# Basic Classifications of Financial Ratios - Financial Management

Because different groups inside and outside a company have varying objectives and expectations, they approach financial analysis from different perspectives. For example, suppliers and short -term creditors are likely to be most concerned with a firm’s current liquidity and near -term cash -generating capacity. Bondholders and holders of preferred stock, who have long -term claims on a company’s earnings and assets, focus on the firm’s cash -generating ability over the long run and on the claims other investors have on the firm’s cash flows.

Common stockholders and potential investors are especially interested in measures of profitability and risk, because common stock prices are dependent on the amount and stability of a firm’s future earnings and dividends. Management is concerned with all aspects of financial analysis on both a short- and a long -term basis, because it is responsible for conducting the firm’s day -to-day operations and earning a competitive rate of return for risks taken, and thereby maximizing shareholder wealth. No single financial ratio can begin to answer all these analytical needs. In fact, six different groups of ratios have been developed:

• Liquidity ratios indicate a firm’s ability to meet short-term financial obligations.
• Asset management ratios indicate how efficiently a firm is using its assets to generate sales.
• Financial leverage management ratios indicate a firm’s capacity to meet short- and longterm debt obligations.
• Profitability ratios measure how effectively a firm’s management generates profits on sales, assets, and stockholders’ investments.
• Market-based ratios measure the financial market’s evaluation of a company’s performance.
• Dividend policy ratios indicate the dividend practices of a firm.

Key Financial Statements

The financial statements of the Drake Manufacturing Company, a medium -sized firm that produces various replacement components for the lawn equipment industry, will be examined to illustrate how ratios are used in financial analysis. Data will be used from Drake’s balance sheet for the years ending December 31, 2006 and 2005 and from its income statement for the year 2006.

The Balance Sheet The balance sheet contains information on Drake’s assets, liabilities, and stockholders’ equity. The figures provide a “snapshot” view of the firm’s financial health on December 31, 2006, and December 31, 2005. Drake’s assets are recorded on the balance sheet at the price the company paid for them (that is, at historic cost). The liabilities are amounts the firm owes its creditors, and the stockholders’ equity (also termed net worth or owners’ equity) is the difference between total assets and total liabilities. The stockholders’ equity accounts in Table are (1) common stock ($10 par value), (2) contributed capital in excess of par, and (3) retained earnings. The Income Statement The income statement in Table Drake’s performance during the year ended December 31, 2006. The cost of sales, other operating expenses, interest expenses, and taxes are deducted from the revenues generated, or net sales, to arrive at the firm’s net income, or earnings after taxes (EAT). The statement in Table also shows how the firm’s earnings are distributed between dividend payments to stockholders and earnings reinvested in the firm. Drake Manufacturing Company Balance Sheet (in Thousands of Dollars) Common -Size Financial Statements Common-size financial statements are also helpful in financial analysis. A common-size balance sheet shows the firm’s assets and liabilities and stockholders’ equity as a percentage of total assets, rather than in dollar amounts. Table shows the Drake Company’s common -size balance sheet on December 31, 2006, and December 31, 2005. A common -size income statement lists the firm’s income and expense items as a percentage of net sales, rather than in dollar amounts. Table contains Drake’s common -size income statement for the year ended December 31, 2006. Common -size financial statements allow trends in financial performance to be detected and monitored more easily than with financial statements showing only dollar amounts. Drake Manufacturing Company Income Statement (in Thousands of Dollars) The Statement of Cash Flows The statement of cash flows is useful in financial analysis, too. It indicates how a firm generated cash flows from its operations, how it used cash in investing activities, and how it obtained cash from financing activities. The statement of cash flows is analyzed. Liquidity Ratios A firm that intends to remain a viable business entity must have enough cash on hand to pay its bills as they come due. In other words, the firm must remain liquid. One way to determine whether this is the case is to examine the relationship between a firm’s current assets and approaching obligations. Liquidity ratios are quick measures of a firm’s ability to provide sufficient cash to conduct business over the next few months. Cash budgets provide the best assessment of a firm’s liquidity position. This section discusses two different liquidity ratios —the current ratio and the quick ratio. Drake Manufacturing Company Common-Size Balance Sheet Drake Manufacturing Company Common-Size Current Ratio The current ratio is defined as follows: Current ratio = Current assets/Current liabilities Current assets include the cash a firm already has on hand and in the bank plus any assets that can be converted into cash within a “normal” operating period of 12 months, such as marketable securities held as short -term investments, accounts receivable, inventories, and prepayments. Current liabilities include any financial obligations expected to fall due within the next year, such as accounts payable, notes payable, the current portion of long-term debt due, other payables, and various accruals such as taxes and wages due. Using data from Table 3.1, Drake’s current ratio at year-end 2006 can be calculated as$50,190/$25,523 = 1.97, or about 2:1. Or, it can be said that Drake’s current assets cover its current liabilities about two times. The ratio is interpreted to mean that to satisfy the claims of short -term creditors exclusively from existing current assets, Drake must be able to convert each dollar of current assets into at least$0.51 of cash ($1.00/1.97 =$0.507, or $0.51). The industry average for the current ratio is 2.40 times,1 meaning that the average firm in the industry must convert only$0.42 ($1.00/2.40 =$0.416, or $0.42) of each dollar of current assets into cash to meet short -term obligations. The fact that Drake’s current ratio is below the industry average does not mean that the firm would consider closing its doors voluntarily to meet the demands of short -term creditors. Nor does it mean that Drake’s creditors are any less well protected than the creditors of competing firms, because no two firms—even those in the same industry—are identical. In fact, ratios that suggest the presence of a problem in one firm may be quite satisfactory for another firm. Drake’s current ratio provides only one standard for measuring liquidity. The financial analyst must dissect, or go behind, the ratio to discover why it differs from the industry average and determine whether a serious problem exists. Quick Ratio The quick ratio is defined as follows: Current assets – Inventories Quick ratio = Current liabilities This ratio, sometimes called the “acid test,” is a more stringent measure of liquidity than the current ratio. By subtracting inventories from current assets, this ratio recognizes that a firm’s inventories are often one of its least-liquid current assets. Inventories, especially work-in-process, are very difficult to liquidate quickly at or near their book value. Referring to the figures on Drake’s balance sheet, the firm’s quick ratio at year-end 2006 is calculated as follows:$50,190-$27530 /$25,523 = $22,660 /$25,523 = 0.89 times

The industry average is 0.92 times; Drake’s quick ratio is nearly equal to that. The quick ratio is interpreted to mean that Drake’s cash and other current assets one step removed from cash —that is, marketable securities and accounts receivable —are equal to 89 percent of the current liabilities. The crucial assumption behind the quick ratio is that a firm’s accounts receivable may be converted into cash within the “normal” collection period (and with little “shrinkage”) or within the period of time for which credit was initially granted. An analyst who doubts the liquidity of a firm’s receivables may wish to prepare an aging schedule. The following one lists Drake’s accounts receivable as of December 31, 2006:

Unfortunately, the data required to prepare an aging schedule are not normally available to outside analysts. Hence, the aging schedule is useful primarily for internal analysis. To evaluate the figures contained in an aging schedule, an analyst would need to consider Drake’s selling terms. If, for example, Drake’s customers are expected to pay within 40 days (which, in fact, they are), then the aging schedule indicates that many accounts are past due.

However, because only 5.2 percent of the firm’s receivables have been outstanding over 90 days, the major problem appears to be with slow -paying rather than uncollectible accounts. Some analysts adjust the quick ratio downward if a significant percentage of a firm’s receivables are long past due and have not been written off as losses.Adjusting Drake’s quick ratio downward involves the following calculation:

(Current assets – Inventories)–Accounts outstanding over 90 days /Current liabilities = $22,660 –$959 / $25,523 = 0.85 times The 0.04 difference between the quick ratio, 0.89 times, and the adjusted ratio, 0.85 times, is probably insignificant. Therefore, even if Drake’s accounts over 90 days old were considered uncollectible, this alone would not indicate any real problem for the firm. Asset Management Ratios One objective of financial management is to determine how a firm’s resources can be best distributed among the various asset accounts. If a proper mix of cash, receivables, inventories, plant, property, and equipment can be achieved, the firm’s asset structure will be more effective in generating sales revenue. Asset management ratios indicate how much a firm has invested in a particular type of asset (or group of assets) relative to the revenue the asset is producing. By comparing asset management ratios for the various asset accounts of a firm with established industrynorms, the analyst can determine how efficiently the firm is allocating its resources. This section discusses several types of asset management ratios, including the average collection period, the inventory turnover ratio, the fixed -asset turnover ratio, and the total asset turnover ratio. Average Collection Period The average collection period is the average number of days an account receivable remains outstanding. It is usually determined by dividing a company’syear -end receivables balance by the average daily credit sales (based on a 365-day year). Average collection period =Account receivable/Annual credit sales/365 Using figures from both Drake’s balance sheet and the income statement, the average collection period at year-end 2006 can be calculated as$18,320/($112,760/365) =$18,320/$308.93 = 59.3 days. Because the industry average for this ratio is 47 days, Drake’s ratio is substantially above the average. Drake’s credit terms call for payment within 40 days. The ratio calculations show that 59.3 days of sales are tied up in receivables, meaning that a significant portion of Drake’s customers are not paying bills on time. (This is also indicated by the aging schedule of the firm’s accounts receivable.) The analyst interprets this ratio to mean that Drake has allocated a greater proportion of total resources to receivables than the average firm in the industry. If the company implemented a more vigorous collection program and reduced the collection period to the industry norm of 47 days, some of these funds would be released for investment elsewhere or for debt reduction. The released funds of (59.3 days – 47 days) _$308.93 per day = $3,800 could be invested in other assets that might contribute more significantly to profitability.5 An average collection period substantially above the industry norm is usually not desirable and may indicate too liberal a credit policy. Ultimately, a firm’s managers must determine if the liberal credit policy generates enough incremental sales and profits to justify the incremental cost.6 In contrast, an average collection period far below the industry norm may indicate that the firm’s credit terms are too stringent and are hurting sales by restricting credit to the very best customers. Although moderate- to slow-paying customers may seem troublesome individually, they can be profitable as a group, and a credit policy that is too tight may drive them to competing firms. Inventory Turnover Ratio The inventory turnover ratio is defined as follows: Inventory turnover =Cost of sales/Average inventory Whereas the cost of sales is usually listed on a firm’s income statement, the average inventory has to be calculated. This can be done in a number of ways. For example, if a firm has been experiencing a significant and continuing rate of growth in sales, the average inventory may be computed by adding the figures for the beginning and ending inventories for the year and dividing by 2. If sales are seasonal or otherwise subject to wide fluctuations, however, it would be better to add the month-end inventory balances for the entire year and divide by 12. Some analysts calculate inventory turnover as simply the ratio of annual sales to ending inventory. Although the sales -to-inventory ratio is technically inferior and gives different results than more commonly used ratios, it may be satisfactory if used consistently when making comparisons between one firm and the industry as a whole. However, the problem with this ratio is that it tends to differ from one firm to another, depending on policies regarding markups on the cost of sales. Because Drake’s sales are spread evenly over the year and its growth rate has been fairly moderate, the average inventory can be calculated by taking the average of the beginning and ending inventory balances,($27,530 + $26,470)/2 =$27,000. Dividing the cost of sales by this figure, $85,300/$27,000, gives an inventory turnover ratio of 3.16 times. This is considerably below the industry norm of 3.9 times, indicating that Drake has a larger investment in inventory relative to the sales being generated than the average firm.

If the company could increase its inventory turns up to the industry average of 3.9 times, its average inventory investment in 2006 would be $21,872 ($85,300/3.9). The released funds, $27,000 –$21,872 = $5,128,could be used either for investment in other, potentially more profitable assets or possibly for debt reduction. Two factors may be responsible for Drake’s apparently excessive amount of inventory: • The firm may be attempting to carry all possible types of replacement parts so that every order can be filled immediately. Drake should carefully examine this policy to determine whether the incremental cost of carrying large stocks of inventory is justified by the incremental profits earned on additional sales. • Some of Drake’s inventory may be damaged, obsolete, or slow moving. Stock falling into these categories has questionable liquidity and should be recorded at a value more reflective of the realizable market value. If a firm’s inventory turnover ratio is too high, it may mean that the firm is frequently running out of certain items in stock and losing sales to competitors. For inventory to contribute fully to profitability, the firm has to maintain a reasonable balance of inventory levels. Fixed-Asset Turnover Ratio The fixed-asset turnover ratio is defined as follows: Fixed-asset turnover =Sales/Net fixed assets This ratio indicates the extent to which a firm is using existing property, plant, and equipment to generate sales. The balance sheet figures that indicate how much a firm has invested in property, plant, and equipment are affected by several factors, including the following: • The cost of the assets when acquired • The length of time since acquisition • The depreciation policies adopted by the firm • The extent to which fixed assets are leased rather than owned Because of these factors, it is possible for firms with virtually identical plants to have significantly different fixed-asset turnover ratios. Thus, the ratio should be used primarily for year -to-year comparisons within the same company, rather than for intercompany comparisons. Drake’s fixed-asset turnover ratio is$112,760/$31,700 = 3.56 times, considerably below the industry average of 4.6 times.However, a financial analyst should acknowledge the shortcomings of the ratio and perform further analyses before concluding that the company makes inefficient use of its property, plant, and equipment. Total Asset Turnover Ratio The total asset turnover ratio is defined as follows: Total asset turnover =Sales/Total assets It indicates how effectively a firm uses its total resources to generate sales and is a summary measure influenced by each of the asset management ratios previously discussed. Drake’s total asset turnover ratio is$112,760/$81,890 = 1.38 times, whereas the industry average is 1.82 times. In view of Drake’s other asset turnover ratios, the firm’s relatively poor showing with regard to this ratio is not surprising. Each of Drake’s major asset investment programs—accounts receivable, inventory, and property, plant, and equipment— has been found apparently lacking. The analyst could look at these various ratios and conclude that Drake is not generating the same level of sales from its assets as other firms in the industry. Financial Leverage Management Ratios Whenever a company finances a portion of assets with any type of fixed-charge financing— such as debt, preferred stock, or leases —the firm is said to be using financial leverage. Financial leverage management ratios measure the degree to which a company is employing financial leverage and, as such, are of interest to creditors and owners alike. Both long- and short-term creditors are concerned with the amount of leverage a company employs because it indicates the company’s risk exposure in meeting debt service charges (that is, interest and principal repayment). A company that is heavily financed by debt offers creditors less protection in the event of bankruptcy. For example, if a company’s assets are financed with 85 percent debt, the value of the assets can decline by only 15 percent before creditors’ funds are endangered. In contrast, if only 15 percent of a company’s assets are debt financed, asset values can drop by 85 percent before jeopardizing the creditors. Owners are interested in financial leverage because it influences the rate of return they can expect to realize on their investment and the degree of risk involved. For example, if a firm is able to borrow funds at 9 percent and employ them at 12 percent, the owners earn the 3 percent difference and are likely to view financial leverage favorably. On the other hand, if the firm can earn only 3 percent on the borrowed funds, the –6 percent difference (3% – 9%) will result in a lower rate of return to the owners. Either balance sheet or income statement data can be used to measure a firm’s use of financial leverage. The balance sheet approach gives a static measure of financial leverage at a specific point in time and emphasizes total amounts of debt, whereas the income statement approach provides a more dynamic measure and relates required interest payments on debt to the firm’s ability to pay. Both approaches are employed widely in practice. There are several types of financial leverage management ratios, including the debt ratio, the debt -to-equity ratio, the times interest earned ratio, and the fixed-charge coverage ratio. Debt Ratio The debt ratio is defined as follows: Debt ratio =Total debt/Total assets It measures the proportion of a firm’s total assets that is financed with creditors’ funds. As used here, the term debt encompasses all short -term liabilities and long-term borrowings. Bondholders and other long -term creditors are among those likely to be interested in a firm’s debt ratio. They tend to prefer a low debt ratio because it provides more protection in the event of liquidation or some other major financial problem. As the debt ratio increases, so do a firm’s fixed -interest charges. If the debt ratio becomes too high, the cash flows a firm generates during economic recessions may not be sufficient to meet interest payments. Thus, a firm’s ability to market new debt obligations when it needs to raise new funds is crucially affected by the size of the debt ratio and by investors’ perceptions about the risk implied by the level of the ratio. Debt ratios are stated in terms of percentages. Drake’s debt ratio as of year-end 2006 is ($25,523 + $22,000)/$81,890 = $47,523/$81,890 = 0.58, or 58 percent. The ratio is interpreted to mean that Drake’s creditors are financing 58 percent of the firm’s total assets.

This figure is considerably higher than the 47 percent industry average, indicating that Drake has less unused borrowing capacity than the average firm in the industry. A high debt ratio implies a low proportionate equity base, that is, the percentage of assets financed with equity funds. As the proportionate equity base declines, investors are more hesitant to acquire a firm’s debt obligations. Whether Drake can continue to finance its assets with 58 percent of “outsider” money largely depends on the growth and stability of future earnings and cash flows.

Because most interest costs are incurred on long-term borrowed funds (greater than one year to maturity) and because long-term borrowing places multiyear, fixed financial obligations on a firm, some analysts also consider the ratio of long-term debt -to-total assets, or long -term debt -to -equity (discussed in the following section).

Another modification that is sometimes made in these ratios is to include the capitalized value of noncancellable financial leases in the numerator. Some analysts also include a firm’s preferred stock with its debt when computing these ratios because preferred stock dividends, like interest requirements, are usually fixed.

Debt -to -Equity Ratio

The debt -to -equity ratio is defined as follows:

Debt-to-equity =Total debt/Total equity

It is similar to the debt ratio and relates the amount of a firm’s debt financing to the amount of equity financing. The debt-to-equity ratio, in actuality, is not really a new ratio. It is simply the debt ratio in a different format. The debt -to -equity ratio is also stated as a percentage. Drake’s debt -to-equity ratio at year-end 2006 is $47,523/$34,367 = 1.383, or 138.3 percent. Because the industry average is 88.7 percent, Drake’s ratio indicates that the firm uses more than the usual amount of borrowed funds to finance its activities.

Specifically, it raises nearly $1.38 from creditors for each dollar invested by stockholders, which is interpreted to mean that the firm’s debt suppliers have a lower margin of safety than is common in the industry. In addition, Drake has a greater potential for financial distress if earnings do not exceed the cost of borrowed funds. Times Interest Earned Ratio The times interest earned ratio is defined as follows: Times interest earned =Earnings before interest taxes (EBIT)/Interest charges Often referred to as simply interest coverage, this ratio employs income statement data to measure a firm’s use of financial leverage. It tells an analyst the extent to which the firm’s current earnings are able to meet current interest payments. The EBIT figures are used because the firm makes interest payments out of operating income, or EBIT.When the times interest earned ratio falls below 1.0, the continued viability of the enterprise is threatened because the failure to make interest payments when due can lead to bankruptcy. Drake’s times interest earned ratio is$11,520/$3,160 = 3.65 times. In other words, it covers annual interest payments 3.65 times; this figure is considerably below the industry norm of 6.7 times. This ratio is further evidence that the company makes extensive use of creditors’ funds to finance its operations. Fixed-Charge Coverage Ratio The fixed-charge coverage ratio is defined as follows: Fixed-charge coverage = EBIT+Lease payments/Interest + Lease payments + Preferred dividends before tax + Before-tax sinking fund It measures the number of times a firm is able to cover total fixed charges, which include (in addition to interest payments) preferred dividends and payments required under long-term lease contracts. Many companies are also required to make sinking fund payments on bond issues which are annual payments aimed at either retiring a portion of the bond obligation each year or providing for the ultimate redemption of bonds at maturity. Under most sinking fund provisions, the firm either may make these payments to the bondholders’ representative (the trustee), who determines through a lottery process which of the outstanding bonds will be retired, or may deliver to the trustee the required number of bonds purchased by the firm in the open market. Either way, the firm’s outstanding indebtedness is reduced.In calculating the fixed-charge coverage ratio, an analyst must consider each of the firm’s obligations on a before -tax basis. However, because sinking fund payments and preferred stock dividends are not tax deductible and therefore must be paid out of after-tax earnings, a mathematical adjustment has to be made. After-tax payments must be divided by (1 – T), where T is the marginal tax rate. This effectively converts such payments to a before-tax basis, or one that is comparable to the EBIT.10 And, since lease payments are deducted in arriving at the EBIT, they must be added back into the numerator of the ratio because the fixed charges (in the denominator) also include lease payments. The fixed -charge coverage ratio is a more severe measure of a company’s ability to meet fixed financial obligations. Using figures from Drake’s income statement for 2006,11 the fixed-charge coverage ratio can be calculated as follows:$11,520 + $150 /$3,160 + $150 +$2,000/(1 – 0.4)= $11,670 / 6,643 = 1.76 times Because the industry average is 4.5 times, once again it is apparent that Drake provides creditors with a smaller margin of safety —that is, a higher level of risk—than the average firm in the industry. As a result, Drake is probably straining its relations with creditors. If a tight money situation developed in the economy, Drake’s high debt and low coverage ratios would most likely limit the firm’s access to new credit sources, and Drake might be forced to curtail operations or borrow on prohibitively expensive and restrictive terms. Profitability Ratios More than any other accounting measure, a firm’s profitsdemonstrate how well its management is making investment and financing decisions. If a firm is unable to provide adequate returns in the form of dividends and share price appreciation to investors, it may be unable to maintain, let alone increase, its asset base. Profitability ratios measure how effectively a firm’s management is generating profits on sales, total assets, and, most importantly, stockholders’ investment. Therefore, anyone whose economic interests are tied to the long -run survival of a firm will be interested in profitability ratios. There are several types of profitability ratios, including the gross profit margin ratio, the net profit margin ratio, the return on investment ratio, and the return on stockholders’ equity ratio. Gross Profit Margin Ratio The gross profit margin ratio is defined as follows: Gross profit margin =Sales-Cost of sales/ Sales It measures the relative profitability of a firm’s sales after the cost of sales has been deducted, thus revealing how effectively the firm’s management is making decisions regarding pricing and the control of production costs. Drake’s gross profit margin ratio is$27,460/$112,760 = 24.4 percent, just slightly below the industry average of 25.6 percent. This percentage indicates that either Drake’s pricing policies or its production methods are not quite as effective as those of the average firm in the industry. Differences in inventory accounting methods (and, to a lesser extent, depreciation methods) used by Drake and the firms included in the industry average also influence the cost of sales and, by extension, the gross profit margin. Net Profit Margin Ratio The net profit margin ratio is defined as follows: Net profit margin = Earnings after taxes (EAT)/Sales It measures how profitable a company’s sales are after all expenses, including taxes and interest, have been deducted. Some analysts also compare an operating profit margin ratio, defined as EBIT/sales. It measures the profitability of a firm’s operations before considering the effects of financing decisions. Because the operating profit margin is computed before considering interest charges, this ratio is often more suitable for comparing the profit performance of different firms. Drake’s net profit margin ratio is$5,016/$112,760 = 4.45 percent, which is below the industry average of 5.1 percent and is interpreted to mean that the company is earning 0.65 percent less on each dollar of sales than the average firm in the industry. This percentage indicates that Drake may be having difficulty controlling either total expenses (including interest, operating expenses, and the cost of sales) or the prices of its products. In this case, the former is probably more accurate, because Drake’s financial structure contains a greater proportion of debt, resulting in more interest charges. Return on Investment (Total Assets) Ratio The return on investment ratio is defined as follows: Return on investment =Earnings after taxes (EAT)/Total assets It measures a firm’s net income in relation to the total asset investment. Drake’s return on investment ratio,$5,016/$81,890, is 6.13 percent, which is considerably below the industry average of 9.28 percent and is a direct result of the firm’s low asset management ratios and low profit margins. Some analysts also like to compute the ratio of EBIT/total assets. This measures the operating profit rate of return for a firm. An after -tax version of this ratio is earnings before interest and after tax (EBIAT) divided by total assets. These ratios are computed before interest charges and may be more suitable when comparing the operating performance of two or more firms that are financed differently. Return on Stockholders’ Equity Ratio The return on stockholders’ equity ratio is defined as follows: Return on stockholders’ equity =Earnings after taxes (EAT)/Stockholders’ equity It measures the rate of return that the firm earns on stockholders’ equity. Because only the stockholders’ equity appears in the denominator, the ratio is influenced directly by the amount of debt a firm is using to finance assets. Drake’s return on stockholders’ equity ratio is$5,016/$34,367 = 14.60 percent. Again, Drake’s ratio is below the industry average of 17.54 percent. The firm’s low asset management ratios and low profit margins result in profitability ratios inferior to the industry norms, even after the effects of debt financing (financial leverage) are considered. Market-Based Ratios The financial ratios discussed in the previous four groups are all derived from accounting income statement and balance sheet information provided by the firm. Analysts and investors are also interested in the financial market’s assessment of the performance of a firm. The market-based ratios for a firm should parallel the accounting ratios of that firm. For example, if the accounting ratios of a firm suggest that the firm has more risk than the average firm in the industry and has lower profit prospects, this information should be reflected in a lower market price of that firm’s stock. Price-to-Earnings (P/E) Ratio The price -to -earnings ratio is defined as follows: P/E =Market price per share/Current earnings per share (Some security analysts use next year’s projected earnings per share in the denominator. There is nothing wrong with this alternative definition as long as comparisons between firms are done on the same basis.) In general, the lower the firm’s risk, the higher its P/E ratio should be. In addition, the better the growth prospects of its earnings, the greater is the P/E multiple. For example, Dell Computer had a P/E ratio of 48.0 in 1999, supported by strong earnings growth and dominant market positions. In contrast, Apple Computer, with relatively weak earnings and facing the risk of intense competition, had a P/E ratio of only 17 times in 1999. Drake’s current (2006) earnings per share are$3.86 (earnings of $5,016 divided by 1,300 shares). If Drake’s current market price is$24 per share, its P/E ratio is 6.22 times. This is below the industry average of 8.0 times, and indicates that Drake has either higher risk than the average firm, lower growth prospects, or both.

As a supplement to the price-to-earnings ratio, financial analysts sometimes also examine a firm’s stock price to free cash flow ratio. Free cash flow represents the portion of a firm’s total cash flow available to service additional debt, to pay common stock dividends, and to invest in other projects (e.g., capital expenditures and/or acquisition of other companies).

Free cash flow is often viewed as a better measure than earnings of the financial soundness of a firm. Earnings data can sometimes be misleading because accounting rules give companies discretion in such areas as the recognition of revenues that have not been received and the allocation of costs over different time periods.13 For example, Integrated Resources and Todd Shipyards had good earnings but had negative cash flow and were forced to file for bankruptcy.

Market Price-to-Book Value(P/BV) Ratio

The market-to-book ratio is defined as follows:

P/BV = Market price per share/Book value per share

Generally, the higher the rate of return a firm is earning on its common equity relative to the return required by investors (the cost of common equity), the higher will be the P/BV ratio. The book value per share of common stock is determined by dividing the total common stockholders’ equity for a firm by the number of shares outstanding. In the case of Drake at year -end 2006, the book value per share is equal to $26.44 (stockholders’ equity of$34,367 divided by 1,300 shares outstanding).

With a market price per share of $24, the market-tobook ratio for Drake is 0.91. This compares unfavorably with the industry average of 1.13. It should be noted that, because the market -to-book ratio contains the book value of the common stockholders’ equity in the denominator (remember that common stockholders’ equity is equal to total assets minus total liabilities), it is affected by the accounting treatments used by a firm in such crucial areas as inventory valuation and depreciation. For this reason, comparisons between firms can often be misleading. Dividend Policy Ratios The two primary dividend policy ratios, the payout ratio and the dividend yield, give insights regarding a firm’s dividend strategies and its future growth prospects. Payout Ratio The payout ratio indicates the percentage of a firm’s earnings that are paid out as dividends. It is defined as: Payout ratio = Dividends per share/Earnings per share In the case of Drake, the payout ratio is equal to 55.7 percent ($2.15 annual 2006 dividends ÷ $3.86 annual 2006 earnings per share). companies are extremely reluctant to cut their dividends because of the negative signal such an action transmits to the financial marketplace. Accordingly, companies with stable earnings are more likely to pay out a greater proportion of their earnings as dividends than are companies with more volatile earnings. Also, companies with a large, continuing number of high-return investment projects are less likely to pay out a high proportion of earnings as dividends because of their need for the capital to finance these projects. Dividend Yield A stock’s dividend yield is the expected yearly dividend divided by the current stock price, or: Dividend yield =Expected dividend per share / Stock price The current dividend yield for Drake is 8.96 percent ($2.15 dividend divided by the \$24 stock price). The returns received by an investor in common stock are the sum of the dividend yield and expected growth in the company’s earnings, dividends, and ultimately its stock price. Stocks with a low dividend yield often indicate high expected future growth.

High dividend yields, such as are common for utility companies, are frequently indicators of low future growth prospects. Very high dividend yields often signal a company facing financial difficulty that the market expects to be accompanied by future cuts in the dividend amount.