302834 Flashcards
Listed below are selected ratios for Angle Company and Brugger Limited, both large firms in manufacturing pressure valves. Also listed are the industry averages for the same ratios. All of the ratios are for the same year.
Angle Brugger Industry Ratio Company Limited Average Current ratio 3.0 2.1 1.8 Quick ratio 1.6 1.0 1.0 A/R turnover 5.0 6.3 6.0 Inventory turnover 4.1 6.3 5.3 Total liability to net worth 2.1 3.0 2.0 Sales to net worth 15.0 20.0 13.5 Sales to total assets 2.8 7.3 5.0 Net income to sales 2.4% 1.1% 1.6% Net income to net worth 8.6% 16.5% 9.9% Net income to net assets 6.6% 8.2% 7.8% Times interest earned 4.3 2.6 4.0 Based on the information presented, the ratios that should be used to determine which company has a stronger liquid position are:
current ratio and quick ratio.
current ratio and inventory turnover.
total liabilities to net worth and current ratio.
quick ratio and times interest earned.
current ratio and quick ratio.
Liquidity refers to the availability of firm resources to meet short-term obligations or liabilities through cash payments. These ratios focus on the timing of cash inflows/outflows, as well as the balance of current asset and liability accounts. The current ratio and the quick ratio are the best overall measures of liquidity, as they measure the relationship of current assets to current liabilities. The current ratio is defined as current assets divided by current liabilities. Whereas, the quick ratio is defined as (cash + near-term investments + current receivables) divided by current liabilities.
Inventory turnover, while a measure of liquidity, is only measuring one particular current asset (inventory), and is not considering liabilities, so the metric is not the best choice. Times interest earned is a solvency ratio, measuring a company’s ability to meet interest payment obligations. Total liabilities to net worth is a solvency measure focused on a company’s ability to meet long-term obligations.
Current Ratio
The current ratio is a liquidity ratio that measures a firm’s ability to discharge currently maturing obligations from existing current assets that are expected to be converted into cash within the maturing period of the claims. Current ratio is a measure of short-term solvency; however, it is less precise than the quick ratio because a sizable amount of total current assets may be tied up in inventory, which is less liquid.
The computation is:
Current assets ÷ Current liabilities
Because balance sheet account totals are based on historical cost, which does not necessarily represent market value, the use of this ratio is limited.
Inventory Turnover
Inventory turnover is an activity ratio that measures the liquidity of inventory; it is the measurement of the effectiveness with which a firm manages its inventory. Inventory turnover is the average number of times that inventory “turns over” or was sold during the period, which can indicate possible over- or understocking, inventory obsolescence, or overpricing.
The computation is:
Cost of goods sold ÷ Average inventory
Note:
The use of average inventory is:
(Beginning balance + Ending balance) ÷ 2
Another average frequently used is the 12-month average, calculated as follows:
(Balance month 1 + Balance month 2 + … + Balance month 12) ÷ 12
This average filters out lows and highs in the business cycle and often provides a better representation of the annual average inventory.
Inventory turnover can be computed for raw materials, work-in-process, or finished goods inventories.
Liquidity
Liquidity is the convertibility of an entity’s assets into ready cash to meet current obligations. Liquid assets are cash on hand and in banks and marketable securities readily convertible into cash.
Quick Ratio
The quick ratio is a liquidity ratio that measures the firm’s ability to discharge currently maturing obligations from most liquid (quick) current assets, cash, marketable equity securities (MES), and accounts receivable (AR). It is more precise than the current ratio because only highly liquid assets are used (i.e., inventories—less liquid and more likely to incur losses in the event of liquidation—and prepaid assets are excluded). It measures immediate liquidity.
The computation is Quick assets ÷ Current liabilities or (Cash + MES + AR) ÷ Current liabilities.
There are limitations on use of this ratio. Accounts receivable may be subject to a lengthy collection period and may have to be factored at less than carrying value to convert to cash immediately. Marketable equity securities are subject to fluctuations in market conditions that affect their liquidation amount.
Ratio
A ratio is a proportional relationship between two single amounts. Financial ratios use amounts from financial statements, such as account balances and classification totals (e.g., Total Assets). Ratios are used in analytical procedures, represent plausible relationships between data that may be reasonably expected to exist and continue in the absence of known conditions to the contrary (AU-C 520), and should show relevant relationships between amounts that are functionally related. Ratios usually reflect risk, rate of return, or both.
Ratios should be understood in terms of the following:
Definition (How is the ratio computed?)
Significance (What does the ratio tell you?)
Limitations (What care should be taken in the use of the ratio?)
Times Interest Earned
Times interest earned is a leverage coverage ratio that measures the firm’s ability to meet interest charges from net operating earnings. It is a measure of solvency.
The computation is EBIT ÷ Interest expense, where EBIT = Earnings before interest and taxes, or Net operating income ÷ Interest expense.
There are limitations on the use of this ratio.
Example: Accrual income does not necessarily indicate the availability of cash to meet fixed charges associated with debt. Lease charges should be included, along with interest, in the denominator and deducted in the numerator. It can be argued that dividends paid
2161.03
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