Flashcards in Becker AUD 4.5 - Financial Ratios Deck (22):

1

## What is the purpose of Financial Ratios in an audit?

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(1) Quantifying relationships among selected items in the F/S.

(2) Compare these ratios to different periods or industry ratios to identify trends that are may be important to investors, lenders, and other interested parties.

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CPA Exam Pass Key (FREEBIE)

Just flip this card.

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Ratio questions on auditing exam may required:

(1) Simple Ratio Calculations

(2) Interpretation of what Ratio means

(3) Analysis of the effects of change

* Sometimes when both NUMERATOR and DENOMINATOR are affected by a given change, the final result (increase or decrease) is NOT easy to determine.

The best way to answer questions like these is to make up numbers and plug them into the ratio formula.

3

## Name 5 types of basic financial financial analysis ratios

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(1) Liquidity ratios

(2) Activity ratios

(3) Profitability ratios

(4) Investor ratios

(5) Long-term debt-paying ability ratios

4

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What are the following:

(1) Liquidity ratios

(2) Activity Ratios

(3) Profitability Ratios

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(1) Liquidity ratios = tells how well the company can pay down its loans within 12 months.

(2) Activity ratios = measures effective use of assets

(3) Profitability ratios = Financial performance in time period

5

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What are the following:

Investor ratios

Long-term debt-paying ability ratios

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Investor ratios = investors use these to measure the company's financials to invest or not.

Long-term debt-paying ability ratios = Coverage ratios measure security for long-term creditors/investors.

6

## What are the limitations on ratios?

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(a) Ratios must rely on accurate data (even if they are happen to be estimates and based on historical costs not reflective of actual current prices in the market)

Other Limitations:

(i) FEW industry BENCHMARKS for comparison

(ii) DISSIMILAR business units may make analysis DIFFICULT

(iii) INFLATION can REDUCE comparability of BALANCE SHEET items

(iv) MGT manipulating ratios (can occur)

(v) Company's choice on using which GAAP rule can affect ratios and REDUCE comparability

(vi) Generalizations are DIFFICULT to make

(vii) RATIOS may use ACCOUNTING DATA (e.g. fixed assets) that do NOT REFLECT FAIR VALUE.

7

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Other Analysis:

What are common size analysis?

How to draft common size analysis for Balance sheets and income statements?

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(1) Common size analysis: Create Common-size F/S to be used to compare Company's performance with SMALLER companies or LARGER companies. Or measure its own performance OVER TIME.

(2) Draft common size F/S:

* Common size balance sheet:

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What is industry statistics analysis?

What is trend analysis?

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(1) industry statistics analysis:

* Comparing ratios to norms in an industry.

* Bench-marking company's performance to Competitors or industry averages

(2) Trend analysis = Ratio analysis to measure trends over time.

9

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Mathematical knowledge:

(1) When a number in the Numerator is BIGGER than the denominator, what happens to the Ratio?

(2) When a number in the DENOMINATOR is BIGGER than the numerator, what happens to the Ratio?

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(1) RATIO gets bigger.

Numerator (HAS BIGGER NUMBER)

-----------------------------

Denominator

Then: The Ratio gets bigger

(2) RATIO gets smaller.

Numerator

---------------------

Denominator (HAS bigger number)

Then: Ratio gets smaller

10

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(1) What are the 4 liquidity ratios?

(2) For these liquidity ratios:

If the ratio is high, what does that mean?

if the ratio is low, what does that mean?

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(1) Liquidity ratios:

(a) Working Capital = Current assets - current liabilities

(b) Current ratio (working capital ratio) = Current assets / current liabilities

* Measures how well company can use current assets to pay off current liabilities

(c) Acid-test ratio =

[cash equivalents + marketable securities + A/R] / Current liabilities

* Measure how well the company uses Cash, marketable securities, and A/R to pay off current liabilities

(d) Cash Ratio =

[Cash equivalents + marketable securities] / Current liabilities

(2)

(a) Ratio HIGH means = The company is able to pay down their debts in the short-term.

This because the NUMERATOR is cash equivalents and other current assets where if there is MORE cash CURRENT assets than debt, then that means the company has ENOUGH money to pay down their debt over time.

(b)

LOW Ratio means = Company is in trouble where it does not have ENOUGH money to pay down its debt.

Low Ratio is from LOW numerator (current assets related items) or VERY HIGH Denominator (current liabilities items)

11

## Name the first 4 of the 9 activity ratios (from the Becker AUD lecture notes)

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(1) Accounts receivable turnover =

Net Credit sales

--------------------------

[[Beg AR + End AR] / 2]

= # times

*This ratio indicates how fast is the company collecting cash on outstanding receivables.

HIGHER the A/R turnover ratio, the faster the company is collecting cash on A/R to be able to pay off future debts and expenses.

(2) Accounts receivable turnover IN DAYS =

[Beg AR + END AR] / 2]

------------------------------------

[Net credit sales / 365 days]

OR:

365

-----

[ Net credit sales / [Beg AR + END AR] / 2] ]

OR:

365 / Receivable turnover

* This ratio indicates Average number of days to Collect A/R (how long in average to collect A/R)

SO: the SHORTER the average time to collect cash on A/R, the better company has to pay off future debt and expenses.

(3) Inventory turnover =

Cost of goods sold

------------------------------

[[BEG inventory + END inventory] / 2]

OR:

COGS / Average Inventory

* Measures how fast the company sells its inventory.

SO: the HIGHER this ratio, the company is doing a good job to increase REVENUES from inventory sales.

(4) Inventory turnover in days =

Average Inventory

--------------------------

[Cost of goods sold / 365]

OR

365 days

------------

[Costs of good sold / [[BEG inventory + END inventory] / 2]]

OR:

365 / Inventory Turnover RATIO

* This RATIO indicates the AVERAGE time in days to sell inventory

SO: the SHORTER the average time (SMALL number), the better the company is doing in selling inventory.

HIGHER the average time (BIG number), indicates that the company is really having a hard time selling its inventory.

12

## Name the first 5 of the 9 activity ratios (from the Becker AUD lecture notes)

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(5) Operating Cycle =

AR turnover in days + Inventory turnover in days

Ex: 59.84 days + 103.11 days = 162.95 days

Total days between Acquisition inventory to Realized cash from sell of inventory

SO:

* Shorting operating cycle means = the company is doing a good in selling inventory and getting cash from A/R very quick

* LONGER operating cycle means = something unusual is going on in terms of Company not

(6) Working Capital Turnover =

Sales

-------------

{[ (Beg. CA - Beg. CL) + (End CA - End CL) ] / 2 }

* measures how well working capital is used

(7) Total Asset turnover =

NET SALES

--------------------------

[[ Beg Assets + End Assets] / 2]

* Measure how well company uses its assets.

* SO: HIGHER this ratio = Company does a good job increasing its sales

(8) Accounts Payable turnover =

Cost of goods sold

-----------------------

[[BEG AP + End AP] / 2]

* Number of times payable were paid off during the year

*SO: HIGHER ratio = Company able to pay off payable on time.

* LOWER ratio = Company is having delays on paying down payable

(9) Days in accounts payable =

[[Beg. AP + END AP] / 2]

-----------------------------

[Cost of goods sold / 365 days]

OR:

365

----------------

[Cost of goods sold / [[BEG AP + End AP] / 2]]

Measures average time to Payable are outstanding before paid off.

* So: HIGHER days means company is taking a long time to pay down payable.

* Shorter days means company is able to pay down debt quickly

13

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CPA PASS KEY

(FLIP over to read)

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Turnover ratios generally use Average balances i.e.

[Beginning Balance + ending balance / 2] for BALANCE SHEET Components.

On recent CPA exam questions: they will use Year-end balance.

So for instance:

[[Year 1 - End balance + year 2 ending balance] / 2] to calculate a Ratio for year 2 balances.

This because a Year 1--ending balance becomes a Year 2 Beginning balance.

14

## Name the first 4 of the Profitability ratios found in Becker AUD Pg. A4-70.

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(1) Net Profit Margin =

Net Income

---------------

Net Sales

* This is a profit rate.

SO: HIGHER this profit rate = The company is doing a good job in making a profit and still a going concern.

(2) Return on Total Assets =

Net income

---------------

Average Total assets

or

Net income

------------------

[[ Beg Total Assets + End total assets] / 2]

* This is a return on assets.

So the HIGH return on assets, means the that company has purchased assets that is generating a lot of money to cover their costs and more.

(3) Return on Assets (ALTERNATE VERSION) =

Net income / net sales x net sales / Average total assets

* This is an increased analysis ratio to find changes in percentages.

net profit margin indicates % of return on each sale while asset turnover indicates the effective use of assets in generating that sale

(4) Return on Investment (ROI) =

Net income + Interest expense (1 - tax rate)

------------------

Average (long-term liabilities + equity)

Ex:

$200,000 + 10,000 x (1 - 0.34)

--------------

[($650,000 + 1,270,000 + $600,000 + 1,150,000) / 2]

= 11.3%

ROI = measures performance of firm without looking at method of financing

15

## Name the next 4 of the Profitability ratios found in Becker AUD Pg. A4-70.

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(5) Return on Common Equity =

Net income - Preferred Dividends

----------

[(Beg Common total equity + End common total equity) / 2]

* The Net income - preferred dividends in numerator MEASURE returns accruing to common shareholders

(6) Net operating margin percentage =

Net operating income

----------

Net Sales

(7) Gross Profit margin % =

Gross profit margin

---------

net sales

(8) operating cash flow per share =

Operating cash flow / Common shares outstanding

Ex:

2250,000 operating cash flow

--------------------

100,000 shares

16

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INVESTOR RATIOS:

Name the 6 ratios

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(1) Degree of Financial leverage =

Earnings before interest and tax

-------------

Earnings before taxes

* This ratio is the factor by which Net income will change with a change in earnings before interest and taxes.

It's a leverage factor for recurring earnings

(2) Earnings per share =

Net income - Preferred dividends

--------------------

Weighted # of C/S outstanding

Ex:

$200,000 NI - $0.00 preferred dividends

-----------

100,000 outstanding c/s

= $2 / share

(3) Price / Earnings ratio =

Market price per share

------------

Diluted Earnings per share

* HIGHER this ratio = Firm has great opportunity to grow.

(4) Dividend Payout ratio =

Dividends per common share

-----------

Diluted earnings per share

* Indicates portion of current earnings being PAID out in dividends to shareholders.

(5) Dividend yield =

Dividends per common share

---------

Market price per common share

* This ratio = measures the relationship between dividends and market price

(6) Book value per share =

Total SE - Preferred stock

----------------

Number of CS outstanding

* This ratio indicates Amount of SE that relates to each share of C/S.

* NOTE: Preferred stock be stated at LIQUIDITY VALUE

17

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LONG-TERM DEBT PAYING ABILITY RATIOS

Name the 4 ratios for this.

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(1) Debt/ Equity =

Total liabilities

------------

Common stockholders' equity

* Lower this ratio the better the company position being able to pay off its debts to creditors

* Lower ratio = protects creditors to avoid default from company

(2) Debt Ratio =

Total liabilities

----------

Total assets

* HIGHER ratio on this means = the assets are greatly financed by creditors.

Ex: $1345K total liabilites / $2615 total assets = 51.4%

More than half of assets financed by creditors

(3) Times Interest ratio =

Earnings before taxes and interest

---------

Interest

* Ratio measures = Company's ability to pay down its interest charges.

* It uses income before interest and taxes to measure how much income available to pay interest expenses and then tax expenses.

(4) Operating Cash flow / total debt =

Operating Cash flow

----

Total Debit

* HIGHER CFLO = MORE cash company has to pay down debt.

* Higher this Ratio = Company has sufficient cash amount to pay down debt.

18

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(1) In the Overall review stage (final review stage), the Engagement partner would use certain formulas to evaluate for any unusual transactions or events.

Which of the following ratios is:

* Usable

* Does not make sense - not usable

(a) Cost of goods sold / Average inventory

(b) Accounts receivable / inventory

(c) current assets / quick assets

(d) Total liabilities / net sales

(2) True or False:

(a) Failure to write down obsolete inventory would affect sales or receivables and thus affect Accounts receivable turnover

(b) Write-off an unusual large reduce reduces the receivables balance (on balance sheet) without reducing the sales in the income statement. Therefore no affect accounts receivable turnover.

(c) Aging of A/R schedule does not affect the overall receivable balance and therefore no effect on A/R turnover.

(d) A decline in the A/R turnover means there was a cutoff of sales at end of the year.

(e) If there was a dramatic INCREASE in the A/R turnover ratio in a 2-year period, then that means that the company is implementation and aggressive cash collection policy.

(f) Deterioration in the Aging Receivables schedule means that there is a smaller receivables balance on the B/S therefore, the A/R turnover ratio declines.

(g) In order for inventory turnover ratio to INCREASE, either:

Cost of sales increases or Average inventory goes down.

(h) When inventory turnover ratio INCREASE, but inventory amounts and sales remains the same, then Cost of sales decreased and therefore Gross profit % decreased.

(i) Total asset turnover is calculated as Sales / Total assets.

If sales stay the same while Total asset turnover ratio GOES, then Total assets went down. Thus, no impact on inventory turnover ratio.

(j) Liquidity ratio and coverage ratios focus on both Balance sheet account balances and income statement account balances

(k) Income statement information is primary used for Profitability analysis ratios.

(L) Statement of retained earnings is primarily a reconciliation of retained earnings account.

(m) Statement of Cash flows assesses cash inflows and cash outflows.

(n) If trading securities are sold at their carry amounts for cash, it would cause an increase in current ratios and quick ratios.

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(1)

(a) Cost of goods sold / Average inventory = Usable

(b) Accounts receivable / inventory

= Does not make sense - not usable

Accounts receivables ties to sales revenue at sales price.

The measure of inventory is to use COST OF GOODS SOLD since inventory is not measured at sales price.

(c) current assets / quick assets

= Does not make sense - not usable

This because: it's Current assets / current liabilities is a valid ratio.

(d) Total liabilities / net sales

= Does not make sense - not usable

This because Total liabilities is used in ratio:

[Total liabilities / total assets] = debt ratio (used by creditors

(2) TRUE OR FALSE:

(a) FALSE.

* Accounts Receivable turnover ratio =

Net Sales / Average A/R

* Therefore, failure to write-down inventory does not affect the Net sales. It does not affect Average A/R

(b) TRUE.

To write down A/R it is:

Dr. Allowance for Doubtful Accounts

Cr Accounts receivable

Here: nothing affects the net sales. So therefore, it also not affects Average A/R turnover ratio

(c) TRUE.

Aging Schedule is used to calculate the ending Allowance amount on the face of B/S. It does not affect the Net sales and the A/R accounts directly.

(d) TRUE.

This because per formula:

A/R turnover = Net sales / [[Beg A/R + End A/R] / 2]

So, improper cutoff of sales at end of year does decrease the A/R turnover ratio.

(e) TRUE.

Accounts receivable balance is DECREASED by cash collection.

So: A/R turnover = Net Sales / [(Beg. A/R + End A/R) / 2]

So, smaller AR amount in A/R turnover ratio,

THEREFORE: A/R turnover ratio GOES UP.

(f) FALSE.

Deterioration in aging a/r schedule means there is an ACTUAL bigger Receivables balance therefore:

A/R turnover = Net Sales / [(Beg. A/R + End A/R) / 2]

* A/R turnover goes down.

(g) True.

Inventory turnover ratio = Cost of sales / [(Beg Inventory + End Inventory) / 2]

Cost of sales UP = Inventory turnover ratio UP

[(Beg Inventory + End Inventory) / 2] goes UP

= Inventory turnover ratio goes DOWN

(h) FALSE.

This because: Inventory turnover goes UP, then that means:

COGS goes up

Then: Net Sales - Costs of goods sold GOES UP = Gross profit (goes DOWN)

Therefore: Gross profit % (GP / Net Sales) = goes DOWN.

(i) TRUE.

(j) FALSE.

Liquidity ratio and coverage ratios focus on ONLY Balance sheet account balances.

(k) TRUE.

Income statement information is primary used for Profitability analysis ratios.

(L) TRUE.

Statement of retained earnings is primarily a reconciliation of retained earnings account.

(m) TRUE

Statement of Cash flows assesses cash inflows and cash outflows.

(n) FALSE.

This because when Trading Securities are sold FOR CASH at their carry value (not fair value) , you are exchanging one asset type for a different asset type at the same $$ amount.

Therefore, NO EFFECT / NO CHANGE to Current Ratio and Quick Ratio.

The only time Current Ratio and Quick Ratio will INCREASE from sell of Trading Securities, when Trading Securities are SOLD FOR CASH at a (higher) FAIR VALUE.

19

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On a CPA exam question,

if you see these columns:

Year 2 Increase over year 1

Assets 300 80

What does "increase over year 1" mean?

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It means that in year 1, the amount was (for this case):

300 (in year 2) - 80 increase = $280

So:

Year 2 assets = $300

Year 1 assets = $280

20

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On Period 1:

You have:

Current ratio = 2.5:1

Quick ratio = 1:2

If cash was used to pay down to reduce A/P, what happens to Current ration and Quick ratio in period 2?

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Hint: in this situation, you plug and chug numbers and calculate to see what's going:

Current Ratio:

2.5 Assets, 1 liabilities (2.5 to 1 = 2.5 / 1 = 2.5)

2.5 - 0.5 cash, 1 - 0.5

So: 2: 0.5 or (2 / 0.5 = 4) = Current ratio goes up

Quick ratio:

1 assets, 2 liabilities (1 / 2 = 0.5)

1 - 0.5 = 0.5 assets; 2 - 0.5 liabilities = 1.5 liabilities

So: 0.5:1.5 or (0.5 / 1.5 = 0.3333; Quick ratio goes down)

21

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What is the Inventory turnover when you have the following info in year 2:

Year 2 data:

COGS = 8000

Beg Inventory = 4000

Purchases = 24000

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4000 Beg inventory + 24000 purchases = 28000

28000 - 8000 cogs = 20,000 End inventory

Inventory turnover RATIO = 8000 COGS / [[4000 Beg + 20,000 End] / 2]

= 8000 / [24,000 / 2]

= 8,000 / 12,000

= 0.66667

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