Accounting Concepts Flashcards
What is the primary purpose of financial statement analysis?
To determine the financial health and performance of the organization.
What does financial statement analysis typically produce?
Ratios based on data from the company being analyzed.
What is more important than the calculation of a financial ratio?
The interpretation of the result.
What should be referenced to judge the meaning of financial ratios?
- Past performance
- Performance of close competitors
- Performance of the industry as a whole
What does a higher debt ratio indicate for a newly formed and fast-growing company?
It may be acceptable, but could be inappropriate for a mature company.
What is a significant limitation when interpreting financial ratios?
They are often derived from historical data, which may not represent future results.
What is the Debt/Equity Ratio formula?
Long Term Debt / Shareholder’s Equity
What does a Debt/Equity Ratio of 0.11 indicate for Can Do Inc.?
The company borrowed 11 cents in debt for every dollar of equity.
What does a Total Debt/Assets Ratio of 0.27 indicate?
The company finances 27% of its assets with debt.
What is the formula for the Times-interest-earned ratio (Interest Coverage ratio)?
Earnings before Interest and Taxes (EBIT) / Interest Charges
What does an Interest Coverage Ratio of less than one indicate?
The company is unlikely to meet its interest obligations.
What is the Cash Flow/Debt Ratio used to measure?
How long it would take to pay off a firm’s debt from its cash flow.
What does a Cash Flow/Debt Ratio of 1.125 indicate for Can Do Inc.?
The company could pay off all its debt in less than a year if it devoted all its operating cash flow to debt repayment.
What does the Current Ratio indicate?
The proportion of current assets to current liabilities.
What is the Quick Ratio also known as?
Acid-test Ratio
What does the Receivables Turnover Ratio measure?
How well the company is collecting on sales provided on credit.
What is the formula for the Receivables Turnover Ratio?
Sales / Average Accounts Receivable
What does a high Receivables Turnover Ratio indicate?
A tight credit policy.
What is the Average Collection Period (ACP)?
Average Accounts Receivable / Average Daily Sales
What does an Average Collection Period of 99.5 days indicate?
The company takes almost 100 days to collect on its Accounts Receivable.
What is a key factor influencing the speed of receivables collection?
The firm’s credit and collections policies.
True or False: Financial ratios provide a perfect measure of a company’s performance.
False
What is the importance of recognizing the inherent limitations of financial ratios?
To use judgment in interpreting the ratios.
What is the Collection Ratio?
A calculation of the average number of days it takes a company to convert its accounts receivables into cash.
What two numbers are involved in calculating the Collection Ratio?
- Revenue per day
- Average accounts receivable for a given period of time
How is Daily Sales calculated?
Revenue for the period divided by the number of days in that period.
If a company has $200,000 of revenue over 90 days, what is the Daily Sales?
$2,222/day
What does an increasing Collection Ratio indicate?
Accounts receivables are not being converted to cash as quickly.
What is the significance of using average accounts receivable in the Collection Ratio calculation?
It reflects activity in the accounts receivable account for the whole period, providing a more accurate measure.
What can a rising Collection Ratio indicate about a company’s customers?
Customers may be in trouble, which could lead to future issues for the company.
What is Inventory Turnover?
Calculated as the cost of goods divided by the average inventory.
What does a high Inventory Turnover indicate?
A company is selling its inventory quickly.
How do you calculate Days’ Sales in Inventory?
Divide 365 by the Inventory Turnover ratio.
What is the formula for the Payables Turnover Ratio?
Purchases divided by accounts payable (or average accounts payable).
What does a high Payables Turnover Ratio indicate?
Lesser reliance on trade credit or a faster payment cycle.
How is the Average Payment Period calculated?
365 days divided by the Payables Turnover Ratio.
What does the Fixed Asset Turnover Ratio measure?
How well the company uses its fixed assets to generate sales.
What is the formula for Fixed Asset Turnover?
Sales divided by Net Fixed Assets.
What does the Aging of Accounts measure?
Characterizes receivables according to the length of time they have been outstanding.
What is the Price/Earnings Ratio?
A valuation measure calculated by dividing the current price per share by earnings per share.
If Can Do Inc.’s shares sell for $11 and EPS is $1.25, what is the Price/Earnings Ratio?
8.8
How is Dividend Yield calculated?
Current dividend per share divided by the current price per share.
If Can Do Inc. pays a dividend of $0.80 per share, what is the Dividend Yield if the share price is $11?
7.3%
What does the Dividend Payout Ratio indicate?
Whether a company can sustain its dividend payouts over time.
How is the Dividend Payout Ratio calculated?
Yearly dividend per share divided by earnings per share.
What is Gross Margin?
Measures the number of sales dollars retained after accounting for direct costs.
What is the formula for Gross Margin Ratio?
(Net Sales - Cost of Goods Sold) divided by Net Sales.
What does the Net Profit Margin indicate?
How much profit a company retains from each dollar of sales.
How is Return on Equity (ROE) calculated?
Net profits divided by Shareholders’ Equity.
If Can Do Inc. has net profits of $90,000 and shareholders’ equity of $1,380,000, what is the ROE?
6.5%
True or False: A higher Net Profit Margin indicates better cost control.
True
Fill in the blank: The __________ measures how efficiently one dollar of sales is turned into profits.
Profitability Ratios
What is the formula for Return on Equity (ROE)?
Net Profits / Shareholders’ Equity X 100%
ROE measures a company’s profitability relative to shareholders’ equity.
What does a higher Return on Equity (ROE) indicate?
Greater ability to generate profits with shareholders’ investments
A higher ROE is generally preferable.
What is the formula for Return on Assets (ROA)?
Net Profits / Total Assets X 100%
ROA measures how well management is using its assets to earn profits.
What does a higher Return on Assets (ROA) signify?
More efficient use of assets to generate profits
A higher ROA is preferable to a lower ROA.
What is the Return on Invested Capital (ROIC) formula?
Net Profit / Invested Capital X 100%
Invested Capital includes various sources like bank advances and retained earnings.
What is Tangible Net Worth?
Value of a company based solely on its tangible assets
Tangible assets include physical items like real estate and machinery.
What is Subordinated Debt?
Debt that ranks after other company debts upon liquidation
Subordinated debt is riskier and typically carries a higher rate of return.
What is Adjusted Equity?
Current market values placed on a company’s assets and liabilities
This reflects real estate and other assets at present market prices.
What does a low Working Capital Ratio indicate?
Potential liquidity problems for a company
This can lead to bankruptcy if working capital is mismanaged.
What are Current Assets?
Assets that can be converted to cash within a year, including:
* Cash
* Stocks and bonds
* Receivables
* Inventories
* Prepaid expenses
Current assets fluctuate with sales.
What are Current Liabilities?
Obligations due within one year, including:
* Overdrafts
* Bank loans
* Unpaid bills
* Commercial paper
* Other short-term expenses
Current liabilities are common in normal business operations.
What is Trade Credit?
Financing that occurs during normal business activities
Accounts payable can be seen as a form of ‘no cost’ financing, but there are costs involved.
What is Activity Based Costing (ABC)?
A method focusing on the costs of activities to estimate product costs
ABC became popular in the recession of the early 1980s.
What are the steps in Activity Based Costing?
- Identify the product or service
- Determine resources and processes needed
- Determine key cost drivers
- Calculate overall cost
These steps can be applied to any business but require significant data management.
What is the role of Management Information Systems (MIS)?
Collecting, processing, and storing information for management decision making
Modern MIS integrates data from various systems to aid decision making.
What distinguishes management accounting from financial accounting?
Management accounting is used internally for decision making, while financial accounting is intended for external parties
Management accounting focuses on future actions, financial accounting on past performance.
What can financial ratios and metrics be used for?
- Comparing the same ratios over different time frames
- Comparing ratios with similar companies
This helps assess profitability, leverage, and liquidity.
What is the importance of working capital management?
Determines a company’s ability to pay obligations and grow
Mismanagement can lead to liquidity issues and bankruptcy.
What is the effect of delaying accounts payable for a firm?
It generates additional financing for a period, reducing the need to borrow on operating credit.
This means the firm is partly financed by its suppliers.
How is trade credit often perceived?
As ‘no cost’ financing, though this view is often erroneous.
All financing has associated costs.
What is working capital management?
The process of optimizing the use of working capital resources while considering various constraints.
Name three sources of cash in working capital management.
- Acceleration in the collection of accounts receivable
- Acceleration in the sales of inventories
- Use of an operating line of credit or trade credit
What may be a cost associated with accounts receivable?
A discount may be applicable to effect a more rapid collection.
Excess pressure can lead to relationship difficulties.
What is a potential constraint when managing inventories?
Demand may limit the quantity that can be liquidated.
What is a disadvantage of extending payment terms on accounts payable?
It may create relationship problems leading to higher pricing for goods and services.
What is the formula for calculating Working Capital?
Current Assets - Current Liabilities.
What does a Working Capital Ratio of 1.67:1 indicate?
The company has $1.67 in resources that can be converted to cash for every $1 of current liabilities.
What is the Quick Ratio also known as?
Acid Test Ratio.
What does the Quick Ratio exclude from current assets?
Inventories.
What is the Quick Ratio calculation if inventories are $200,000?
Current assets - Inventory = $300,000 / Current liabilities = $300,000 = 1.00:1.
True or False: The Quick Ratio will always be higher than the Working Capital Ratio.
False.
What does a larger Working Capital Ratio generally indicate?
Better liquidity.
What is a potential issue with having too high a Working Capital Ratio?
It may indicate that the company is holding too much cash or unsold inventory.
What should be assessed alongside the Working Capital Ratio?
The nature of the current assets and their liquidity.
What is cash flow management?
Understanding the cash receipts and disbursements, along with their timing.
What can a lack of understanding of cash flows lead to?
Financial difficulties due to unmet cash and loan needs.
What does the term ‘current liabilities’ refer to?
Obligations that are due within one year.
What is the importance of cash flow forecasting?
It helps senior management understand cash flow dynamics to prevent financial difficulties.
What two components are involved in cash flow management?
- Understanding cash receipts
- Understanding cash disbursements
What is the total debt/assets ratio?
Long term debt/shareholders equity
What is the Interest Coverage Ratio?
Earnings before interest and taxes / Interest Charges
What is the Cash flow / Debt ratio?
Operating cash flow / long term debt
What is the current ratio?
Current assets / Current liabilities
What is the Quick Ratio?
Current assets - inventories / Current liabilities
What is the receivables turnover ratio?
Sales / Average accounts receivable
What is the average collection period?
Average accounts receivable / Average daily sales
What is the collection ratio?
Revenue per day : average accounts receivable
What is inventory turnover?
Cost of goods sold / Average inventory
What is the inventory turnover in days?
Number of days / inventory turnover ratio
What is the payables turnover ratio?
Purchases / accounts payable
What is fixed asset turnover?
Sales / Net fixed assets
What is the price - earnings ratio?
Current price / last year’s earnings
What is the dividend yield?
Current dividend per share / Current price per share x 100%
What is the dividend payout ratio?
Yearly dividend per share / Earnings per share x 100%
What is the gross margin ratio?
Net sales - cost of goods sold / Net sales x 100%
What is the net operating margin?
Earnings before interest and taxes (EBIT) / net sales x 100%
What is net profit margin?
Net profits / Net sales x 100%
What is return on Equity?
Net profits / Shareholders equity x 100%
What is return on assets?
Net profits / total assets x 100%
What is the return on invested capital?
Net profit / Invested capital x 100%
