ratios formulas in excel sheet

7/28/2019 Ratios Formulas in Excel Sheet

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Copyright, 2010, Jaxworks, All Rights Reserved.

Since 1996, JaxWorks has offered a suite ofFree Excel workbooks and spreadsheets, and associated MS Word, PDF and HTMLdocuments, that cover a number of financial, accounting and sales functions. These are invaluable small business tools.

Also included Free are:

- business plan tools, including spreadsheets and excellent instructions- Excel functions glossary and guide;- free training courses for most Microsoft Office applications. These guides are in PDF format and rival commercial books!- comprehensive list of acronyms, ratios and formulas in customer financial analysis, and financial terms;- suite of online calculators, including, breakeven analysis, productivity analysis, business evaluation;- Altman Z-Score (covering publicly and privately held f irms, and small businesses);- and payroll analysis.

If you are involved in financial analysis at any level, or want to learn more about MS Excel and other applications in the Of fice suite thissite is invaluable.
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2/18

Ratios Introduction

Income Statement

Balance Sheet

Earnings Per Share

Quick Ratio

Average Collection Period

Inventory Turnover

Debt Ratio

Equity Ratio

Times Interest Earned

Current Ratio

Instructions Return on Equity

Net Profit Margin

Return on Assets

Gross Profit Margin

Copyright, 2010, Jaxworks, All Rights Reserved.


3/18

InstructionsPlease Read This Page Carefully

Data Entry

The "Income Statement" and "Balance Sheet" are your two data entry worksheets.

Navigation:

1. The "Index Worksheet" is your transportation page. All pages have a return button to i t.

Additional Instructions:

1. Look for the red corner triangles for additional instructions on the worksheets. For example:>>>>

Printing:

1. Be sure to "Print Preview" before printing a page. All pages are setup to print.

2. You may print multiple pages by holding down the CONTROL-KEY and clicking on individual TABS or

Right click on a tab and "select all sheets".


4/18

Ratios Introduction

This workbook produces 12 important financial ratios. These ratios are usually though

four basic categories: profitability ratios, liquidity ratios, activity ratios, and leverage ra

Category RatioProfitability ratios Earnings Per Share

Gross Profit MarginNet Profit MarginReturn on AssetsReturn on Equity

Liquidity ratios Current RatioQuick Ratio

Activity ratios Average Collection PeriodInventory Turnover

Leverage ratios Debt RatioEquity RatioTimes Interest Earned

This is by no means an exhaustive list of the ratios that have been developed to help financial position and the way that it conducts business. It is, however, representative

Analyzing Profitability Ratios

If you are considering investing money in a company, its profitability is a major concerintends to pay dividends to its stockholders, those dividends must come out of its profhopes to increase its worth in the marketplace by enhancing or expanding its product source of capital to make improvements is its profit margin. There are several differenof evaluating a company's profitability.

Analyzing Liquidity Ratios

The issue of liquidity, as you might expect, concerns creditors. Liquidity is a companydebts as they come due. A company may have considerable total assets, but if those convert to cash it is possible that the company might be unable to pay its creditors in a

Creditors want their loans to be paid in the medium of cash, not in a medium such as equipment.

Analyzing Activity Ratios

There are various ratios that can give you insight into how well a company manages itactivities. One primary goal-perhaps, the primary goal-of these activities is to produceeffective use of its resources. Two ways to measure this effectiveness are the Averagand the Inventory Turnover rate.

Analyzing Leverage Ratios

The term "leverage" means the purchase of assets with borrowed money. Suppose thretails office supplies. When you receive an order for business cards, you pay one of ypercent of the revenue to print them for you. This is a variable cost: the more you sell,

But if you purchase the necessary printing equipment, you could make the business cdoing would turn a variable cost into a fixed cost: no matter how many cards you sell, them is fixed at however much you paid for the printing equipment. The more cards yoyour profit margin. This effect is termed operating leverage.

If you borrow money to acquire the printing equipment, you are using another type of financial leverage. The cost is still f ixed at however much money you must pay, at regthe loan. Again, the more cards you sell, the greater your profit margin. But if you do nto cover the loan payment, you could lose money. In that case, it might be difficult to fmake the loan payments or to cover your other expenses. Your credit rating might fallfor you to borrow other money.

Leverage is a financial tool that accelerates changes in income, both positive and negcreditors and investors are interested in how much leverage has been used to acquirestandpoint of creditors, a high degree of leverage represents risk because the comparepay a loan. From the investors' standpoint, if the return on assets is less than the coto acquire assets, then the investment is unattractive. The investor could obtain a bett

ways-one way would be to loan funds rather than to invest them in the company.

SummaryThis workbook has some of the financial ratios that are important to understanding ho


5/18

F o r ec as t ed To t al

1ST QTR 2ND QTR 3RD QTR 4TH QTR 1999

Sales

Sales $2,000,000 $1,500,000 $1,300,000 $2,010,100 $6,810,100

Cost of sales $945,000 $865,000 $833,000 $946,616 $3,589,616

Gross profit $1,055,000 $635,000 $467,000 $1,063,484 $3,220,484

Expenses

Operating expenses $424,000 $318,000 $275,600 $426,141 $1,443,741

Interest $16,250 $16,250 $16,250 $16,250 $65,000

Depreciation $32,500 $33,958 $33,958 $33,958 $134,374

Amortization $1,250 $1,250 $1,250 $1,250 $5,000Total expenses $474,000 $369,458 $327,058 $477,599 $1,648,115

Operating income $581,000 $265,542 $139,942 $585,885 $1,572,369

Other income and expenses

Gain (loss) on sale of assets $100,000 $10,000 $3,000 $405,700 $518,700

Other (net) $20,000 $50,000 $100,000 $200,000 $370,000

Subtotal $120,000 $60,000 $103,000 $605,700 $888,700

Income before tax $701,000 $325,542 $242,942 $1,191,585 $2,461,069

Please enter a tax percentage

Taxes @ 30% $210,300 $97,663 $72,883 $357,475 $738,321

Net income $490,700 $227,879 $170,059 $834,109 $1,722,748

Detailed Supporting Information

Cost of sales

Direct labor $320,000 $240,000 $208,000 $321,616 $1,089,616

Materials $500,000 $500,000 $500,000 $500,000 $2,000,000

Other costs $125,000 $125,000 $125,000 $125,000 $500,000

ANNUAL I NCOME STATEMENT

COMPANY NAMECompany AddressCity, State ZIP CodePhone Number fax Fax Number

Copyright, 2010, JaxWorks, All Rights Reserved.


6/18

A c t u al Fo r ec as t

2002 1ST QTR 2ND QTR 3RD QTR 4TH QTR

ASSETS

Current Assets

Cash and cash equivalents $451,000 $90,360 $229,233 $469,196 ($945,586)

Accounts receivable $350,000 $657,534 $493,151 $427,397 $660,855

Inventory $400,000 $630,411 $590,959 $575,178 $1,186,002

Other current assets $10,000 $60,000 $45,090 $76,320 $50,000

Total Current Assets $1,211,000 $1,438,305 $1,358,433 $1,548,091 $951,271

Fixed Assets

Land $100,000 $112,500 $125,000 $137,500 $150,000

Buildings $1,500,000 $1,450,000 $1,450,000 $1,450,000 $1,450,000

Equipment $800,000 $875,000 $875,000 $875,000 $875,000

Subtotal $2,400,000 $2,437,500 $2,450,000 $2,462,500 $2,475,000

Less-accumulated depreciation $400,000 $432,500 $466,458 $500,416 $534,374

Total Fixed Assets $2,000,000 $2,005,000 $1,983,542 $1,962,084 $1,940,626

Intangible Assets

Cost $50,000 $50,000 $50,000 $50,000 $50,000

Less-accumulated amortization $20,000 $21,250 $22,500 $23,750 $25,000

Total Intangible Assets $30,000 $28,750 $27,500 $26,250 $25,000

Other assets $25,000 $33,000 $120,000 $5,000 $23,000

Total Assets $3,266,000 $3,505,055 $3,489,475 $3,541,425 $2,939,897

A c t u al Fo r ec as t

LIABILITIES AND 1999 1ST QTR 2ND QTR 3RD QTR 4TH QTR

STOCKHOLDERS' EQUITY

Current Liabilities

Accounts payable $600,000 $328,767 $328,767 $328,767 $328,767

Notes payable $100,000 $50,000 $50,000 $50,000 $50,000

Current portion of long-term debt $100,000 $100,000 $100,000 $100,000 $100,000

Income taxes $30,000 $183,300 $52,663 $14,983 ($188,735)

Accrued expenses $90,000 $83,288 $62,466 $54,137 $83,708

Other current liabilities $16,000 $12,000 $12,000 $12,000 $12,000

Total Current Liabilities $936,000 $757,355 $605,896 $559,887 $385,740

Non-Current Liabilities

Long-term debt $600,000 $500,000 $500,000 $500,000 $500,000

Deferred income $100,000 $90,000 $90,000 $90,000 $90,000

Deferred income taxes $30,000 $27,000 $27,000 $27,000 $27,000Other long-term liabilities $50,000 $90,000 $40,000 $40,000 $40,000

Total Liabilities $1,716,000 $1,464,355 $1,262,896 $1,216,887 $1,042,740

Shares Outstanding 1,000 1,000 1,000 1,000 1,000

Capital stock issued $100,000 $100,000 $100,000 $100,000 $100,000

Additional paid in capital $50,000 $50,000 $50,000 $50,000 $50,000

Retained earnings $1,400,000 $1,890,700 $2,076,579 $2,174,538 $1,747,157

$1,550,000 $2,040,700 $2,226,579 $2,324,538 $1,897,157

Total Liabilities and Equity $3,266,000 $3,505,055 $3,489,475 $3,541,425 $2,939,897

ANNUAL BALANCE SHEET

COMPANY NAMECompany AddressCity, State ZIP CodePhone Number fax Fax Number



7/18

Profitability RatiosEarnings Per Share (EPS) Ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Net income $490,700 $227,879 $170,059 $834,109

Shares of common stock outstanding 1,000 1,000 1,000 1,000

EPS $491 $228 $170 $834

Earnings Per Share (EPS)Depending on your financial objectives, you might consider investing in a company to obtain a steadyreturn on your investment in the form of regular dividend payments, or to obtain a profit by owning thestock as the market value of its shares increases. These two objectives might both be met, but in practicethey often are not. Companies frequently face a choice of distributing income in the form of dividends, orretaining that income to invest in research, new products, and expanded operations. The hope, of course,is that the retention of income to invest in the company will subsequently increase its income, thusmaking the company more profitable and increasing the market value of its stock.

In either case, Earnings Per Share (EPS) is an important measure of the company's income. Its basicformula is:

EPS = Income Available for Common Stock / Shares of Common Stock Outstanding

EPS is usually a poor candidate for vertical analysis, because different companies always have differentnumbers of shares of stock outstanding. It may be a good candidate for horizontal analysis, if you haveaccess both to information about the company's income and shares outstanding. With both these items,you can control for major fluctuations over time in shares outstanding. This sort of control is important: itis not unusual for a company to purchase its own stock on the open market to reduce the number ofoutstanding shares. So doing increases the value of the EPS ratio, perhaps making the stock appear amore attractive investment.

Note that the EPS can decline steadily throughout the year. Because, the number of shares outstandingis constant throughout the year, the EPS changes are due solely to changes in net income.

Many companies issue at least two different kinds of stock: common and preferred. Preferred stock is

issued under different conditions than common stock. Preferred stock is often callable at the company'sdiscretion, it pays dividends at a different (usually, higher) rate per share, it might not carry votingprivileges, and often has a higher priority than common stock as to the distribution of liquidated assets ifthe company goes out of business.

Calculating EPS for a company that has issued preferred stock introduces a slight complication. Becausethe company pays dividends on preferred stock before any distribution to shareholders of common stock,it is necessary to subtract these dividends from net income:

EPS (Net Income - Preferred Dividends) / Shares of Common Stock Outstanding



8/18

Profitability RatiosGross Profit Margin Quarter 1 Quarter 2 Quarter 3 Quarter 4

Sales $2,000,000 $1,500,000 $1,300,000 $2,010,100

Cost of sales $945,000 $865,000 $833,000 $946,616

Gross profit margin 52.8% 42.3% 35.9% 52.9%

Gross Profit MarginThe gross profit margin is a basic ratio that measures the added value that the market places on acompany's non-manufacturing activities. Its formula is:

Gross profit margin = (Sales - Cost of Goods Sold) / Sales

The cost of goods sold is, clearly, an important component of the gross profit margin. It is usuallycalculated as the sum of the cost of materials the company purchases plus any labor involved in themanufacture of finished goods, plus associated overhead.

The gross profit margin depends heavily on the type of business in which a company is engaged. Aservice business, such as a financial services institution or a laundry, typically has little or no cost of

goods sold. A manufacturing, wholesaling, or retailing company typically has a large cost of goods sold,with a gross profit margin that varies from 20 percent to 40 percent.

The gross profit margin measures the amount that customers are willing to pay for a company's product,over and above the company's cost for that product. As mentioned previously, this is the value that thecompany adds to that of the products it obtains from its suppliers. This margin can depend on theattractiveness of additional services, such as warranties, that the company provides. The gross profimargin also depends heavily on the ability of the sales force to persuade its customers of the value addedby the company.

This added value is, of course, created by other costs such as operating expenses. In turn, these costsmust be met largely by the gross profit on sales. If customers do not place sufficient value on whateve

the company adds to its products, there will not be enough gross profit to pay for the associated costs.Therefore, the calculation of the gross profit margin helps to highlight the effectiveness of the company'ssales strategies and sales management.



9/18

Profitability RatiosNet Profit Margin Quarter 1 Quarter 2 Quarter 3 Quarter 4

Net Income $490,700 $227,879 $170,059 $834,109

Sales $2,000,000 $1,500,000 $1,300,000 $2,010,100

Net profit margin 24.5% 15.2% 13.1% 41.5%

Net Profit MarginThe net profit margin narrows the focus on profitability, and highlights not just the company's sales efforts,but also its ability to keep operating costs down, relative to sales. The formula generally used todetermine the net profit margin is:

Net Profit Margin = Earnings After Taxes / Sales

When net profit margin falls dramatically from the first to the fourth quarters, a principal culprit is cost ofsales.

Another place to look when you see a discrepancy between gross profit margin and net profit margin isoperating expenses. When the two margins covary closely, it suggests that management is doing a good

job of reducing expenses when sales fall, and increasing expenses when necessary to supporproduction and sales in better times.



10/18

Profitability RatiosReturn on Assets Full Year

EBITDA $1,776,743

Total assets $3,368,963

Return on assets 52.7%

Return on AssetsOne of management's most important responsibilities is to bring about a profit by effective use of theresources it has at hand. One ratio that speaks to this question is return on assets. There are severalways to measure this return; one useful method is:

Return on Assets = (Gross Profit - Operating Expense) / Total Assets

This formula will return the percentage earnings for a company in terms of its total assets. The better thejob that management does in managing its assets-the resources available to it-to bring about profits, thegreater this percentage will be.

It's normal to calculate the return on total assets on an annual basis, rather than on a quarterly basis.



11/18

Profitability RatiosReturn on Equity Quarter 1 Quarter 2 Quarter 3 Quarter 4

Earnings after taxes $490,700 $227,879 $170,059 $834,109

Stockholder's equity $2,040,700 $2,226,579 $2,324,538 $1,897,157

Return on equity 24.0% 10.2% 7.3% 44.0%

Return on EquityAnother related profitability measure to Return on Assets is the Return on Equity. Again, there are severalways to calculate this ratio; here, it is measured according to this formula:

Return on Equity = Net Income / Stockholder's Equity

You can compare return on equity with return on assets to infer how a company obtains the funds used toacquire assets.

The principal difference between the formula for return on assets and for return on equity is theuse of equity rather than total assets in the denominator, and it is here that the technique ofcomparing ratios comes into play. By examining the difference between Return on Assets andReturn on Equity, you can largely determine how the company is funding its operations.

Assets are acquired through two major sources: creditors (through borrowing) and stockholders (throughretained earnings and capital contributions). Collectively, the retained earnings and capital contributionsconstitute the company's equity. When the value of the company's assets exceeds the value of its equity,you can expect that some form of financial leverage makes up the difference: i.e., debt financing.

Therefore, if the Return on Equity ratio is much larger than the Return on Assets ratio, you can infer thatthe company has funded some portion of its operations through borrowing.



12/18

Liquidity RatiosCurrent ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Current assets $1,438,305 $1,358,433 $1,548,091 $951,271

Current liabilities $757,355 $605,896 $559,887 $385,740

Current ratio 1.9 2.2 2.8 2.5

Current RatioThe current ratio compares a company's current assets (those that can be converted to cash during thecurrent accounting period) to its current liabilities (those liabilities coming due during the same period).The usual formula is:

Current Ratio = Current Assets / Current Liabilities

The current ratio measures the company's ability to repay the principal amounts of its liabilities.

The current ratio is closely related to the concept of working capital. Working capital is the differencebetween current assets and current liabilities.

Is a high current ratio good or bad? Certainly, from the creditor's standpoint, a high current ratio meansthat the company is well-placed to pay back its loans. Consider, though, the nature of the current assets:they consist mainly of cash and cash equivalents. Funds invested in these types of assets do notcontribute strongly and actively to the creation of income. Therefore, from the standpoint of stockholdersand management, a current ratio that is very high means that the company's assets are not being used tobest advantage.



13/18

Liquidity RatiosQuick ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Current assets $1,438,305 $1,358,433 $1,548,091 $951,271

Inventory $630,411 $590,959 $575,178 $1,186,002

Current liabilities $757,355 $605,896 $559,887 $385,740

Quick ratio 1.1 1.3 1.7 -0.6

Quick RatioThe quick ratio is a variant of the current ratio. It takes into account the fact that inventory, while it is acurrent asset, is not as liquid as cash or accounts receivable. Cash is completely liquid; accountsreceivable can normally be converted to cash fairly quickly, by pressing for collection from the customer.But inventory cannot be converted to cash except by selling it. The quick ratio determines the relationshipbetween quickly accessible current assets and current liabilities:

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

The quick ratio shows whether a company can meet its liabilities from quickly-accessible assets.

In practice, a quick ratio of 1.0 is normally considered adequate, with this caveat: the credit periods thathe company offers its customers and those granted to the company by its creditor must be roughly equal.If revenues will stay in accounts receivable for as long as 90 days, but accounts payable are due within30 days, a quick ratio of 1.0 will mean that accounts receivable cannot be converted to cash quicklyenough to meet accounts payable.

It is possible for a company to manipulate the values of its current and quick ratios by taking certainactions toward the end of an accounting period such as a fiscal year. It might wait until the start of thenext period to make purchases to its inventory, for example. Or, if its business is seasonal, it mighchoose a fiscal year that ends after its busy season, when inventories are usually low. As a potentialcreditor, you might want to examine the companys current and quick ratios on, for example, a quarterlybasis.

Both a current and a quick ratio can also mislead you if the inventory figure does not represent the currenreplacement cost of the materials in inventory. There are various methods of valuing inventory. The LIFOmethod, in particular, can result in an inventory valuation that is much different from the inventory'scurrent replacement value; this is because it assumes that the most recently acquired inventory is alsothe most recently sold.

If your actual costs to purchase materials are falling, for example, the LIFO method could result in anover-valuation of the existing inventory. This would tend to inflate the value of the current ratio, and tounderestimate the value of the quick ratio if you calculate it by subtracting inventory from current assets,rather than summing cash and cash equivalents.



14/18

Activity RatiosAverage Collection Period Quarter 1 Quarter 2 Quarter 3 Quarter 4

Accounts Receivable $657,534 $493,151 $427,397 $660,855

Credit sales per day $22,222 $16,667 $14,444 $22,334

Average Collection Period 30 30 30 30

Average Collection PeriodYou can obtain a general estimate of the length of time it takes to receive payment for goods or servicesby calculating the Average Collection Period.One formula for this ratio is:

Average Collection Period = Accounts Receivable / (Credit Sales / Days)

Where Days is the number of days in the period for which Accounts Receivable and Credit Salesaccumulate.

You should interpret the average collection period in terms of the company's credit policies. If, foexample, the company's policy as stated to its customers is that payment is to be received within two

weeks, then an average collection period of 30 days indicates that collections are lagging. It may be thacollection procedures need to be reviewed, or it is possible that one particularly large account isresponsible for most of the collections in arrears. It is also possible that the qualifying procedures used bythe sales force are not stringent enough.

The calculation of the Average Collection Period assumes that credit sales are distributed roughly evenlyduring any given period. To the degree that the credit sales cluster at the end of the period, the AverageCollection Period will return an inflated figure. If you obtain a result that appears too long (or too short), besure to check whether the sales dates occur evenly throughout the period in question.

Regardless of the cause, if the average collection period is over-long, it means that the company is losingprofit. The company is not converting cash due from customers into new assets that can, in turn, be usedto generate new income.



15/18

Activity RatiosInventory Turnover Ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Cost of Goods Sold $945,000 $865,000 $833,000 $946,616

Average Inventory $630,411 $590,959 $575,178 $1,186,002

Inventory Turnover 1.5 1.5 1.4 0.8

Inventory Turnover RatioNo company wants to have too large an inventory (the sales force excepted: salespeople prefer to beable to tell their customers that they can obtain their purchase this afternoon). Goods that remain ininventory too long tie up the company's assets in idle stock, often incur carrying charges for the storage ofthe goods, and can become obsolete while awaiting sale.

Just-in-Time inventory procedures attempt to ensure that the company obtains its inventory no soonethan absolutely required in order to support its sales efforts. That is, of course, an unrealistic ideal, but bycalculating the inventory turnover rate you can estimate how well a company is approaching the ideal.

The formula for the Inventory Turnover Ratio is:

Inventory Turnover = Cost of Goods Sold / Average Inventory

where the Average Inventory figure refers to the value of the inventory on any given day during the periodduring which the Cost of Goods Sold is calculated. The higher an inventory turnover rate, the moreclosely a company conforms to just-in-time procedures.

The figures for cost of goods sold and average inventory are taken directly from the Income Statement'scost of sales and the Balance Sheet's inventory levels. In a situation where you know only the beginningand ending inventory-for example, at the beginning and the ending of a period-you would use the averageof the two levels: hence the term "average inventory."

An acceptable inventory turnover rate can be determined only by knowledge of a company's businesssector. If you are in the business of wholesaling fresh produce, for example, you would probably requirean annual turnover rate in the 50s: a much lower rate would mean that you were losing too muchinventory to spoilage. But if you sell computing equipment, you could probably afford an annual turnoverate of around 3 or 4, because hardware does not spoil, nor does it become technologically obsoletemore frequently than every few months.



16/18

Leverage RatiosDebt ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Total Liabilities $1,464,355 $1,262,896 $1,216,887 $1,042,740

Total Assets $3,505,055 $3,489,475 $3,541,425 $2,939,897

Debt ratio 41.8% 36.2% 34.4% 35.5%

Debt RatioThe debt ratio is defined by this formula:

Debt ratio = Total debt / Total assets

It is a healthy sign when a company's debt ratio is falls, although both stockholders and potential creditorswould prefer to see the rate of decline in the debt ratio more closely match the decline in return on assets.As the return on assets falls, the net income available to make payments on debt also falls. This companyshould probably take action to retire some of its short-term debt, and the current portion of its long-termdebt, as soon as possible.



17/18

Leverage RatiosEquity ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

Total Equity $2,040,700 $2,226,579 $2,324,538 $1,897,157

Total Assets $3,505,055 $3,489,475 $3,541,425 $2,939,897

Equity ratio 58.2% 63.8% 65.6% 64.5%

Equity RatioThe equity ratio is the opposite of the debt ratio. It is that portion of the company's assets financed bystockholders:

Equity Ratio = Total Equity / Total assets

It is usually easier to acquire assets through debt than to acquire them through equity. There are certainobvious considerations: for example, you might need to acquire investment capital from many investors;whereas you might be able to borrow the required funds from just one creditor. Less obvious is the issueof priority.

By law, if a firm ceases operations, its creditors have the first claim on its assets to help repay the

borrowed funds. Therefore, an investor's risk is somewhat higher than that of a creditor, and the effect isthat stockholders tend to demand a greater return on their investment than a creditor does on its loan.The stockholder's demand for a return can take the form of dividend requirements or return on assets,each of which tend to increase the market value of their stock.

But there is no "always" in financial planning. Because investors usually require a higher return on theiinvestment than do creditors, it might seem that debt is the preferred method of raising funds to acquireassets. Potential creditors, though, look at ratios such as the return on assets and the debt ratio. A highdebt ratio (or, conversely, a low equity ratio) means that existing creditors have supplied a large portion ofthe company's assets, and that there is relatively little stockholder's equity to help absorb the risk.



18/18

Leverage RatiosTimes Interest Earned Ratio Quarter 1 Quarter 2 Quarter 3 Quarter 4

EBIT $717,250 $341,792 $259,192 $1,207,835

Interest charges $16,250 $16,250 $16,250 $16,250

Times interest earned 44.1 21.0 16.0 74.3

Times interest Earned RatioOne measure frequently used by creditors to evaluate the risk involved in loaning money to a firm is theTimes Interest Earned ratio. This is the number of times in a given period that a company earns enoughincome to cover its interest payments. A ratio of 5, for example, would mean that the amount of interespayments is earned 5 times over during that period.

The usual formula is:

Times Interest Earned = *EBIT / Total Interest Payments

*EBIT stands for Earnings Before Interest and Taxes.

The Times Interest Earned ratio, in reality, seldom exceeds 10. A value of 44.1 is very high, althoughcertainly not unheard of during a particularly good quarter. A value of 5.1 would usually be consideredstrong but within the normal range.

Notice that this is a measure of how deeply interest charges cut into a company's income. A ratio of 1, foexample, would mean that the company earns enough income (after covering such costs as operatingexpenses and costs of sales) to cover only its interest charges. There would be no income remaining topay income taxes (of course, in this case it's likely that there would be no income tax liability), to meetdividend requirements or to retain earnings for future investments.

Copyright 2010 JaxWorks All Rights Reserved

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