Flashcards in Ratio Analysis Deck (29):

1

## Define "ratio analysis" (for financial management)

### The development of quantitative relationships between various elements of a firm's financial, operating and other information.

2

## Describe the benefits provided by ratio analysis

###
Provides measures and enables comparisons of a firms operating and financial activities and position:

1. For a single firm over time;

2. Across firms.

Facilitates identifying operating and financial strengths and weaknesses of a firm.

3

## When a ratio requires using a Balance Sheet value together with an Income Statement value, how should the Balance Sheet value be determined?

### When a Balance Sheet value is used together with an Income Statement value in a ratio, the Balance Sheet value must be an average balance for the period covered by the Income Statement, not the year-end (or other point-in-time) balance.

4

## Define "liquidity measures". (aka solvency measures)

### Measurements of the ability of a firm to pay its obligations as they become due; useful in working capital management.

5

## What does "working capital" measure? How is it expressed as a formula?

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Measures the extent to which current assets exceed current liabilities and, thus, are uncommitted in the short term; expressed as:

Working Capital = Current Assets - Current Liabilities.

6

## What does the "working-capital ratio" (also called the "current ratio") measure? How is it expressed as a formula?

###
Measures the quantitative relationship between current assets and current liabilities in terms of the "number of times" current assets can cover current liabilities; expressed as:

Working Capital Ratio = Current Assets/Current Liabilities.

7

## What does the "acid test ratio" (also called the "quick ratio") measure? How is it expressed as a formula?

###
Measures the relationship between highly liquid assets and current liabilities; expressed as:

Acid Test Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Current Liabilities

Note: Inventory is excluded from the numerator.

8

## What does the "defensive-interval ratio" measure? How is it expressed as a formula?

###
Measures the relationship between highly liquid assets and the average daily use of cash; expressed as:

Defensive-Interval Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Average Daily Cash Expenditures.

9

## What does the "times-interest-earned ratio" measure? How is it expressed as a formula?

###
Measures the ability of current earnings to cover interest payments for a period; expressed as:

(Net Income + Interest Expense + Income Tax Expense)/Interest Expense.

10

## Describe operational activity measures.

### Ratios (and other measures) that measure the efficiency with which a firm carries out its operating activities.

11

## What does the "operating cycle length" measure? How is it expressed as a formula?

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Measures the average length of time to invest cash in inventory, convert the inventory to receivables, and collect the receivables; it measures the time to go from cash back to cash and is expressed as:

Operating Cycle Length = Number of Days' Sales in Average Receivables + Number of Days' Supply in Inventory.

12

## What does the "accounts receivable turnover ratio" measure? How is it expressed as a formula?

###
Measures the number of times that accounts receivable turnover (are incurred and collected) during a period; expressed as:

Accounts Receivable Turnover = Credit Sales/Average Net Accounts Receivable. Useful in assessing credit policies and collection efficiency.

13

## What does the "number of days' sales in average receivables ratio" measure? How is it expressed as a formula?

###
Measures the average number of days required to collect receivables; measures the average age of receivables.

Number of Days Sales in Average Receivables = 365 (or other days)/Accounts Receivable Turnover.

14

## What does the "inventory turnover ratio" measure? How is it expressed as a formula?

###
Measures the number of times that inventory is acquired and sold or used during a period; expressed as:

Inventory Turnover = Cost of Goods Sold/Average Inventory. Useful in assessing overstocking/understocking of inventory and obsolete inventory.

15

## What does the "number of days' supply in inventory ratio" measure? How is it expressed as a formula?

###
Measures the number of days inventory is held before it is sold or used; indicates the efficiency of inventory management.

Number of Days Supply in Inventory = 365 (or other days)/Inventory Turnover.

16

## Describe profitability measures.

### Ratios (and other measures) that measure aspects of a firm's operating (profit/loss) results on a relative basis.

17

## What does the "gross profit margin ratio" measure? How is it expressed as a formula?

###
Measures how much (percentage) of each sales dollar that is available to cover operating expenses and provide a profit; expressed as:

Gross Profit Margin = Gross Profit/Net Sales

18

## What does the "net profit margin on sales" measure? How is it expressed as a formula?

###
Measures how much (percentage) of each sales dollar that ends up as net income; expressed as:

Profit Margin = Net Income/Net Sales.

19

## What does the "return on total assets" (also called the "return on investment") measure? How is it expressed as a formula?

###
Measures the rate of return on total assets and indicates the efficiency with which invested resources (assets or total equity) are used; expressed as:

Net Income + Interest Expense + Income Taxes/Average Total Assets.

(NOTE: Some versions may not add back Interest Expense and/or Income Taxes.)

20

## What does the "return on owners' (all stockholders') equity ratio" measure? How is it expressed as a formula?

###
Measures the rate of return (earnings) on all stockholders' investment; expressed as:

ROE = Net Income/Average Stockholders' Equity.

21

## Describe the "Common Stock dividend payout rate" measure.

###
Measures the extent (percent) of earnings distributed to common shareholders; expressed as:

C/S Dividend Payout Rate = C/S Cash Dividends/Net Income Available for Common Shareholders.

Also, can be computed on a per share basis.

22

## What does the "residual income" measure? How is it expressed as a formula?

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Measures the excess of an entity's dollar amount of income over the dollar amount of its required return on average investment (based on its hurdle rate of return); expressed as:

Residual Income = Net Income - (Average Invested Capital x Hurdle Rate).

23

## What does the "economic value added (EVA)" measure? How is it expressed as a formula?

###
Measures an entity's economic profit (not its accounting profit) as accounting earnings before deducting interest less the dollar value of opportunity cost associated with long-term debt and shareholders' equity; expressed as:

EVA = Earnings before interest - [Opportunity cost rate x (L-T debt + SE)].

24

## What does the "price-earnings ratio" ("P/E ratio"; also called the "multiple") measure? How is it expressed as a formula?

###
also called the "multiple") measure? How is it expressed as a formula? Measures the price of a share of common stock relative to its latest earnings per share; expressed as:

P/E Ratio = Market price per common share/Earnings per common share.

Notice, it measures the number of times ("multiples") earnings per share is reflected in the market price.

25

## Describe equity or investment-leverage measures.

### Measures of relative sources of equity and equity value.

26

## What does the "debt to equity ratio" measure? How is it expressed as a formula?

###
Measures the relative amounts of assets provided by creditors (debt) and shareholders; expressed as:

Debt to Equity = Total Liabilities/Total Shareholders' Equity.

27

## What does the "owners' equity ratio" measure? How is it expressed as a formula?

###
Measures the proportion of assets provided by shareholders; expressed as:

Owners' Equity Ratio = Shareholders' Equity/Total Assets.

28

## What does the "debt ratio" measure? How is it expressed as a formula?

###
Measures the proportion of assets provided by creditors and indicates the extend of leverage used in funding the entity; expressed as:

Debt Ratio = Total Liabilities/Total Assets.

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