# Financial Terms & Calculations

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2 Calculating Asset Turnover - In basic form, this is meant to measure the amount of sales generated for every dollars worth of assets over a given period. This is also meant to measure how well a company is leveraging its assets to produce revenue. As a general rule the higher the number the better. Those companies with low profit margins, however, may tend to have higher asset turnover than those with higher profit margins. They may also be used to show how capital intensive a business is. As an example, electric utilities are heavy industry manufactures and even a local cable TV firm is hugely asset based and generates loss sales as compared to software developers. Asset turnover basic formula is simply sales divided by assets. Probably the best measurement is to use average assets, which could simply utilize the assets at the beginning of the period and the end of the period to determine the average. If this ratio that has been measured declines, it could be because there is an over investment in plant equipment or other fixed assets and if the ratio is high, it could mean that there is to much sales revenue and not enough investment. Either case indicates an inefficient management of resources. Calculating APR APR measures either the rate of interest that invested money earns in one year or the cost of credit expressed as a yearly rate. Probably the most important aspect of the APR, besides the actual payment required, is the comparison that is available with APR numbers. Whether you are evaluating investment alternative or borrowing funds it is important to understand and compare alternatives. You must understand that as a rule of thumb the annual percentage rate is typically slightly higher than the quoted rate and when expressing the cost of credit you must obtain the other costs of obtaining the credit, in addition to the interest, such as any loan closing costs or financial fees that might be outside the computation of APR s. When used in the context of investment APR is commonly referred to as annual percentage yield (APY). For the mathematician in you, the annual percentage rate formula can be described as follows: APR=[1+i/m]m-1.0 In the above formula, (i) is referred to interest quoted-expressed as a decimal and (m) is the number of compound periods per year. Calculating Book Value In its pure form, book value measures a company s common equity (common stock) as it appears on its balance sheet. This is important because it represents the company s net worth to its shareholders based on the difference between assets and liabilities plus debt. You must understand the book value is substantially different from market value especially where primary assets may be intangible (high tech and knowledge based industries and other type businesses). When compared with its market value book value helps reveal high revenue, regarded by the investment community in that the market value is notably higher than the book value, indicating that the investors have a high regard for the company. A comparison measure is a company s book value per share and it shows the value of the company s assets that each shareholder theoretically would receive if the company were liquidated. The book value also is used to describe the actual value of the individual asset on a balance sheet once it is reduced by the accumulative depreciation. Unfortunately, book value may be unrealistic since some assets are depreciated and in fact could be depreciated fully, except any residual land values that could still be sold for a large amount of funds, in fact greater than the amount accrued on the asset. Calculating Contribution Margins This measurement implies that products or services are meant to contribute to net profit and therefore measurement is available to determine that contribution. That measurement will help a business decide how to direct its resources, which from time to time can be limited. The entire management of the process from eliminating or creating product lines, pricing, structuring payment methods or sales commissions or bonuses, directing marketing and advertising expenditures, and the appropriation of time can be aided by the knowledge of the contribution margin of the product/service. Its calculation is reasonably straight forward as it simply takes the sales price minus the available cost to equal the contribution margin. For example, if the sales price of a good is \$ and the cost is \$500.00, then the contribution margin is \$ or 50% of sales, meaning that.50 of every sales dollar

3 remains to contribute to fixed costs and the profit after the cost directly related to the sales is subtracted. The basic assumption is of course that after the accounting information is available for available cost including any indirect cost of services. Calculating Debt-to-Capital Ratio This measurement is important as it measures the percentage of total funding represented by debt. If you compare a company s long-term liabilities to its total capital, the debt-to-capital ratio provides review of extent to which the company relies on external debt financing towards funding and therefore is a measurement of risk to its shareholders. It also represents the measure of the company s borrowing capacity and its ability to pay financial payments. Bond-rating agencies and analysts typically use it to check creditworthiness. Generally the greater the debt a company has; the higher the risk. However, it can be misleading to assume that lowest ratio is automatically the best ratio. Utilities for instance have a high capital requirement so their debt-tocapital ratios are high so are those of manufacturing companies, especially those who are developing a new technology or product. It is certain that the higher level of debt, the higher the requirement is for a company to have the ability to create positive earnings and a steady cash flow. The most common method to determine the ratio is to divide total long-term debt by total assets (total longterm debt plus shareholders funds) that looks like the following: Total liabilities/total assets = debt-tocapital ratio If you are to calculate this or understand it, there are few items that you should be knowledgeable of. First debt calculation should include any long-term capital leases; if a company has an interest in other companies then that value must be added to the shareholders equity; if a company s external assets exceeds the rate of interest paid to creditors then a high debt-to-capital ratio occurs, while meaning less security for shareholders since debt holders are paid first in bankruptcies, it can still be tolerable; also do not try to confuse debt-to capital with debt-tocapitalization, which compares debt with total market capitalization that could change with company s stock price changes, if it is a publicly traded entity. Inventory to Net Working Capital This ratio tells how much of the company s funds are tied up in inventory. If this number is high compared to the industry average, it could mean the business has too much inventory on hand. It is preferable to run your business with as little inventory as possible on hand, while not affecting potential sales opportunities. The Inventory divided by Net Working Capital Calculating Debt-to-Equity Ratio This measurement seeks to understand how much money a company owes compared with how much money shareholders and owners have invested in the company. The debt-to-equity ratio will reveal the portion of debt and equity the company has used to finance its business. It also will reveal the company s borrowing capacity. The higher the ratio is, the greater the portion of debt but also the greater the risk. There has been some that described the debt-to-equity ratio as a test of long-term corporate health because debt establishes a commitment to repay money throughout a period of time even though there is still no assurance that cash can be created to honor that commitment. Creditors and lenders rely heavily on a ratio to evaluate its borrowers. The debt-to-equity ratio is calculated by dividing debt by owner s equity, where equity is typically the figure stated for the preceding calendar or fiscal year. The most common formula for the ratio is: Total liabilities/owners equity = debt to equity ratio It is very important that equity be measured against time, against companies within the industry as different analysis could occur. The lower the number is indicates better financial stability than a high number, practically, if facing higher interest rates the company s requirement for debt service increases. If a ratio is greater than one occurs, then assets are typically financed mainly with debt, when less than one equity provides a majority of the financing.

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