3.1 Activity Ratios Flashcards
Formula for Accounts Receivable Turnover
Net credit sales / average accounts receivable
avg. accounts receivable = (beginning AR + Ending AR) / 2
Higher is better
Formula for days’ sales outstanding in receivables
Days in year / Accounts receivable turnover
Lower is better
A corporation has a decrease in its operating cycle and a decrease in its cash cycle. All else remaining unchanged, this would occur if the corporation’s
A. Payables period increased
B. Receivables period decreased
C. Receivables period increased
D. Inventory period increase
B. Receivables period decreased
Operating cycle = Days’ sales in receivables + days’ sales in inventory.
Thus, a reduction in days’ sales in receivables would decrease the operating cycle.
Cash cycle = operating cycle - days’ purchases in payables.
So, the decrease in the operating cycle would cause a decrease in the cash cycle.
The company had net accounts receivable of $168,000 and $147,000 at the beginning and end of the year, respectively. The company’s net income for the year was $204,000 on $1,700,000 in total sales. Cash sales were 6% of total sales. The company’s average accounts receivable turnover ratio for the year is
A. 9.51
B. 10.15
C. 10.79
D. 10.87
B. 10.15
AR Turnover = Net credit sales / average AR
Net credit sales
= total sales $1,700,000 x 94% credit sales percentage
= $1,598.000
Average accounts receivable
= (168,000 + 147,000) / 2 = 157,500
AR turnover
= 1,598,000 / 157,500 = 10.146 times
Formula for Inventory Turnover
Inventory turnover = COGS / Average inventory
Average inventory = (Beg inventory + Ending inventory) / 2
Higher is better
Formula for days’ sales in inventory
Days’ sales in inventory = days in year / inventory turnover
Formula for Accounts Payable turnover
AP turnover = purchases / average accounts payable
Avg. AP = (Beg. AP + Ending AP) / 2
Formula for Days’ purchases in AP
Days’ purchases in AP = days in year / AP turnover
Definition Cash Cycle
portion of the operating cycle when we do not have cash, when cash is tied up in the form of inventory or accounts receivable
portion of operating cycle not accounted for by days’ purchases in accounts payable
Formula for cash cycle
cash cycle = operating cycle - days’ purchases in accounts payable
operating cycle = days’ sales outstanding in receivable + days’ sales in inventory
Explain how the use of financial ratios can be advantageous to management.
Financial ratios relate financial statement line items to each other. By calculating standardized ratios, management can asses the firm’s liquidity, financial activity, solvency, and profitability. Management can also compare the firm’s performance to that of others in its industry.
Based on the data presented below, what is the cost of sales for the year?
Current ratio 3.5
Acid test ratio 3.0
Year-end current liabilities $600,000
Beginning inventory $500,000
Inventory turnover 8.0
A. $1,600,000
B. $2,400,000
C. $3,200,000
D. $6,400,000
C. $3,200,000
The current ratio is the ratio of current assets to current liabilities. Since the current ratio and current liabilities are known, current assets can be determined as follows:
Current assets ÷ Current liabilities = Current ratio
Current assets ÷ $600,000 = 3.5
Current assets = $600,000 × 3.5 = $2,100,000
Quick assets can be determined similarly:
Quick assets ÷ Current liabilities = Acid test ratio
Quick assets ÷ $600,000 = 3.0
Quick assets = $600,000 × 3.0 = $1,800,000
Assuming the company had no prepaid expenses, the difference between current assets and quick assets is inventory.
Ending inventory = Current assets – Quick assets
= $2,100,000 – $1,800,000
= $300,000
Once ending inventory is known, average inventory can be determined [($500,000 + $300,000) ÷ 2 = $400,000], and, finally, cost of sales can be calculated:
Cost of sales ÷ Average inventory = Inventory turnover
Cost of sales ÷ $400,000 = 8.0
Cost of sales = $400,000 × 8.0 = $3,200,000
The difference between average and ending inventory is immaterial.
Current ratio 2.0
Quick ratio 1.5
Current liabilities $120,000
Inventory turnover (based on cost of goods sold) 8 times
Gross profit margin 40%
Net sales for the year were
A. $800,000
B. $480,000
C. $1,200,000
D. $240,000
A. $800,000
Net sales can be calculated indirectly from the inventory turnover ratio and the other ratios given.
If the current ratio is 2.0, and current liabilities are $120,000, current assets must be $240,000. Similarly, if the quick ratio is 1.5, the total quick assets must be $180,000. The only major difference between quick assets and current assets is that inventory is not included in the definition of quick assets. Consequently, ending inventory must be $60,000 ($240,000 - $180,000). The inventory turnover ratio (COGS / Avg. inventory) is 8. Thus, COGS must be 8 times average inventory, or $480,000, given no material difference between average and ending inventory. If the gross profit margin is 40%, the COGS percentage is 60%. COGS equals 60% of sales, and net sales must be $800,000 ($480,000 / 60%).
A change in credit policy has caused an increase in sales, an increase in discounts taken, a decrease in the amount of bad debts, and a decrease in the investment in accounts receivable. Based upon this information, the company’s
A. Average collection period has decreased.
B. Percentage discount offered has decreased.
C. Accounts receivable turnover has decreased.
D. Working capital has increased.
A. Average collection period has decreased.
An increase in discounts taken accompanied by declines in receivables balances and doubtful accounts all indicate that collections on the increased sales have been accelerated. Accordingly, the average collection period must have declined. The average collection period is a ratio calculated by dividing the number of days in a year (365) by the receivable turnover. Thus, the higher the turnover, the shorter the average collection period. The turnover increases when either sales (the numerator) increase, or receivables (the denominator) decrease. Accomplishing both higher sales and a lower receivables increases the turnover and results in a shorter collection period.
The year-end financial statements for Queen Bikes reflect the data presented as follows. Ten percent of Queen’s net sales are in cash.
Net sales
Year 1: 1,500 units at $100
Year 2: 1,200 units at $100
Year 3: 1,200 units at $125
Ending inventory
Year 1: 100 units at $50
Year 2: 100 units at $50
Year 3: 100 units at $50
Average receivables
Year 1: $12,500
Year 2: $12,000
Year 3: $14,400
Net income
Year 1: $18,750
Year 2: $ 9,400
Year 3: $26,350
Queen’s inventory turnover ratios for Year 2 and Year 3 are
A. 24 and 24, respectively.
B. 12 and 18, respectively.
C. 12 and 12, respectively.
D. 18 and 18, respectively.
C. 12 and 12, respectively.
The cost of the 1,200 units sold in Year 2 at $50 each would have been $60,000. Dividing the $60,000 cost of sales by the $5,000 average inventory results in a turnover of 12. The 1,200 units sold in Year 3 also would have cost $60,000 and the turnover would again be 12.
The year-end financial statements for Queen Bikes reflect the data presented as follows. Ten percent of Queen’s net sales are in cash.
Net sales
Year 1: 1,500 units at $100
Year 2: 1,200 units at $100
Year 3: 1,200 units at $125
Ending inventory
Year 1: 100 units at $50
Year 2: 100 units at $50
Year 3: 100 units at $50
Average receivables
Year 1: $12,500
Year 2: $12,000
Year 3: $14,400
Net income
Year 1: $18,750
Year 2: $ 9,400
Year 3: $26,350
Queen’s receivables turnover ratios for Year 2 and Year 3 are
A. 10.8 and 9.0, respectively.
B. 9.0 and 9.375, respectively.
C. 10.00 and 10.42, respectively.
D. 1.00 and 1.04, respectively.
B. 9.0 and 9.375, respectively.
The receivables turnover ratio equals net credit sales divided by average accounts receivables. For Year 2 the calculation is [($120,000 × .9) ÷ $12,000] = 9.0, and for Year 3 it is [($150,000 × .9) ÷ $14,400] = 9.375.
A firm has a current ratio of 2.5 and a quick ratio of 2.0. If the firm experienced $2 million in cost of sales and sustains an inventory turnover of 8.0, what are the firm’s current assets?
A. $1,000,000
B. $500,000
C. $1,500,000
D. $1,250,000
D. $1,250,000
The only major difference between the current ratio and the quick ratio is the inclusion of inventory in the numerator. If cost of sales is $2 million and inventory turns over 8 times per year, then average inventory is $250,000 ($2,000,000 ÷ 8). Since the only difference between the two ratios is inventory, inventory must equal .5 (2.5 – 2.0) times current liabilities; therefore, current liabilities are $500,000. Thus, current assets divided by $500,000 equals 2.5. Therefore, current assets must equal $1,250,000 (2.5 × $500,000).
Formula for Asset Turnover
Asset Turnover = Net sales / average total assets
The selected data pertain to a company at December 31:
Quick assets $208,000
Acid test ratio 2.6 to 1
Current ratio 3.5 to 1
Net sales for the year $1,800,000
Cost of sales for the year $990,000
Average total assets for the year $1,200,000
The company’s asset turnover ratio for the year is
A. .675
B. .825
C. 1.21
D. 1.50
D. 1.50
The asset turnover ratio equals $1,800,000 of net sales divided by $1,200,000 of average total assets. The asset turnover ratio is therefore equal to 1.50.
The ratio that measures a firm’s ability to generate sales from its assets is
A. Days’ sales in inventory.
B. Sales to working capital.
C. Days’ sales in receivables.
D. Asset turnover.
D. Asset turnover.
Asset turnover measures the level of capital investment relative to sales volume. It is a measure of how well a company uses its assets. A high turnover is preferable because it signifies that a given level of resources is being used to generate greater sales.
A company has $3 million per year in credit sales. The company’s average days’ sales outstanding is 40 days. Assuming a 360-day year, what is the company’s average amount of accounts receivable outstanding?
A. $500,000
B. $333,333
C. $250,000
D. $75,000
B. $333,333
Dividing $3 million of sales by 360 days results in an average of $8,333.33 per day. Multiplying the average daily sales by the 40 days outstanding results in $333,333.
A company computed the following items from its financial records for the current year:
Current ratio 2 to 1
Inventory turnover 54 days
Accounts receivable turnover 24 days
Current liabilities turnover 36 days
The number of days in the operating cycle for the current year was
A. 60
B. 90
C. 78
D. 42
C. 78
The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. It is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. The number of days’ sales in inventory is given as 54 days. The number of days’ sales in receivables is given as 24. Therefore, the number of days in the operating cycle is 78 (54 + 24).
Accounts receivable turnover ratio will normally decrease as a result of
A. The write-off of an uncollectible account (assume the use of the allowance for credit losses method).
B. A significant sales volume decrease near the end of the accounting period.
C. An increase in cash sales in proportion to credit sales.
D. A change in credit policy to lengthen the period for cash discounts.
D. A change in credit policy to lengthen the period for cash discounts.
The accounts receivable turnover ratio equals net credit sales divided by average receivables. Hence, it will decrease if a company lengthens the credit period or the discount period because the denominator will increase as receivables are held for longer times.
A company sells 10,000 skateboards a year at $66 each. All sales are on credit, with terms of 3/10, net 30, that is, a 3% discount if payment is made within 10 days; otherwise full payment is due at the end of 30 days. One half of the customers are expected to take advantage of the discount and pay on day 10. The other half are expected to pay on day 30. Sales are expected to be uniform throughout the year for both types of customers.
What is the expected average collection period for the company?
A. 5 days.
B. 10 days.
C. 15 days.
D. 20 days.
D. 20 days.
The average collection period is the average time it takes to receive payment from customers. Because one-half of the customers will pay on day 10 and half will pay on day 30, the average collection period is 20 days [0.5(10 days) + 0.5(30 days)].
To determine the operating cycle for a retail department store, which one of the following pairs of items is needed?
A. Days’ sales in accounts receivable and average merchandise inventory.
B. Cash turnover and net sales.
C. Accounts receivable turnover and inventory turnover.
D. Asset turnover and return on sales.
C. Accounts receivable turnover and inventory turnover.
The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. For a retailer, it is the time from purchase of inventory to collection of cash. Thus, the operating cycle of a retailer is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. Inventory turnover equals cost of goods sold divided by average inventory. The days’ sales in inventory equals 365 (or another period chosen by the analyst) divided by the inventory turnover. Accounts receivable turnover equals net credit sales divided by average receivables. The days’ sales in receivables equals 365 (or other number) divided by the accounts receivable turnover.
A corporation experiences a decrease in sales and cost of goods sold, an increase in accounts receivable, and no change in inventory. If all else is held constant, what is the total effect of these changes on the receivables turnover and inventory ratios?
Inventory Turnover: Increased/Decreased
Receivables Turnover: Increased/Decreased
Inventory Turnover: Decreased
Receivables Turnover: Decreased
Cost of goods sold is the numerator of the inventory turnover ratio and average inventory is the denominator. A decrease in the numerator accompanied by an unchanged denominator results in a decrease in the overall ratio. Net credit sales is the numerator of the receivables turnover ratio and average net receivables is the denominator. A decrease in the numerator and an increase in the denominator result in a decrease in the overall ratio.
A company changes its credit policy from 2/10 net 30 to 1/10 net 90. The most likely effect of this change is to
A. Increase the days’ sales outstanding in accounts receivable and decrease the cash cycle.
B. Decrease the days’ sales outstanding in accounts receivable and increase the cash cycle.
C. Increase the days’ sales outstanding in accounts receivable and increase the cash cycle.
D. Decrease the days’ sales outstanding in accounts receivable and decrease the cash cycle.
C. Increase the days’ sales outstanding in accounts receivable and increase the cash cycle.
With an increased window for accounts receivable and less incentive to pay the balance early, the average collection period is likely to increase. Since days’ sales outstanding in accounts receivable measures the average number of days it takes to collect a receivable, it increases with this change in credit policy. The cash cycle is found by subtracting days’ purchases in payables from the operating cycle. The formula for the operating cycle is Days’ sales outstanding in accounts receivable + Days’ sales in inventory. Since days’ sales outstanding in accounts receivable increases, so does the cash cycle.
An entity has net sales of $5,000,000 and a total debt to total assets ratio of 70%. If the entity has total debt of $1,000,000, its total asset turnover is
A. 7.14
B. 3.50
C. 3.33
D. 2.45
B. 3.50
Total asset turnover equals net sales divided by total assets. If the debt-to-total assets ratio is 70% and debt is $1,000,000, total assets must be $1,428,571 ($1,000,000 ÷ 0.7). Given sales of $5,000,000, total asset turnover must be 3.50 ($5,000,000 net sales ÷ $1,428,571 total assets).
The following financial information is given (in millions of dollars):
Prior Year / Current Year
Sales $10 / $11
Cost of goods sold 6 / 7
Current assets:
Cash 2 / 3
Accounts receivable 3 / 4
Inventory 4 / 5
Based on year-end figures for assets, between the prior year and the current year, did the days’ sales in inventory and days’ sales in receivables increase or decrease? Assume a 365-day year.
Days’ Sales in Inventory: increased/decreased
Days’ Sales in Receivables: increased/decreased
increase, increased
Inventory turnover ratio for the current year can be calculated as follows:
Inventory turnover = Cost of goods sold ÷ Average inventory
= $7,000,000 ÷ $5,000,000
= 1.4 times
Days’ sales in inventory
= 365 ÷ 1.4 = 260.71
* For the prior year:
Inventory turnover ratio
= $6,000,000 ÷ $4,000,000 = 1.5 times
Days’ sales in inventory
= 365 ÷ 1.5 = 243.33
Thus, there was an increase in days’ sales in inventory.
Receivables turnover ratio for the current year can be calculated as follows:
AR turnover = Net credit sales ÷ Ending receivable
= $11,000,000 ÷ $4,000,000
= 2.75 times
Days’ sales in receivables
= 365 ÷ 2.75 = 132.72
For the prior year:
AR turnover = $10,000,000 ÷ $3,000,000 = 3.33 times
Days’ sales in receivables
= 365 ÷ 3.33 = 109.5
Thus, days’ sales in receivables also increased.
The following computations were made from Bruckner Co.’s current-year books:
Number of days’ sales in inventory 55
Number of days’ sales in trade accounts receivable 26
What was the number of days in Bruckner’s current-year operating cycle?
A. 26
B. 81
C. 55
D. 40.5
B. 81
The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. It is equal to the sum of the number of days’ sales in inventory (average number of days to sell inventory) and the number of days’ sales in receivables (the average collection period). The number of days’ sales in inventory is given as 55 days. The number of days’ sales in receivable is given as 26 days. Hence, the number of days in the operating cycle is 81 (55+26).
The controller of Palmito Company has gathered the following information:
Beginning of Year / End of Year
Inventory $6,400 / $7,600
Accounts receivable 2,140 / 3,060
Accounts payable 3,320 / 3,680
Total sales for the year were $85,900, of which $62,400 were credit sales. The cost of goods sold was $24,500.
Palmito’s payables turnover ratio for the year was
A. 17.8 times.
B. 16.9 times.
C. 7.3 times.
D. 7.0 times.
C. 7.3 times.
Purchases are calculated as follows:
Cost of goods sold $24,500
Plus: Ending inventory 7,600
Goods available for sale $32,100
Less: Beginning inventory (6,400)
Purchases $25,700
Palmito’s payables turnover can be calculated as follows:
Payables turnover = Purchases ÷ Average accounts payable
= $25,700 ÷ [($3,320 + $3,680) ÷ 2]
= $25,700 ÷ $3,500
= 7.3
A company had $6 million in credit sales last fiscal year. The company’s beginning accounts receivable balance was $1 million and its ending receivable balance was $1.25 million on its year-end financial statements. If the industry average period for the collection of accounts receivables is 90 days, the company’s accounts receivable collection period is less than the industry average by approximately
A. 60 days
B. 22 days
C. 52 days
D. 68 days
B. 22 days
Days’ sales outstanding in receivables measure the average number of days it takes to collect a receivable.
- Days’ sales outstanding in receivables = days in year / accounts receivable turn over.
- AR turnover = net credit sales / average accounts receivable.
AR turn over is 5.33 {$6 million / [($1 million + $1.25 million) / 2]}. Days’ sales outstanding in receivables is 68 days (365 days / 5.33). Thus, the company’s accounts receivable collection period is less than the industry average by 22 days (90 days - 68 days).
The following represents select financial information of J Company for the year ended December 31, Year 1:
Inventory – 1/1/Year 1: $ 60,000
Inventory – 12/31/Year 1: 40,000
Accounts Payable – 1/1/Year 1: 30,000
Accounts Payable – 12/31/Year 1: 20,000
Cost of Goods Sold: 270,000
Calculate J Company’s accounts payable turnover ratio for the year ended December 31, Year 1.
A. 12.5 times
B. 5.0 times
C. 10.0 times
D. 10.8 times
C. 10.0 times
AP turnover ratio = purchases / avg. AP
Purchases for the period can be derived from the formula for cost of goods sold (COGS = Beginning inventory + purchases - ending inventory). Thus purchases amount to $250,000 ($270,000 + 40,000 - 60,000). The average accounts payable balance is $25,000 [($30,000 + 20,000) / 2]. Therefore, the accounts payable turnover ratio is 10.0 times ($250,000 / $25,000).
An entity has total asset turnover of 3.5 times and a total debt to total assets ratio of 70%. If the entity has total debt of $1,000,000, it has a sales level of
A. $2,450,000
B. $5,000,000
C. $200,000
D. $408,163
B. $5,000,000
If the debt-to-total assets ratio is 70% and debt is $1,000,000, total assets must be $1,428,571 ($1,000,000 / 0.7). Given total asset turn over (sales / total assets) of 3.5, sales must be $500,000 (1,428,571 x 3.5).
Working capital turnover
sales / working capital
The following data are available for the current year for the Ben Jonson Company. It uses a 365-day year when computing ratios.
Net credit sales
12/31 Year 2: $6,205,000
Accounts receivable
12/31 Year 2: 335,000
12/31 Year 3: $350,000
Inventory
12/31 Year 2: 870,000
12/31 Year 3: 960,000
Cost of goods sold
12/31 Year 2: 4,380,000
If the Ben Jonson Company’s cash cycle for Year 2 is 51.40 days, its days’ purchases in accounts payable equal
A. 40.81 days
B. 71.11 days
C. 104.19 days
D. 143.61 days
A. 40.81 days
The operating cycle is the time that passes between acquiring inventory and collecting cash for its sale. It is the sum of the days’ sales in receivables and the days’ sales in inventory. Ben Jonson holds its inventory 72.50 days [$870,000 ending inventory / ($4,380,000 COGS / 365 days)] and its receivable 19.71 days [$335,000 ending accounts receivable / ($6,205,000 net credit sales / 365 days)]. Its operating cycle is 92.21 days (72.50 + 19.71). The cash cycle equals the operating cycle minus the days’ purchases in accounts payable (days in year / accounts payable turnover). Consequently, the days’ purchases in accounts payable equal 40.81 days (92.21 days in the operating cycle - 51.40 days in the cash cycle).
The information below pertains to Zach Enterprises for the years indicated.
Ending Year 1:
Inventory $ 60,000
Accounts payable 50,000
Accrued expenses 70,000
Cost of goods sold 240,000
Ending Year 2:
Inventory $ 70,000
Accounts payable 80,000
Accrued expenses 110,000
Cost of goods sold 270,000
Zach’s accounts payable turnover for Year 2 is
A. 3.50 times
B. 4.15 times
C. 4.31 times
D. 5,23 times
C. 4.31 times
Purchases are calculated as follows:
COGS $270,000
Plus: Ending Inventory 70,000
= Goods available for sale = $340,000
Minus: Beginning Inventory ($60,000)
= Purchases $280,000
The accounts payable turnover is calculated as follows:
Accounts payable turnover = purchases / average accounts payable
= $280,000 / [(50,000 + 80,000)/2]
= 4.31 times
A retail company has experienced rapid growth in sales during the current year. An analyst has calculated the following ratios for this company.
Prior Year / Current Year
Inventory turnover 5.4 / 9.3
Receivables turnover 4.2 / 3.5
Fixed asset turnover 2.4 / 3.6
Quick ratio 1.5 / 1.2
Based on the above, the analyst may conclude that sales increased due to more
A. Competitive pricing.
B. Stores opening in the current year.
C. Control over inventory sales.
D. Favorable credit policies.
D. Favorable credit policies.
The analyst can conclude that sales increased due to more favorable credit policies. The inventory turnover ratio increased drastically, meaning that COGS increased, average inventory decreased, or both. At the same time, the receivables turnover decreased, meaning average accounts receivable increased. Sales did not decrease; the question stem explains that they increased. The increase in average accounts receivable and the decrease in inventory can best be explained by a more favorable credit policy because this would allow more customers to purchase from the company even if they lack the best credit standings.
A company with an accounts receivable turnover of 8.1 would be most concerned if
A. The company’s credit terms with vendors are net 30 days.
B. The accounts receivable turnover for the industry was 10.4.
C. A best practice analysis indicated an accounts receivable turnover of 13.0.
D. Last year’s days sales outstanding in receivables was 44.9.
A. The company’s credit terms with vendors are net 30 days.
Since the company’s accounts receivable turnover is 8.1, it takes 45.06 days (365 / 8.1) to collect the accounts receivable. The terms of “net 30 days” mean that full payment of vendors’ invoice is due in 30 days. The company may have difficulties paying vendors’ invoices on time because its collection period is longer than its number of days to settle payables.
A corporation has days’ sales in receivables of 40 days, days’ sales in inventory of 45 days, and a cash cycle of 30 days. The corporation has days’ purchases in payables of
A. 35 days.
B. 55 days.
C. 115 days.
D. 25 days.
B. 55 days.
A company’s operating cycle is the amount of time that passes between the acquisition of inventory and the collection of cash on the sale of that inventory, which is the same as the days’ sales in receivables plus the days’ sales in inventory.
In this case, the operating cycle is 85 days, consisting of the 40 days in receivables plus the 45 days in inventory. The cash cycle is that portion of the operating cycle that is not accounted for by days’ purchases in accounts payable. In this case, the cash cycle makes up 30 of the 85 days in the operating cycle. Therefore, the days’ purchases in payables must be 55 days (85 days - 30 days)
A firm has decided to make an additional investment in its operating assets, which are financed by debt. Assuming all other factors remain constant, this increase in investment will have which of the following effects?
Operating profit margin: no change/decrease/increase
Total Assets Turnover: no change/decrease/increase
Return on Assets: no change/decrease/increase
Operating profit margin: no change
Total Assets Turnover: decrease
Return on Assets: decrease
An additional investment in operating assets that are financed by debt will cause assets and liabilities to increase proportionally. This transaction would have no effect on income statement balances. Therefore, there will be no change in operating profit margin (operating income / sales). Both the total asset turnover (net sales / average total assets) and the return on assets (net income / average total assets) will decrease as the denominator of these ratios will increase, but the numerator remains constant.
A firm expects to report net income of at least $10 million annually for the foreseeable future. The firm could increase its return on equity by taking which of the following actions with respect to its inventory turnover and the use of equity financing?
Inventory Turnover: Increase/Decrease
Use of Equity Financing: Increase/Decrease
Inventory Turnover: Increase
Use of Equity Financing: Decrease
Return on equity, in the most general terms, is the ratio of net income to total equity. Increasing inventory turnover raises the numerator, and decreasing equity financing lowers the denominator. This combination is thus the only effective means of increasing return on equity.
