Chapter 8 Flashcards
What are financial ratios?
Relationships between certain items on the income statement and balance sheet.
Define Earning Power
The ability of a company to generate income.
Define liquidity.
The ability of a company to meet its current obligations.
Define solvency
The ability of a company to meet its long-term obligations.
What are the three common financial ratios used to determine earning power?
Earnings per share
Return on Equity
Common Size comparative statements.
Define earnings per share.
Data used to evaluate the past performance of a business, project its future earnings, and weigh investment opportunities
How do investors use earnings per share?
They compare it and share price for publically traded companies.
Define return on equity.
The rate of return on the common stockholder’s equity.
What is a common size comparative statement?
A statement assigning net sales as 100% value and then expressing each income statement item as a percentage of net sales.
How is liquidity measured?
It is measured by analyzing the strength of its working capital. (current ratio)
Working capital is the excess of its current assets over its liability’s
What is current ratio?
It is the relationship of a companies current assets to its current liabilities.
What is the acid test (or quick) ratio?
The ratio of quick assets to liabilities.
What are quick assets?
Current assets that can be quickly turned into cash-cash, notes receivable, accounts receivable, and market securities.
How is days sales uncollected calculated?
Average daily sales=Total sales/365
Days sales uncollected=accounts receivable balance/average daily sales.
Define inventory turnover.
The number of times average inventory is sold during an accounting period.
What does high inventory turnover indicate?
It indicates good merchandizing.
How is merchandise inventory turnover calculated?
merchandise inventory turnover=cost of goods sold/average inventory
What is debt service ratio?
The number of times that debt service can be paid from income.
Debt service is the principle and interest paid on a mortgage or other debt.
Why and how is debt service ratio calculated?
It is calculated to measure the security of the return offered to bondholders or a mortgage holder.
Debt ratio=(income before taxes + interest expense)/debt service
Ratio should be 2:1 or greater
What is leverage ratio and how is it calculated?
leverage ratio the relationship between liabilities and fixed assets.
leverage ratio=mortgage payable/book value of assets
What is return on fixed assets and how is it calculated?
return on fixed assets=income before debt service/average fixed assets
Used to measure management’s performance
What is an audit and when is it commonly required?
It is a formal review of an organizations financial records.
They are required for publically traded companies by the SEC, by lenders, or by large corporations with subsidiaries or branch offices.
Define earning power, liquidity, and solvency.
earning power-the ability to generate income
liquidity-the ability to meet current obligations
solvency-the ability to meet long-term obligations
Explain current ratio.
It is the relationship between a companies current assets and liabilities.
It is calculated by dividing current assets by current liabilities.
The higher the ratio the more liquid the company’s current position
What is debt service ratio?
It is the number of times debt service can be paid from income.
Why is return on fixed assets a measure of management’s performance?
Fixed assets are used to earn profit and management is responsible for how assets are used, therefore the return on fixed assets measures performance
Which set of ratios measures the ability of a firm to meet its long-term obligations?
a) earnings power
b) liquidity
c) solvency
d) profitability
c) solvency
When financial statement items are shown as a percentage of a total, the resulting comparison is known as a(n):
a) prior year comparison
b) industry comparison
c) budget comparison
d) common-size comparison
d)common-size comparison
Which is considered an adequate acid test ratio (quick test)?
a) 1 to 1
b) 2 to 1
c) 3 to 1
d) 5 to 1
a) 1 to 1
The ratio that indicates management’s ability to make its mortgage payment is called:
a) debt service ratio
b) leverage ratio
c) current ratio
d) return on equity
a) debt service ratio
Audited financial statements are always required by which entity?
a) the Securities and Exchange Commission
b) the lending bank
c) the internal audit department
d) the owner
a) the Securities and Exchange Commission
