Profitability ratios offer several different measures of the success of the firm at generating profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:

1. Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales
= (120,000 - 45,000) / 120,000
= 0.625

Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is defined as:

2. Return on Assets = Net Income / Total Assets
= 31,500 / 140,000
= 0.225

Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each dollar invested in the firm's stock. Return on equity is defined as follows:

3. Return on Equity = Net Income / Shareholder Equity
= 31,500 / 64,000
= 0.49

4. Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as follows:

Receivables Turnover
= Annual Credit Sales / Accounts Receivable
= 120,000 / 22,000
= 5.55

The receivables turnover often is reported in terms of the number of days that credit sales remain in accounts receivable before they are collected. This number is known as the collection period. It is the accounts receivable balance divided by the average daily credit sales, calculated as follows:

5. Average Collection Period
= Accounts Receivable / (Annual Credit Sales / 365)
= 22,000 / (120,000 / 365)
= 67 days

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period divided by the average inventory level during that period:

6. Inventory Turnover = Cost of Goods Sold / Average Inventory
= 45,000 / 30,000
= 1.5

The inventory turnover often is reported as the inventory period, which is the number of days worth of inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:

Inventory Period = Average Inventory / Annual Cost of Goods Sold / 365
= 30,000 / (45,000 / 365)
= 243 days

7. Fixed Asset Turnover = sales / fixed assets
= 120,000 / 73,000
= 1.64

Fixed asset turnover is the ratio of sales (on your income statement) to the value of your fixed assets (on your balance sheet). It indicates how well your business is using its fixed assets to generate sales.

Generally speaking, the higher the ratio, the better because a high ratio indicates your business has less money tied up in fixed assets for each dollar of sales revenue. A declining ratio may indicate that you've over-invested in plant, equipment, or other fixed assets.

8. Total Asset Turnover = Sales / Total Assets
= 120,000 / 140,000
= 0.86

Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. They are of particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick ratio.

The current ratio is the ratio of current assets to current liabilities:

9. Current Ratio = Current Assets / Current Liabilities

= 67,000 / 46,000
= 1.46

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain solvent during downturns.

One drawback of the current ratio is that inventory may include many items that are difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:

10. Quick Ratio = Current Assets - Inventory / Current Liabilities
= 67,000 - 30,000 / 46,000
= 37,000 / 46,000
= 0.80

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt.

The debt ratio is defined as total debt divided by total assets:

11. Debt Ratio = Total Debt / Total Assets

= 30,000 / 140,000
= 0.21

12. The times interest earned ratio indicates how well the firm's earnings can cover the interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:

Interest Coverage = EBIT / Interest Charges
= 47,000 / 5,000
= 9.4

13. Fixed Charge Coverage

A ratio that indicates a firm's ability to satisfy fixed financing expenses, such as interest and leases. It is calculated as the following:
= EBIT + Fixed Charge / Fixed Charge + Interest
= 47,000 + 8,000 / 8,000 + 5,000
= 4.23