring assets by comparing the debt and equity structure of the business. In other words, it measures the true cost of borrowing money or raising funds through equity to finance new capital purchases and expansions based on the companys current level of debt and equity structure.Management typically uses this ratio to decide whether the company should use debt or equity to finance new purchases.This ratio is very comprehensive because it averages all sources of capital; including long-term debt, common stock, preferred stock, and bonds; to measure an average cost of borrowing funds. It is also extremely complex. Figuring out the cost of debt is pretty simple. Bonds and long-term debt are issued with stated interest rates that can be used to compute their overall cost. Equity, like common and preferred shares, on the other hand, does not have a readily available stated price on it. Instead, we must compute an equity price before we apply it to the equation.Thats why many investors and creditors tend not to focus on this measurement as the only capital price indicator. Estimating the cost of equity is based on several different assumptions that can vary between investors. Lets take a look at how to calculate WACC.FormulaThe WACC formula is calculated by dividing the market value of the firms equity by the total market value of the companys equity and debt multiplied by the cost of equity multiplied by the market value of the companys debt by the total market value of the companys equity and debt multiplied by the cost of debt times 1 minus the corporate income tax rate. Wow, that was a mouthful. Heres what the equation looks like.

Re = the cost of equityRd = the cost of debtE = the market value of the companys equityD = the market value of the companys debtV = the total market value of the companys combined debt and equity or E + DE/V = percentage of total financing consisting of equityD/V = percentage of total financing consisting of debtTc = the corporate income tax rateCalculatorNow lets break the WACC equation down into its elements and explain it in simpler terms. Heres a list of the elements in the weighted average formula and what each mean.

This equation is pretty complex because there are so many different pieces involved, but there are really only two elements that are confusing: establishing the cost of equity and the cost of debt. After you have these two numbers figured out calculating wacc is a breeze.The cost of equity, represented by Re in the equation, is hard to measure precisely because issuing stock is free to company. A company doesnt pay interest on outstanding shares. In addition, each share of stock doesnt have a specified value or price. It simply issues them to investors for whatever investors are willing to pay for them at any given time. When the market it high, stock prices are high. When the market is low, stock prices are low. Theres no real stable number to use. So how to measure the cost of equity?We need to look at how investors buy stocks. They purchase stocks with the expectation of a return on their investment based on the level of risk. This expectation establishes the required rate of return that the company must pay its investors or the investors will most likely sell their shares and invest in another company. If too many investors sell their shares, the stock price could fall and decrease the value of the company. I told you this was somewhat confusing. Think of it this way. The cost of equity is the amount of money a company must spend to meet investors required rate of return and keep the stock price steady.Compared with the cost of equity, the cost of debt, represented by Rd in the equation, is fairly simple to calculate. We simply use the market interest rate or the actual interest rate that the company is currently paying on its obligations. Keep in mind, that interest expenses have additional tax implications. Interest is typically deductible, so we also take into account the amount of tax savings the company will be able to take advantage of by making its interest payments, represented in our equation Rd(1 Tc).So what does all this mean?AnalysisTo put it simply, the weighted average cost of capital formula helps management evaluate whether the company should finance the purchase of new assets with debt or equity by comparing the cost of both options. Financing new purchases with debt or equity can make a big impact on the profitability of a company and the overall stock price. Management must use the equation to balance the stock price, investors return expectations, and the total cost of purchasing the assets. Executives and the board of directors use weighted average to judge whether a merger is appropriate or not.Investors and creditors, on the other hand, use this ratio to evaluate whether the company is worth investing in or loaning money to. Since the WACC represents the average cost of borrowing money across all financing structures, higher weighted average percentages mean the companys overall cost of financing is greater and the company will have less free cash to distribute to its shareholders or pay off additional debt. As the weighted average cost of capital increases, the company is less likely to create value and investors and creditors tend to look for other opportunities.You can think of this as a risk measurement. As the average cost increases, the company must equally increase its earnings and ability to pay the higher costs or investors wont see a return and creditors wont be repaid. Investors use a WACC calculator to compute the minimum acceptable rate of return. If their return falls below the average cost, they are either losing money or incurringopportunity costs.ExampleLets take a look at an example. Assume the company yields an average return of 15% and has an average cost of 5% each year. The company essentially makes a 10% return on every dollar it invests in itself. An investor would view this as the company generating 10 cents of value for every dollar invested. This 10-cent value can be distributed to shareholders or used to pay off debt.Now lets look at an opposite example. Assume that the company only makes a 10% return at the end of the year and has an average cost of capital of 15 percent. This means the company is losing 5 cents on every dollar it invests because its costs are higher than its returns. No investor would be attracted to a company like this. Its management should work to restructure the financing and decrease the companys overall costs.As you can see, using a weighted average cost of capital calculator is not easy or precise. There are many different assumptions that need to take place in order to establish the cost of equity. Thats why many investors and market analysts tend to come up with different WACCs for the same company. It all depends on what their estimations and assumptions were. This is why many investors use this ratio for speculation purposes and tend to value more concrete calculations for serious investing decisions.Residual IncomeResidual income is the amount of money left over after necessary expenses and costs have been paid for a period. This concept can be applied to both personal finances and corporate operations. Lets answer the question; what is residual income for both situations.PersonalPersonal residual income, often called discretionary income, is the amount of income or salary left over after debt payments, like car loans and mortgages, have been paid each month. For example, Jims take-home pay is $3,000 a month. His mortgage payment, home equity loan, and car loan are the following respective: $1,000, $250, and $200. Using a residual income calculator, Jim would calculate his RI to be $1,550 a month. This is the amount of money he has left over after his monthly debt payments are make t