Two other
ratios we can
use to measure profitability are Operating Income to Sales and Return on Assets.
Operating Income to Sales
Operating Income to Sales compares Earnings Before Interest and Taxes (EBIT) to
Sales.
By using EBIT, we place more emphasis on operating results and we more closely
follow
cash flow concepts. Operating Income to Sales is calculated as follows:
EBIT / Net Sales
Chapter 4
8
EXAMPLE — Net Sales are $ 460,000 and Earnings Before Interest and
Taxes is $ 100,000. This gives us a return of 22% on sales, $ 100,000 / $
460,000 = .22. For every $ 1.00 of sales, we generated $ .22 in Operating
Income.
Return on Assets
Return on Assets measures the net income returned on each dollar of assets. This
ratio
measures overall profitability from our R in assets. Higher rates of return are
desirable. Return on Assets is calculated as follows:
Net Income / Average Total Assets
EXAMPLE — Net Income is $ 60,000 and average total assets for the year
are $ 500,000. This gives us a 12% return on assets, $ 60,000 / $ 500.000
= .12.
Return on Assets is often modified to ensure accurate measurement of returns. For
example,
we may want to deduct out preferred dividends from Net Income or maybe we should
include
operating assets only and exclude intangibles, investments, and other assets not
managed
for an overall rate of return.
Leverage Ratios
Another important group of detail ratios are Leverage Ratios. Leverage Ratios
measure the
use of debt and equity for financing of assets. We previously looked at the
Financial
Leverage Ratio as part of Return on Equity. Three other leverage ratios that we
can use are
Debt to Equity, Debt Ratio, and Times Interest Earned.
Debt to Equity
Debt to Equity is the ratio of Total Debt to Total Equity. It compares the funds
provided by
creditors to the funds provided by shareholders. As more debt is used, the Debt
to Equity
Ratio will increase. Since we incur more fixed interest obligations with debt,
risk increases.
On the other hand, the use of debt can help improve earnings since we get to
deduct interest
expense on the tax return. So we want to balance the use of debt and equity such
that we
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