Chapter 4

Question 1

Financial Ratios

Answer 1

accounting data restated in relative terms in order to help people identify some of the financial strengths and weaknesses of a company.

Question 2

5 Questions that can be answered by Ratio Analysis

Answer 2

1. How liquid is the firm?
2. Are the firm’s managers generating adequate operating profits from the company’s assets?
3. How is the firm financing its assets?
4. Are the firm’s managers providing a good return on the capital provided by the shareholders?
5. Are the firm’s managers creating shareholder value?

Question 3

Liquidity

Answer 3

a firm’s ability to pay its bills on time. Liquidity is related to the ease and speed with which a firm can convert its noncash assets into cash.

(Can we expect a company to be able to pay creditors on a timely basis?)

Question 4

A Liquid Asset

Answer 4

is one that can be converted quickly and routinely into cash at the current market price.

Question 5

Measuring Liquidity: Perspective 1

-Compare a firm’s current assets with current liabilities using

Answer 5

• Current Ratio

- Acid Test or Quick Ratio

Question 6

Current Ratio

Answer 6

the firm’s current assets divided by its current liabilities. This ratio indicates a company’s degree of liquidity by comparing its current assets to its current liabilities.

Question 7

Current Ratio Formula

Answer 7

Current Assets ÷ Current Liabilities

Question 8

When we use the current ratio, we assume that the firm’s accounts receivable will be collected and turned into cash on a timely basis and that its inventories can be sold without any extended delay.

Answer 8

Given that a company’s inventory by its very nature is less liquid than its accounts receivable–it must first be sold before any cash can be collected–so a more stringent measure of liquidity would exclude the inventories and include only the firm’s cash and accounts receivable in the numerator.

Question 9

Acid-test (Quick) Ratio

Answer 9

the sum of a firm’s cash and accounts receivable divided by its current liabilities. This ratio is a more stringent measure of liquidity than the current ratio because it excludes inventories and other current assets (those that are least liquid) from the numerator.

Question 10

Acid-test (Quick) Ratio Formula

Answer 10

(Cash + Accounts Receivable)
÷
Current Liabilities

Question 11

Measuring Liquidity: Perspective 2

-Measure a firm’s ability to convert accounts receivable and inventories into cash.

Answer 11

• Days in Receivables (Average Collection Period)

- Inventory Turnover

Question 12

Days in Receivables (Average Collection Period)

Answer 12

a firm’s accounts receivable divided by the company’s average daily credit sales (annual credit sales ÷ 365). This ratio expresses how many days on average it takes to collect receivables.

Question 13

Days in Receivables (Average Collection Period) Formula

Answer 13

Accounts Receivable
÷
Daily Credit Sales

OR

Accounts Receivable
÷
(Annual Credit Sales ÷ 365)

Question 14

Accounts Receivable Turnover Ratio

Answer 14

a firm’s credit sales divided by its accounts receivable. This ratio expresses how often accounts receivable are “rolled over” during a year.

Question 15

Accounts Receivable Turnover Ratio Formula

Answer 15

Annual Credit Sales
÷
Accounts Receivable

OR

365 Days
÷
Days in Receivables

Question 16

Whether we use the days in receivables or the accounts receivable turnover ratio,

Answer 16

the conclusion is the same.

Question 17

Days in Inventory

Answer 17

inventory divided by daily cost of goods sold. This ratio measures the number of days a firm’s inventories are held on average before being sold; it also indicates the quality of the inventory.

Question 18

Days in Inventory Formula

Answer 18

Inventory
÷
Daily Cost of Goods Sold

OR

Inventory
÷
(Annual Cost of Goods Sold ÷ 365)

Question 19

Inventory Turnover

Answer 19

a firm’s cost of goods sold divided by its inventory. This ratio measures the number of times a firm’s inventories are sold and replaced during the year, that is, the relative liquidity of the inventories.

Question 20

Inventory Turnover Formula

Answer 20

Cost of Goods Sold
÷
Inventory

OR

365 Days
÷
Days in Inventory

Question 21

When we calculate accounts receivable turnover or days in receivable, we use SALES in our computation.

Answer 21

When we calculate days in inventory or inventory turnover, we use COST OF GOODS SOLD.

We do this because inventory is measured at cost.

Question 22

Current Ratio

Answer 22

Measures a firm’s liquidity.

A higher ratio means greater liquidity.

Question 23

Acid-Test Ratio

Answer 23

Gives a more stringent measure of liquidity than the current ratio in that it excludes inventories and other current assets from the numerator.
A higher ratio means greater liquidity.

Question 24

Days in Receivables

Answer 24

Indicates how rapidly a firm is collecting its receivables.

A longer period means a slower collection of receivables and that the receivables are of lesser quality.

A shorter period means a faster collection of receivables and that the receivables are of greater quality.

Question 25

Accounts Receivable Turnover

Answer 25

Tells how many times a firm’s accounts receivable are collected, or turned over, during a year. Provides the same information as the days in receivables, just expressed differently, where a high number incites fast collections and a low number indicates slow collections.

Question 26

Days in Inventory

Answer 26

Measures how many days a firm’s inventories are held on average before being sold.

The more days required, the lower the quality of the inventory.

The less days required, the higher the quality of inventory.

Question 27

Inventory Turnover

Answer 27

Gives the number of times a firm’s inventory is sold and replaced during the year; as with days in inventory. serves as an indicator of the quality of the inventories; the higher the number, the better the inventory.

Question 28

Question 1.

Answer 28

.

Question 29

Question 2. Are the firm’s managers generating adequate operating profits from the company’s assets?

Answer 29

• Operating Return on Assets (OROA)
• Operating Profit Margin
• Total Asset Turnover
• Fixed Asset Turnover

Question 30

“Do the firm’s managers produce adequate profits form the company’s assets?”

-From the perspective of the firm’s shareholders, there is no more important question to be asked.

Answer 30

One of the most important ways managers create shareholder value is to earn strong profits on the assets in which they have invested.

Question 31

Operating profits are the income generated from the firm’s assets independent of how the firm is financed.

Answer 31

(Notice that we are using operating profits rather than net income)

Question 32

Operating Return on Assets (OROA)

Answer 32

the ratio of a firm’s operating profits divided by its total assets. This ratio indicates the rate of return being earned on the firm’s assets.

Question 33

Operating Return on Assets (OROA) Formula

Answer 33

Operating Profits
÷
Total Assets