6. Ratios

Question 1

Return on asset ROA
Net income/Average assets*
*beg asset + end asset/2
This financial ratio indicates how efficiently a company can turn its assets into profit, with a higher ROA implying more productive assets. Use when comparing similar companies within the same industry.

Question 2

Liquidity ratios
measure the company’s ability to pay its short term obligations ie. current liabilities. Creditors prefer higher liquidity ratios ie greater then 1.0, it indicates the company has a greater ability to pay its obligations as they come due.

Current ratio
Current asset / current liabilities

Quick ratio or acid-test
Cash + MS + AR /current liabilities
MS marketable securities
*measures comp. ability to pay its
short term obligations using only assets that can be easily converted to cash within 90 days ie. quick asset

Cash ratio
Cash + MS / current liabilities

Question 3

Average days sales in inventory DSI

Average days sales in inventory
365 days / Inventory turnover

Inventory turnover
COGS / average inventory

Average inventory
Beg inventory + end inventory / 2

It measures how effectively en entity manages its inventory. The formula calculates the average time it takes an entity to convert inventory into sale. DSI measures the number of days needed to sell inventory (fewer days is best) and inventory turnover measures the number of times inventory is sold and replenished during a period (higher number is best).

Question 4

Price to earnings ratio
Price per share / EPS

Basic EPS
Net Income - preferred dividends / weighted average number of common shares

P/E ratio measures whether a company’s stock price is overvalued/undervalued. It can also be a benchmark when comparing companies in the same industry.

Question 5

Accounts receivable turnover
(Average collection period)

Net credit sale* / Aver. Receivables**
* credit sale less returns less allowance
**average receivable = beg bal + end bal) /2

AR turnover in days = 360/AR turnover

AR ratio provide a better assessment of collectability from customers.
AR turnover provide info as the average number of days for AR to be collected ie. days sales in AR) .
Only credit sale are utilized in the calculation of AR turnover ratio but where there no info is provided to distinguish cash sale from credit sale, net sales can be used as a numerator.

Question 6

Receivable collection period
Aver. Receivable/ Aver. Credit Sale per day

Total asset turnover
Sale/ Average Total Assets

Question 7

Net sale
- COGS
——————
Gross profit

• selling expenses
• general and administrative expenses
• depreciation expenses
  ————————————
  Operating Income (gross margin)

Question 8

Earning per share
Net income - Preferred Dividends/ weighted aver. Common shares outstanding
Measures net income earned on each share of Common Stock.

Price earnings ratio
Market price of stock/earnings per share
Measures the ratio of market price per share to earnings per share

Dividends payout ratio
Cash dividends/ net income
Measures % of earnings distributed in the form of cash dividends.

Question 9

Days sale outstanding DSO

AR / Aver. Day’s sales on credit*
* (sales on credit/365)
One of the metrics used to assess the collection process is days sale outstanding DSO. DSO represents the average number of days it takes to convert AR to cash ie. Collect the receivable. The ratio evaluates the operating efficiency of a company’s collection. Faster collection of AR reduces the DSO and increases the speed at which AR are collected to cash.

Question 10

The main reason that a firm would strive to reduce the number of days sales outstanding is to increase CASH.

Question 11

Debt to equity - solvency ratio
Total debt ( liabilities)/ total equity
Ratio showes the proportion of debt versus equity used to finance a company’s assets and generate returns. The higher a company’s D/E ratio, the more leveraged it is and the riskier the company is to investors and creditors. Useful when comparing similar companies within the same industry.

Question 12

Long term debt to equity ratio
Total long term debt/ total equity

Question 13

Financial leverage ratio
Total assets / Total equity

Question 14

Inventory
If numerator lower and denominator higher, turnover is lower
The costing method will directly impact the numerator and denominator.
FIFO: cogs comparisons the earliest cost of purchase. In period of rising prices, fifo produces the lower cogs and the higher ending inventory, resulting in a lower inventory turnover.
LIFO: cogs is made up of the most recent purchase costs. If prices are rising, lifo results in the highest cogs and the lowest ending inventory, which produces a higher turnover.

Question 15

Current Asset or Average Accounts Receivable include Allowance for credit loss!

Question 16

Selling inventory increases the quick ratio regardless of whether the inventory is sold at a profit or loss. Since inventory is not included in the quick ratio, the only effect is to increase cash (in the numerator) which in turn increases the ratio.
Collecting AR at a quicker pace increases cash and decreases AR by the same amount, it would not increase the ratio.

Question 17

If in problem they provide current ratio is 3-to-1 and current liability is $322 then current asset 3x322 =966
To calculate quick ratio you can just substitute what you have to quick ratio to find amount of Inventory and prepaid expenses.

Question 18

For higher inventory turnover the numerator needs to be higher, LIFO will get the ratio higher.
Higher cogs, lower ending inventory.

Question 19

Sometime on question you may use ending inventory instead of average inventory of AR, beginning not provided.

Question 20

Variance analysis compares current period financial amounts to prior period or budgeted amount. Significance performance may indicate performance or productivity issues.
A favorable variance occurs when actual performance is better than budgeted performance and an unfavorable variance occurs when actual performance is worse than budgeted performance. While large actual may seem favorable, it could signal an unfavorable variance if it pertain to expenses where lower actual costs are performed.

Question 21

Return on common shareholders’ equity
Net income available to common shareholders (net income less preferred dividends) / by average common stockholders’ equity

Question 22

Debt to Equity
Total liability / Shareholders Equity

Question 23

Return on Sale
Operating Profit / Revenue
* Revenue is Sale***

Question 24

Number of days’ sales in average inventories is calculated:
Average inventory at cost (beg invent + end invent/2) 336+288\2=312

Average sales per day at cost
Cogs/300 working days per year
1,200 cogs/300= $4,000

Number of days’ sales in average inventories is $312/4,000 = 78 days

Question 25

Return on investment:
1. Return on sale
Net operation profit/Sale

2. Asset turnover
   Sale/Total asset