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Investment Theory and Portfolio Development - Ratio Analysis: Activity, Profitability and Debt Ratios

  1. Activity Ratios - a metric of how well a company is able to convert inventory and receivables into cash.
    1. Inventory Turnover Ratio: annual sales/average inventory. A high number is a positive indicator of a company's success at turning its inventory into cash.
    2. Average Collection Period: receivables/sales per day. A high number is a positive indicator of a company's success at turning its accounts receivable into cash.
    3. Fixed Asset Turnover: annual sales/fixed assets. This ratio indicates the sales per dollar investment of fixed assets (property, plant and equipment).

  2. Profitability Ratios - there are several which provide different perspectives on a firm's earnings capacity.
    1. Operating Profit Margin: earnings before interest and taxes/sales.
    2. Net Profit Margin: earnings after taxes/sales.
    3. Return on Assets: earnings after taxes/total assets.
    4. Return on Equity (ROE): earnings after tax/equity.
    5. Payout Ratio: dividends/earnings. Indicates how much of earnings are paid out. The reciprocal of the ratio indicates retained earnings, e.g. those that the company chooses to plow back into its business rather than pay out to shareholders.

  3. Debt Ratios - measure the degree of a company's indebtedness, as well as its ability to service such debt.
    1. Debt Service Ratio (times interest earned): EBIT (Earnings Before Interest and Taxes)/Annual interest and principal payments. This ratio measures how many times a company can service its debt.
    2. Debt Ratio: debt/equity or total assets.
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