A6

Question 1

What are the types of financial ratios

Answer 1

Liquidity ratios: measure S-T ability to pay obligations

Activity ratios: measure effective use of assets

Profitability ratios: measure the financial performance of an entity

Investor ratios: measure performance and market-based metrics

Coverage ratios: measure security for long-term creditors/investors

Question 2

What are some limitations of using financial ratios

Answer 2

• Few industry benchmarks exist for comparison
• Dissimilar business units make analysis difficult
• Management may manipulate financial data and ratios
• Inflation can reduce comparability of balance sheet items
• The choice or change in accounting principles can affect ratios and reduce comparability

Question 3

How are the current ratio and quick ratio calculated

Answer 3

Current Ratio = CA/CL

Quick Ratio = (cash and cash equivalents + short term marketable securities + receivables (net)) / CL

Question 4

How are earnings per share (EPS) and the price/earnings (P/E) ratio calculated

Answer 4

Basic EPS = Income available to common shareholders/ weighted average of common shares outstanding

P/E ratio = Price per share/Basic EPS

Question 5

How are A/R turnover and inventory turnover calculated?

Answer 5

A/R Turnover = Sales (net) / Average A/R (net)

Inventory Turnover = COGS/ Average inventory

Question 6

How are profit margin and the return on assets calculated

Answer 6

Profit margin = Net Income/ Sales (net)

ROA = Net Income/ Average total assets

Question 7

How are the debt to equity ratio, the total debt ratio and times interest earned calculated

Answer 7

Debt to Equity = Total Liabilities/Total Equity

Total Debt Ratio = Total Liabilities/Total Assets

Times Interest Earned = Earning before interest expense and taxes/Interest Expense