Cash Conversion Cycle

Cash Conversion Cycle
Cash 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 by days sales outstanding (DSO) and the
number of days it takes to sell inventories is measured by days 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:
Formula
Cash Conversion Cycle = DSO + DIO DPO
Where,
DSO is days sales outstanding = Average Accounts Receivable 365
Credit
Sales
DIO is days inventory outstanding = Average Inventories 365 Cost of

Goods
Sold
DPO is days payables outstanding = Average Accounts Payable 365 Cost

of Goods Sold
Alternatively, it can also be calculated using the following formula if we know
the operating cycle:
Cash conversion cycle = operating cycle DPO
The 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.
Analysis
Cash 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.
Example
Calculate 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):
2012
2013
2014
Days Sales Outstanding
52.51
52.46
48.65
Days Inventory
27.27
26.12
26.81
Days Payables Outstanding
55.51
57.82
64.37
19.01
25.66
30.51
Days Inventory
3.26
4.37
6.3
Days Payables Outstanding
74.39
74.54
85.45
HPQ
AAPL
Solution
Cash conversion cycle for HPQ for 2012 = 52.51 + 27.27 55.51 = 24.27
The following table shows cash conversion cycle for both companies for the
three years.
2012
2013
2014
HPQ
24.27
20.76
11.09
AAPL
-52.12
-44.51
-48.64
AAPL has negative cash conversion cycle of 44 to 52 days during the threeyear
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 Cycle

The 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.
Formula
The 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.
Analysis
The 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 the cash from 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.
Example
Tim'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 high inventory turnover
ratio for 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 days
DSO represents days sales outstanding: 2 days
DPO represents days payable outstanding: 12 days
Tim'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 Ratio
The 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 the current
ratio or quick 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.
Formula
The 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 that GAAP considers them an
equivalent.
Current liabilities are always shown separately from long-term liabilities on

the face of the balance sheet.
Analysis
The 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 of cash and
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.
Example
Sophie'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: $10,000
Cash Equivalents: $2,000
Accounts Payable: $5,000
Current Taxes Payable: $1,000
Current Long-term Liabilities: $10,000

Sophie'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 Inventory
The 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.
Formula
The 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 ratio
Days inventory usually focuses on ending inventory whereas inventory
turnover focuses on average inventory.
Analysis
The days sales in 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.
Example
Keith'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.
The 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.
Formula
The 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-end balance sheet. Credit

sales, however, are rarely reported separate from gross sales on the income
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 ratio
Analysis
The days sales outstanding formula shows investors and creditors how well
companies' can collect cash from their customers. Obviously, sales don'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 as bad
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.
Example
Devin'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: $15,000
Net Credit Sales: $175,000
Devin'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 Ratio
Debt ratio is a solvency ratio that 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 the financial leverage of 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.
Formula
The debt ratio is calculated by dividing total liabilities by total assets. Both of
these numbers can easily be found the balance 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.
Analysis
The 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.
Example
Dave'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
overall debt levels.
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 Ratio
The 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 the debt 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.
Formula
The 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 the income 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 of financial
statements. Many times this is mentioned in the financial statement notes,
however.
Analysis
The 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.
Example
Burton'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 Analysis
The Dupont analysis also called the Dupont model is a financial ratio based
on the return 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 Margin
Total Asset Turnover
Financial Leverage
Based 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.
Formula
The 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.
Analysis
This model was developed to analyze ROE and the effects different business
performance measures have on this ratio. 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.
Example
Let'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:
Ratio
Sally
Joe
Profit Margin
30%
15%
Total Asset Turnover
.50
6.0
Financial Leverage
3.0
.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. Investors can then apply perceived risks with each company's
business model.
Equity Multiplier
The equity multiplier is a financial leverage ratio that 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 all liquidity ratios and 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 how leveraged a
company is.
Formula
The 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.

Analysis
The equity multiplier is a ratio used to analyze a company's debt
and equity financing 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 the DuPont analysis to illustrate how
leverage affects a firm's return on equity. Higher multiplier ratios tend to
deliver higher returns on equity according to the DuPont analysis.
Example
Tom'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's financial statements, he has
$1,000,000 of total assets and $900,000 of total equity. 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 Ratio
The equity ratio is an investment leverage or solvency ratio that 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.
Formula
The 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 the balance sheet are
included in the equity ratio calculation.
Analysis
In 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
higher equity ratios 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 and benchmarks.
Example
Tim'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 totalequity is $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 Ratio

The fixed charge coverage ratio is a financial that 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 the times interest earned ratio or 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.
Formula
The 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 of fixed costs can be used in this formula. This
coverage ratio is not limited to only one cost.
Analysis
The 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 a solvency ratio because 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.
Example
Quinn'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 a profitability ratio that 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.
Formula
Gross 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:
Analysis
Gross 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 big purchase discount when they
buy their inventory from the manufacturer or 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. Here is another great explaination.
Example
Assume 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 Ratio

The 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.
Formula
The 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 the income statement before 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 or revenues.
The revenue number used in the calculation is just the total, top-line revenue
or net sales for the year.
Analysis
The 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.
Example
If Christie's Jewelry Store sells custom jewelry to celebrities all over the
country. Christie reports the follow numbers on her financial statements:
Net Sales:
$1,000,000
Cost of Goods Sold:
$500,000
Rent:
$15,000
Wages:
$100,000
Other
Expenses:
Operating
$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 ratio is a helpful comparison.
Accounts Payable Turnover Ratio

The 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.
Formula
The 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 any general
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
average payables is
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.
Analysis
Since 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.
Example
Bob'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's balance 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 Ratio
The 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.
Formula
The 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 income equals total revenues minus total expenses and is usually
the last number reported on the income statement.
Analysis
The 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 additional revenues is 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.
Example
Trisha'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 Rate
The 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 the dividend payout
ratio because 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.
Formula
The retention rate is calculated by subtracting the dividends distributed
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.
Analysis
Since 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.
Example
Ted'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 Ratio
The 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.
Formula
The 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 the income 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.
Analysis
The 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 total interest expense 4 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.
Example
Tim'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 Ratio
The working capital ratio, also called the current ratio, is a liquidity ratio that
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.
Formula
The 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 the balance 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.
Analysis
Since 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
positive working capital.
Example
Since 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 WCR
Current assets decrease= decrease in WCR
Current liabilities increase = decrease in WCR
Current liabilities decrease = increase in WCR
Let'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 - CAGR
Compound 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.
Formula
CAGR 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.
Example
Some 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
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.
Analysis
The 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.
EBITDA
EBITDA, which stands for earnings before interest, taxes, depreciation, and
amortization,
is
financial
calculation
that
measures
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.
Formula
The 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.
Analysis
So 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 a financial 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.
Margin
The 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.
Example
Lets 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: $25,000
Rent: $10,000
Utilities: $4,000
Cost of Goods Sold: $35,000
Interest: $5,000
Depreciation: $15,000
Taxes: $3,000
Jakes net income at the end of the year equals $3,000. Jakes EBITDA is
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 - IRR
Internal 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 the net 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 percentage return is 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 than break even, they consider this the
minimum acceptable return on an investment.
Formula
The 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 the discount rate that will
make the NPV equal to zero.
Example
It 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 estimated internal 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.
Analysis
Remember, 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 - ROI
Return on investment or ROI is aprofitability ratio that 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.
Formula
The 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 and cost of goods sold as
the revenues and 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.
Example
Now 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, the fair market value of per share is $3.50. Keith sells
the share and 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.
Analysis
Generally, 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 Margin
Gross 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 of raw materials anddirect 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 the income
statement in one form or another. Lets take a look at how to calculate gross
profit and what its used for.
Formula
The 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.
Example
Monica 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: $1,000,000
COGS: $350,000
Rent: $100,000
Utilities: $10,000
Office expenses: $2,500
Monica 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 of COGS from 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.
Analysis
The 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 Value
Enterprise 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 account other balance sheet items like 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.
Formula
The 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.
Example
Lets 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: $50,000
Inventory: $15,000
Liabilities: $25,000
Common Stock: $75,000
Retained 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.
Analysis
As 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 many moving parts and each section of balance sheet should be
examined in the estimated purchase price.
Weighted Average Cost of Capital - WACC
The weighted average cost of capital, also called the WACC, is afinancial
ratio that 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.
Formula
The 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 equity

Rd = the cost of debt
E = the market value of the companys equity

D = the market value of the companys debt
V = the total market value of the companys combined debt and equity or E
+D
E/V = percentage of total financing consisting of equity
D/V = percentage of total financing consisting of debt
Tc = the corporate income tax rate
Calculator
Now 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?
Analysis
To 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
incurring opportunity costs.
Example
Lets 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 Income
Residual 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.
Personal
Personal 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
that he can put into savings or use to purchase new assets.
This is an important concept in personal finance because banks typically use

this calculation to measure the affordability of a loan. In other words, does
Jim make enough money to pay his existing bills and an additional loan
payment? If Jims RI is high, his loan application will have a greater chance of
being approved. If his RI is low, he will probably get rejected for the loan
immediately.
Many people in the investment world also define residual income as revenue
stemming from a passive source. This revenue is created without a direct
input of effort or time. The investment itself creates addition revenues
without having to be managed. Some examples include royalties, dividends,
interest, and rent. Take a dividend stock for example. Once the money is
invested once, it will keep producing a dividend every year without having to
input additional time or resources. This concept is the Holy Grail for most
investors.
Those first two examples deal more with personal finance than business
finance. Lets look at a business residual income definition.
Business
Managerial accountants define residual income as the amount of operating
revenues left over from a department or investment center after the cost of
capital used to generate the revenues have been paid. In other words, its
the net operating income of a department or investment center. You can also
think of it as the amount that a departments profits exceed its minimum
required return.
Lets take a look at how its calculated.
Formula
The residual income formula is calculated by subtracting the product of the

minimum
required
return
on
capital
and
the
average
cost
of
the
departments capital from the departments operating income.
This equation is pretty simple and incredible useful for management because
it looks at one of a departments key components of success: its required
rate of return. This component helps management evaluate whether the
department is making enough money to maintain, close, or expand its
operation. Its essentially an opportunity costmeasurement based on the
trade off of investing in capital in one department over the other. For
instance, if management can invest company revenues in department A and
earn a 15% return, department B would have to make at least 15% in order
for the management to consider the investment. If department B doesnt
meet minimum 15% return rate, it might be shut down or redirected.
The residual income business calculation allows management to easily
identify whether an investment center is meeting its minimums. If the RI
positive, the department is making more than its minimum. If the RI is
negative, on the other hand, the department is not meeting its minimums.
Many times management also uses the residual income measurement in
conjunction with the return on investment ratio.
Lets take a look at a business accounting example.
Example
Lets
use
Jim
from
our
personal
finance
example.
Jims
furniture
manufacturer builds tables and has several large pieces of equipment in the
sawmill used to re-saw logs and boards down to the finished dimensions. The
sawmill has net operating revenues of $100,000 for year. The saws in the
mill cost Jim a total of $500,000 and he is currently earning a return of 10%
in his wholesale table business. Thus, he sets a minimum required return of
10 percent.
Lets compute Jims RI.
As you can see, Jim has $50,000 of net operating income left over after the
cost of capital was paid. This means Jims mill is making more than the
minimum 10 percent required and way more than the wholesale business.
Jim is better off investing in the milling and sawing operations than
increasing the wholesale business.
Jim can also use the $50,000 of residual income to fund other capital
expansions, repay lenders, or pay investors dividends.
Rule of 72
The rule of 72 is a mathematical way to estimate the number of years it will
take for your money to double with compounding interest. In other words, its
a simplified method to figure out how long your money has to be invested in
order to double at a given interest rate.
Investors often use this calculation when evaluating the difference between
similar investments. They want to see their investments grow, so they can
take the proceeds to invest in more opportunities in the future. Keep in mind
that this doesnt have to be Wall Street investors or brokers.
Average Americans can use this method to estimate the amount of money
they will have in a retirement account or how much their share in a mutual
fund will be worth in five years. The rule 72 will calculate how long it takes to
double your money in an investment. In other words, its a simplified, very
limited future value calculator that will compute the value of your investment
in the future.
This formula is a great shortcut because the full-length investment equation
for compounding interest is long and complicated. You can use this simple
rule of thumb as a base estimate for investments. Heres how it works.
Formula
The rule of 72 formula is calculated by multiplying the investment interest
rate by the number of years invested with the product always equal to 72.
Applying a little bit of algebra we can rearrange the rule of 72 equation to

calculate the number of years required to double your money with a given
interest rate compounded annually.
Or it can be written like this to calculate the annual compounded interest

rate required to double your investment in a given time period.
Keep in mind that the rule of 72 definition requires that the interest be
compounded annually. This method will not work for investments with semiannual or quarterly compounded interest as is. If you want to use this
method for investment returns like that, you will need to modify it.
Lets take a look at an example.
Example
Heres an example table of the way a rule of 72 calculator works. As you can
see, the first column represents the annual rate of investment that will be
compounded at the end of every year. The second column shows the number
of years it will take for the investment to double in value. The third column is
always 72 because thats how the formula works. The investment rate
multiplied by the number years is always equal to seventy-two.
Lets assume you have $10,000 to invest in a mutual fund and you want to
know how long it will take to become $20,000. You are positive that you can
get an average return of 8 percent each year. Looking at our table above, we
can see that it will take your investment about 9 years to reach the $20,000
goal.
We can also do the reverse calculation. Lets assume you have $10,000 and
you want to know what annually compounded interest rate you will need to
double your money in 5 years. Going back to our table, you can see it will
require an interest rate of a little over 14 percent to meet your $20,000 goal
in a 5-year span.
Obviously, we could have used the equation to calculate each of these
examples, but I figured the table would be easier. We can also use a future
value calculator or the actual future value formula to verify that these
numbers are accurate, but we dont have to. This method works. Its a great
shortcut because allows you to easily estimate the value of your investment
into the future without the technical details of the actual future value
equation. Depending on the interest rate, you can probably do the
calculations in your head.
One thing to keep in mind is that this method does not take into
consideration other future factors that could derail your investment plans.
For instance, inflation rates might change over the course of your
investments life. You can however use the rule of 72 to calculate the effects
of inflation on your money. For example, if the inflation rate went from 3
percent to 4 percent, your money will lose half of its value in 18 years
instead of 24 years.
You can even compare the rise of current costs like tuition and medical
expenses with the rate of interest. This is pretty could. Test it out for yourself.
You can use it for all kinds of interesting future value calculations.
Marginal Revenue
Margin revenue is a ratio that calculates the change in overall income
resulting from the sale of one additional product or unit. You can think of it
like the additional money collected or income earned from the last unit sold.
This is a microeconomic term, but it also has many financial and managerial
accounting applications.
Management uses marginal revenue to analyze consumer demand, set
product prices, and plan production schedules. Understand these three key
concepts is crucial for any manufacturer. Misjudging customer demand can
lead to product shortages resulting in lost sales or it can lead to production
overages resulting in excess manufacturing costs.
Setting the pricing structure of a product is one way to change the demand
level of the product and influence the production schedules. For instance,
raising the price of the product will typically reduce the demand and the
need for manufacturing. An increased price might however result in more
profits and ability to innovate manufacturing in the future. It might, on the
other hand, encourage consumers to purchase products from competitors
instead and the company will lose even more sales. Management considers
all of these scenarios when analyzing the MR.
Lets take a look at how to calculate marginal revenue and some other uses
for this metric.
Formula
The marginal revenue formula is calculated by dividing the change in total
revenue by the change in quantity sold.
To calculate the change in revenue, we simply subtract the revenue figure

before the last unit was sold from the total revenue after the last unit was
sold.
You can use the marginal revenue equation to measure the change in any
production level, but its typically used to measure the change in producing
one additional unit. Thus, the denominator is typically one. Lets expand on
this more with an example.
Example
Jans Machining is a manufacturer of office supplies. Jan is currently focused
on the upcoming production run of specialty pencils and is using the margin
revenue curve to figure out how much to produce and set the sales price. Jan
operates in an industry with several limited competitors and a set demand.
Jan figures that she can produce 100 pencils and sell them for $150 each
resulting in $15,000 of revenues. Continuing with her analysis, Jan estimates
that she will need to drop the price from $150 a pencil to $149 a pencil if she
produces more than 2,000 units. Heres how to find marginal revenue if Jan
produced one extra unit.
Since Jan had to drop her price $1 in order to produce and sell an extra unit,
her revenue per unit went down, but her total revenues went up. Thus, Jans
marginal revenue for this product is $49. We calculated that by multiplying
the new production amount (2,001 units) by the new price ($149) and
subtracting the original revenue number (2,000 units x $150 = $15,000).
This example can be expanded into different products, quantities, and
industries, but we will keep it simple for now.
Margin Analysis
As you can see from our example, the marginal revenue definition is a pretty
simply concept. It does, however, have a huge influence over product pricing
and production levels based on the manufacturers industry and product.
For instance, in a truly competitive market place where manufacturers are
selling mass-produced, homogenous products at the market price, the
marginal revenue is equal to the market price. In other words, manufacturers
of commodities with little differentiation will always sell their products at the
market price because its a competitive market place. If they raise their
prices, consumers will buy from one of their competitors. You can think this
as a farmer who sells corn. The market sets the corn price each year. If he
charges more than the market, consumers will purchase corn from his
competitors because there is no difference between his product and theirs.
The opposite is true in a low output or highly specialized industry. Since there
are fewer product alternatives available, the production level of the company
affects the selling price. In other words, less supply will increase demand and
increase the willingness of consumers to pay higher prices. The company
obviously has to keep the marginal revenue product inside the constraints of
the price elasticity curve, but they can adjust their output and pricing
structure to optimize their profitability.
Return on Sales - ROS
Return on sales, often called the operating profit margin, is a financial ratio
that calculates how efficiently a company is at generating profits from its
revenue. In other words, it measures a companys performance by analyzing
what percentage of total company revenues are actually converted into
company profits.
Investors and creditors are interested in this efficiency ratio because it shows
the percentage of money that the company actually makes on its revenues
during a period. They can use this calculation to compare company
performance from one period to the next or compare two different sized
companies performance for a given period.
These attributes make this equation extremely useful for investors because
they can analyze the current performance trends of a business as well as
compare them with other companies in the industry no matter the size. In
other words, a Fortune 500 company could be compared with a regional firm
to see which is able to operate more efficiently and turn revenue dollars into
profit dollars without regard to non-operating activities.
Lets take a look at how to calculate the return on sales ratio.
Formula
The return on sales formula is calculated by dividing the operating profit by

the net sales for the period.
Keep in mind that the equation does not take into account non-operating
activities like taxes and financing structure. For example, income tax
expense and interest expense are not included in the equation because they
are not considered operating expenses. This lets investors and creditors
understand the core operations of the business and focus on whether the
main operations are profitable or not.
Analysis
Since the return on sales equation measures the percentage of sales that are
converted to income, it shows how well the company is producing its core
products or services and how well the management teams is running it.
You can think of ROS as both an efficiency and profitability ratio because it is
an indicator of both metrics. It measures how efficiently a company uses its
resources to convert sales into profits. For instance, a company that
generates $1,000,000 in net sales and requires $900,000 of resources to do
so is not nearly as efficient as a company that can generate the same about
of revenues by only using $500,000 of operating expenses. The more
efficient management is a cutting expenses, the higher the ratio.
It also measures the profitability of a companys operating. As revenues and
efficiency increases, so do profits. Investors tend to use this iteration of the
formula to calculate growth projects and forecasts. For example, based on a
certain percentage, investors could calculate the potential profits if revenues

doubled or tripled.
Lets take a look at an example.
Example
Assume Jims Bowling Alley generates $500,000 of business each year and
shows operating profit of $100,000 before any taxes or interest expenses are
accounted for. Jim would calculate his ROS ratio like this:
As we can see, Jim converts 20 percent of his sales into profits. In other
words, Jim spends 80 percent of the money he collects from customers to run
the business. If Jim wants to increase his net operating income, he can either
focus on reducing expenses or increasing revenues.
If Jim can reduce these expenses while maintaining his revenues, his
company will be more efficient and as a result will be more profitable.
Sometimes, however, it isnt possible to reduce expenses lower than a
certain amount. In this case, Jim should strive for higher revenue numbers
while keeping the expenses the same. Both of these strategies will help
make Jims Bowling Alley more successful.
Operating Income
Operating income, often referred to as EBIT or earnings before interest and
taxes, is a profitability formula that calculates a companys profits derived
from operations. In other words, it measures the amount of money a
company makes from its core business activities not including other income
expenses not directly related to the core activities of the business.
Typically a multi-step income statement lists this calculation at the end of the
operating section as income from operations. This section always is
presented before the non-operating and income tax sections to compute net
income.
This is an important concept because it gives investors and creditors an idea
of how well the core business activities are doing. It separates the operating
and non-operating revenues and expenses to give external users a clear
picture of how the company makes money.
Keep in mind that just because a business shows a profit on the bottom line
for the year doesnt mean the business is healthy. It could actually mean the
opposite.
For
instance, a
business
might
be
losing
customers
and
downsizing. As a result, they are liquidating their equipment and realizing

huge gains. The core activities are losing money, but equipment sales are
making money. This business is clearly not healthy.
Investors and creditors can use this section to evaluate how well the
company is doing as well as forecast future performance.
Lets take a look at how to calculate operating income.
Formula
The operating income formula is calculated by subtracting operating
expenses, depreciation, and amortization from gross income.
As you can see, there are a few different components. Lets take a look at
each one of them. Gross income, also called gross profit, is calculated by
subtracting the cost of goods sold from the net sales. You can think of this
like the amount of money the company has left to fund its operating
expenses after all cost associated with producing the products have been
paid.
Operating expenses typically include all of the costs associated with running
the core business activities. Here are a few examples:
Rent
Utilities
Insurance
Wages
Commissions
Freight and Postage
Supplies expense
Depreciation and amortization are often included in this list and always used
in the operating income equation. Lets take a look at an example.
Example
Bills Sandwich Shop makes some of the best subs and grinders in the
Philadelphia area. Bill is working on refinancing his current loans with a new
bank, so he has to prepare a multiple step income statement with a detailed
operating section.
Thus, Bill analyzes his accounting system and discovers that he sold
$200,000 of subs during the year and had the following expenses.
Cost of goods sold: $35,000
Rent: $12,000
Utilities: $5,000
Wages: $50,000
Insurance: $10,000
Bill also got into a car accident and totaled his delivery truck during the year.
Unfortunately, the insurance company wouldnt cover the damages and Bill
had to report a loss from the vehicle of $50,000. Bill would compute his
operating income like this:
As you can see, Bill simply subtracts all of the expenses associated with the
operations of the business from the net revenues leaving him with an
$88,000 profit from operations. Notice that the $50,000 loss from the car
accident is not included. This loss is a non-operating activity. Thus, it
reported after the income from operations.
Analysis
Investors, creditors, and company management use this measurement to
evaluate the efficiency, profitability, and overall health of a company.
Remember, the operating income definition states that it measures the
profits
from
the
core
business
activities
without
taking
into
account extraordinary items. The higher the operating income, the more
likely the company will be profitable and able to pay off its debt.
Investors and creditors also follow this number very closely because it gives
them an idea of the future scalability of the company. For instance, a positive
trending operating profit can indicate that there is more room for the
company to grow in the industry. A sinking number indicates the opposite.
Management is well aware of this fact and can try to fraudulently change the
ratio by accelerating revenue recognition or delaying the recognition of
expenses. Both of these tactics are against GAAP.
Going back to your example, investors and creditors acknowledge the fact
that Bill has a large loss from his truck, but that doesnt impact his extremely
profitable business activities selling sandwiches.
Net Operating Income - NOI
Net operating income is a profitability formula that is often used in real
estate to measure a commercial propertys profit potential and financial
health by calculating the income after operating expenses are deducted. In
other words, it measures the amount of cash flows that a property has after
all necessary expenses have been paid.
Real estate investors and creditors use this calculation to evaluate the cash
flows of a specific property and determine whether it is a good investment or
creditworthy. They also use this ratio to formulate an initial value of the
property. For example, they look at how much money the property can
generate after all of the operating expenses have been paid in order to
decide how valuable it is and what price they are willing to pay for it.
Since there are many different ways a piece of property can generate
income, investors and creditors need to include all revenues in their
evaluation. For example, a rental property can generate cash from renting
apartments, charging parking fees, servicing vending machines, or operating
laundry machining. All of these activitiescontribute to the cash flows of the
property and necessary expenses.
This concept isnt exclusive to real estate. Other industries refer to this
calculation as EBIT or earnings before interest and taxes and use it to base
investment decisions on as well.
Lets take a look at how to calculate net operating income.
Formula
The net operating income formula is calculated by subtracting operating
expenses from total revenues of a property.
As I mentioned earlier, revenues include more than just rental income. This
includes all revenues from a piece of real estate. Here are the most common
examples of revenue sources:
Rental income
Parking fees
Service charges
Vending machines
Laundry machines
The operating expenses in the NOI formula consist of all necessary expenses
associated with the revenue generating activities. In other words, these are
all the expenses required to maintain the property and run the rental
business. Here are a few examples:
Property management fees
Insurance
Utilities
Property taxes
Repairs and maintenance
Keep in mind that there are several different expenses that are not included
in this category like income taxes and interest expense.
As you can see, the net operating income equation is pretty simple, so lets
take a look at a real estate example.
Example
Marcia owns a real estate business that purchases existing rental properties
and potential rental properties. She is constantly looking for new real estate
to invest in that she can either improve or run more efficiently than the
current owners. Today she is evaluating two small apartment buildings that
show the following items on theirannual income statement.
Apartment #1
Rental income: $100,000
Property management fees: $20,000
Property taxes: $15,000
Repairs: $20,000
Insurance: $10,000
Apartment #2
Rental income: $50,000
Property management fees: $1,000
Property taxes: $1,000

Repairs: $1,000
Insurance: $2,000
Marcia uses the NOI equation to evaluate if either or these buildings is worth
purchasing and judge which apartment complex is a better investment.
Heres how she would calculate it.
As you can see, the first apartment generates more gross revenues during
the year, but it also has more expenses than the second building. Thus, the
second building actually has a higher NOI than the first option. You might
assume its a better investment than the first, but there are other things we
need to consider.
Analysis
Theres a lot more that goes into evaluating whether a rental property is
worth investing in than this calculation, but this equation gives us good
insight into the cash flows of the properties. We need to take a look at each
of the expenses to see how future cash flows will be affected.
For example, assume the first apartment just had a new roof put on and the
$20,000 of repairs will not be there in future years. Now the first option is
much more attractive. This is an example of how this analysis can be
manipulated by management. Expenses can be frontloaded or put off to a
later date to make the property look less or more attractive to different
investors.
Thats why real estate investors always look at the overall condition of the
property and revenue potential before running this analysis.

Cash Conversion Cycle

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Cash Conversion Cycle

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Cash Conversion Cycle

Cash conversion cycle is an efficiency ratio which measures the number of

DIO is days inventory outstanding = Average Inventories 365 Cost of

DPO is days payables outstanding = Average Accounts Payable 365 Cost

Days Sales Outstanding

Days Payables Outstanding

Days Sales Outstanding

Days Payables Outstanding

Cash Conversion Cycle

Current liabilities are always shown separately from long-term liabilities on

Current Long-term Liabilities: $10,000

The days sales in inventory is a key component in a company's inventory

Accounts receivable can be found on the year-end balance sheet. Credit

Sinking Fund Obligations

Here is Burton's debt service coverage calculation:

Based on these three performances measures the model concludes that a

Since each one of these factors is a calculation in and of itself, a more

Total Asset Turnover

Sally's is generating sales while maintaining a lower cost of goods as

Both of these accounts are easily found on the balance sheet.

shareholders shows potential shareholders that the company is worth

investing in since so many investors are willing to finance the company. A

Fixed Charge Coverage Ratio

The gross margin of a business is calculated by subtracting cost of goods

Operating Margin Ratio

Operating income, also called income from operations, is usually stated

Cost of Goods Sold:

Here is how Christie would calculate her operating margin.

Accounts Payable Turnover Ratio

Net sales is calculated by subtracting any returns or refunds from gross

The times interest earned ratio is calculated by dividing income before

Both of these figures can be found on the income statement. Interest

Tim's Tile Service is a construction company that is currently applying for a

management can use to make future financial decisions.

CAGR formula is calculated by first dividing the ending value of the

profitability before deductions that are often considered irrelevant in the

coverage ratio to compare big companies that either have significant

This is not a financial ratio. Instead, its a calculation of profitability that is

investment. Instead, well look at the basic idea of recognizing profits as a

simplistic earnings portion of the formula is usually altered with a present

Monica is currently achieving a 65 percent GP on her clothes. This means

Traditionally, the market capitalization method is used to compute the value

reflects the retained earnings of the company. In other words, profitable

Re = the cost of equity

E = the market value of the companys equity

This is an important concept in personal finance because banks typically use

The residual income formula is calculated by subtracting the product of the

departments capital from the departments operating income.

Applying a little bit of algebra we can rearrange the rule of 72 equation to

Or it can be written like this to calculate the annual compounded interest

To calculate the change in revenue, we simply subtract the revenue figure

The return on sales formula is calculated by dividing the operating profit by

certain percentage, investors could calculate the potential profits if revenues

downsizing. As a result, they are liquidating their equipment and realizing

Property taxes: $1,000

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