八 Investment Tools: Financial Statement Analysis: Financial Ratios and Earnings per Share1: Analysis of Financial Statementsa: Calculate, interpret, and discuss the uses of measures of a companys internal liquidity, operating performance, risk profile, growth potential, and external liquidity.Measures of a companys internal liquidityThese ratios are the:1. Current ratio = current assets / current liabilities. 2. Quick ratio = cash + marketable securities + receivable / current liabilities. 3. Cash ratio = cash + marketable securities / current liabilities. The current, quick, and cash ratios differ only in the liquidity of the current assets that the analyst projects will be used to pay off the current liabilities. Other ratios ask:1. Does the company collect its receivables on a timely basis? a. Receivables turnover = sales / average receivables b. Average receivables collection period = 365 / receivables turnover 2. How fast does the company move its inventory through the system? a. Inventory turnover = cost of goods sold / average inventory b. Average inventory processing period = 365 / inventory turnover 3. Does the company pay its current bills? a. Payables turnover = cost of goods sold / average accounts payable b. Average payment period = 365 / payables turnover The cash cycle is the time period that exists from when the firm pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the firms finished goods.Cash conversion cycle = collection period + inventory period - payment period. Example: Receivables turnover = 9, days receivables out (collection period) = 41 days, inventory turnover = 6, days inventory in stock (inventory period) = 61 days, payables turnover = 11, and days payables out (payment period) = 33 days. Cash conversion cycle = 41 days + 61 days - 33 days = 69 days.Measures of a companys operating performanceOperating efficiency ratios question how efficiently management is using the assets they have at their disposal. Efficiency ratios are all sales to balance sheet item ratios. total asset turnover = sales / total assets fixed asset turnover = sales / fixed assets equity turnover = sales / equity Operating profitability ratios look at how good management is at turning their efforts into profits.Gross profit margin = gross profits / sales.Operating profit margin = operating profit / sales, this ratio is also written as EBIT / sales Net profit margin = EAT / sales, also know the before tax profit margin = EBT / sales Return on total capital = EAT + interest / capital Return on owners equity = ROE = EAT / equity Measures of a companys risk profileBusiness risk is related to the firms industry, the variability of sales due to the firms products, customers and method of doing business.1. Business risk = standard deviation of operating income / mean operating income 2. Sales variability = coefficient of variation of sales, sales variability = standard deviation of sales / mean sales 3. Operating leverage =ave % change in operating earn/ave % change in sales Financial risk occurs on top of business risk. Financial risk is related to the uncertainty caused by the fixed cost associated with borrowed money.Leverage ratios show where the money comes from:a. debt to equity ratio = total long-term debt / equity b. assets to equity ratio = assets / equity also called the financial leverage multiplier c. debt to capital ratio = total long-term debt / total long-term capital d. total debt ratio = long-term + short-term debt / total capital. Earnings or cash flow ratios are designed to show the earnings or cash that is available to meet the required interest and lease payments. Debt service ratios.a. Interest coverage = operating profit / interest expense = EBIT / I b. Total fixed charge coverage = EBIT + lease payments/interest + lease payments + (preferred dividends/1-tax rate) c. Cash flow / interest expense d. Cash flow coverage = (cash flow + interest expense) / interest expense e. Cash flow / long-term debt. Measures of a companys growth potentialGrowth analysis: Investors and creditors are interested in the firms growth potential. Investors because high growth means high stock prices, and creditors because high growth means the firms ability to repay its obligations is improved.1. Sustainable growth (g) = (earnings retention rate)(ROE), Where: the earnings retention rate = 1 - (dividends/net income) 2. ROE = EAT/salessales/assetsassets/equity Example: A firm has a predictable dividend payout ratio of 40%, a net profit margin of 12%, an asset turnover of 1.3 and an equity multiplier leverage measure of 1.4. Estimate the firms sustainable growth rate.g = (earnings retention rate)(ROE) = (1 - dividend payout)(EAT/S)(S/A)(A/Eq)g = (1 - .4)(.12)(1.3)(1.4) = .13 or 13%Measures of a companys external liquidityExternal liquidity is the relative speed at which you can trade your shares with