Ratios

Question 1

Compute Average Collection Period

Answer 1

365 / AR Turnover
365 / (Net Credit Sales / Average AR)
Average AR / Average Daily SAles
Average AR / (Net Credit Sales/365)

Only for credit sales. Total sales will shift ratio.
Use Average AR Net of allowance for doubtful accounts

Question 2

Beta Coefficient

Answer 2

Measures market risk of a security relative to other securities

Question 3

Return on Equity

Answer 3

Net Income - Preferred Dividends / Average Common Equity

Or, using the DuPont equation:

ROE = Net income − Preferred dividends × Sales × Average assets
Sales Average assets Average stockholders’ equity

The denominator consists of the average of the total equity less preferred shares and minority interest. One of the major problems with this ratio is that the historical issue price is used as opposed to the current market value.
The common stockholders’ leverage ratio (Average assets/Average stockholders’ equity used above) measures the portion of assets that are financed through common equity (also called the equity multiplier). The larger this ratio, the greater the financial leverage will be. Various organizations within an industry will have potentially dramatic differences in ROE resulting from financing decisions—debt vs. equity. If ROA is greater than the cost of borrowing, then ROE will be higher than ROA due to the impact of financial leverage.
Calculation using data from the Sample Company for 20X2 (section 2160.01):

Net income − Preferred dividends = Return on equity
Average common equity

    $75,000 − $15,000         = 22%
($300,000 + $250,000) ÷ 2

Question 4

Required Rate of Retun

Answer 4

Risk-free rate + Beta coefficient (Market rate - Risk-free rate)

Question 5

Return on Assets

Answer 5

Net Income / Average Total Assets

ALSO Profit Margin Ratio x Asset Turnover Ratio
ALSO Return on Equity x (1 - Debt Ratio)

Question 6

Book Value per Share

Answer 6

Total Stockholders’ Equity - Preferred Equity (and dividends in arears) / Number of Share of Common Stock Outstanding

Question 7

Earnings per Share

Answer 7

Net Income - Preferred Dividends / Average Total Equity

Question 8

Profit Margin Ratio

Answer 8

Profit Measure / Net Income

Question 9

Asset Turnover

Answer 9

Total sales / Total average assets

Question 10

Dividend Payout Ratio

Answer 10

Cash Dividends Paid on Common Stock / (Net income - Preferred Dividends)

Question 11

Defensive Interval Ratio

Answer 11

A ratio that measures liquidity - indicator of ability to pay debts with quick assets

Current assets / Daily operating expenses

Question 12

Watson Corporation computed the following items from its financial records for 20X1:

Price-earnings (P/E) ratio 12
Payout ratio 0.6
Asset turnover 0.9
The dividend yield on Watson’s common stock for 20X1 is:

Answer 12

The dividend yield on Watson’s common stock for 20X1 is 5.0%, calculated as follows:

Dividend yield = Dividends per common share / Market price per share

P/E ratio = Market price per share / Earnings per share
= 12

Payout ratio = Dividends / Earnings
= 0.60

Dividend yield = (Earnings/Market price)(1) x (Dividends/Earnings)(2)
Dividend yield = 1/12 x 0.60
= 0.05 or 5%
1 Reciprocal of the price-earnings (P/E) ratio

2 Payout ratio

Question 13

DuPont Equation / Method

Answer 13

Using the DuPont equation:

                          Net income     Net sales         Average assets Return on equity = ---------- x -------------- x ---------------------
 (ROE)                 Net sales    Average assets   Average stockholders'
                                                   equity = Profit margin × Total asset turnover × Equity multiplier

Question 14

Return on equity can be found using the following equation:

                Net income − Preferred dividends  Return on equity = --------------------------------
                      Average common equity

Answer 14

As total assets increase, ROE will decrease if all other financial statement items are held constant because the increase in assets will be associated with a matching increase in stockholders’ equity, given that assets equal liabilities plus stockholder’s equity.

ROE will decrease, not increase, as the debt ratio decreases. Given that assets equal liabilities plus stockholder’s equity, as debt decreases, the funding provided by stockholder’s equity increases, lowering ROE.

ROE will increase as COGS (cost of goods sold) as a percentage of sales decreases because the main driver of the numerator, net income, will increase, causing an increase in ROE.

ROE will decrease as equity increases because the denominator, average common equity, would increase, creating a smaller ratio holding sales and net income constant.

Question 15

Return on Investment

Answer 15

ROI = Net income / Invested Capital (or operating assets)

Can be at point in time or over period of time, in which case you would use an average

Question 16

Dividend Yield

Answer 16

Dividends per common share / Market price per share

Question 17

Payout Ratio