Chapter 4 Flashcards
Financial Ratios
accounting data restated in relative terms in order to help people identify some of the financial strengths and weaknesses of a company.
5 Questions that can be answered by Ratio Analysis
- How liquid is the firm?
- Are the firm’s managers generating adequate operating profits from the company’s assets?
- How is the firm financing its assets?
- Are the firm’s managers providing a good return on the capital provided by the shareholders?
- Are the firm’s managers creating shareholder value?
Liquidity
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?)
A Liquid Asset
is one that can be converted quickly and routinely into cash at the current market price.
Measuring Liquidity: Perspective 1
-Compare a firm’s current assets with current liabilities using
- Current Ratio
- Acid Test or Quick Ratio
Current Ratio
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.
Current Ratio Formula
Current Assets ÷ Current Liabilities
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.
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.
Acid-test (Quick) Ratio
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.
Acid-test (Quick) Ratio Formula
(Cash + Accounts Receivable)
÷
Current Liabilities
Measuring Liquidity: Perspective 2
-Measure a firm’s ability to convert accounts receivable and inventories into cash.
- Days in Receivables (Average Collection Period)
- Inventory Turnover
Days in Receivables (Average Collection Period)
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.
Days in Receivables (Average Collection Period) Formula
Accounts Receivable
÷
Daily Credit Sales
OR
Accounts Receivable
÷
(Annual Credit Sales ÷ 365)
Accounts Receivable Turnover Ratio
a firm’s credit sales divided by its accounts receivable. This ratio expresses how often accounts receivable are “rolled over” during a year.
Accounts Receivable Turnover Ratio Formula
Annual Credit Sales
÷
Accounts Receivable
OR
365 Days
÷
Days in Receivables
Whether we use the days in receivables or the accounts receivable turnover ratio,
the conclusion is the same.
Days in Inventory
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.
Days in Inventory Formula
Inventory
÷
Daily Cost of Goods Sold
OR
Inventory
÷
(Annual Cost of Goods Sold ÷ 365)
Inventory Turnover
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.
Inventory Turnover Formula
Cost of Goods Sold
÷
Inventory
OR
365 Days
÷
Days in Inventory
When we calculate accounts receivable turnover or days in receivable, we use SALES in our computation.
When we calculate days in inventory or inventory turnover, we use COST OF GOODS SOLD.
We do this because inventory is measured at cost.
Current Ratio
Measures a firm’s liquidity.
A higher ratio means greater liquidity.
Acid-Test Ratio
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.
Days in Receivables
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.
Accounts Receivable Turnover
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.
Days in Inventory
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.
Inventory Turnover
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 1.
.
Question 2. Are the firm’s managers generating adequate operating profits from the company’s assets?
- Operating Return on Assets (OROA)
- Operating Profit Margin
- Total Asset Turnover
- Fixed Asset Turnover
“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.
One of the most important ways managers create shareholder value is to earn strong profits on the assets in which they have invested.
Operating profits are the income generated from the firm’s assets independent of how the firm is financed.
(Notice that we are using operating profits rather than net income)
Operating Return on Assets (OROA)
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.
Operating Return on Assets (OROA) Formula
Operating Profits
÷
Total Assets
