FINANCIAL RATIOS

Question 1

Liquidity Ratios: are measures of a firm’s short-term ability to pay maturing obligations.Include:

Answer 1

Current ratio=Current assets/Current liabilities;

Quick ratio=Cash and cash equivalents+short-term marketable securities+Receivables (net)/current liabilities.

Question 2

Activity ratios:are measures of how effectively an enterprise is using its asset;
(pass key: Turnover ratios generally use average balances[eg., (beginning balance +ending balance]/2 for balance sheet components. However, on some recent CPA exam questions, candidates have been instructed to use year-end balances instead. Please be sure to read the question carefully to determine the appropriate method to use.)

Answer 2

Accounts receivable turnover=Sales (net)/Average accounts receivable (net); (faster turnover gives credibility to the current and acid-test ratios)

Days sales in accounts receivable=Ending accounts receivable (net)/[sales(net)/365]; (The ratio indicates the average number of days required to collect accounts receivables)

Inventory turnover=COGS/Average inventory; (Note: Use COGS not sales) (This measure of how quickly inventory is sold is an indicator of enterprise performance. The higher the turnover, in general, the better the performance)

Days in inventory=Ending inventory/[COGS/365]; (This ratio indicates the average number of days required to sell inventory)

Accounts payable turnover=COGS/average accounts payable; (The ratio indicates the number of times trade payables turn over during the year. A low turnover may indicate a delay in payment, such as from a shortage of cash)

Days of payables outstanding=Ending accounts payable/[COGS/365]; (The ratio indicates the average length of time trade payables are outstanding before they are paid)

Cash conversion cycle=Days sales in accounts receivable+Days in inventory-Days of payables outstanding; (The ratio indicates the average length of time it takes from when the company pays cash for an inventory purchase to when the company receives cash from a sale)

Asset turnover=Sales(net)/Average total assets; (A high ratio indicates effective asset use to generate sales)

Question 3

Profitability ratios: Measure the financial performance of an enterprise for a given time period. Include:

Answer 3

1. Profit margin=Net income/Sales (net);
2. Return on assets=Net income/Average total assets;
3. Return on sales=Income before interest income, interest expense, and taxes/Sales (net);
4. Return on equity=Net income/Average total equity;
5. Gross (profit) margin=Sales (net)-COGS/Sales (net);
6. Operating cash flow ratio=Cash flow from operations/Ending current liabilities

Question 4

Investor ratios: are measures that are on interest to investors. Include:

Answer 4

1. Basic earnings per share= Income available to common shareholders/Weighted average common shares outstanding;
2. Price earnings ratio=Price per share/Basic earnings per share; (This statistic indicates the investment potential of an enterprise; a rise in this ratio indicates that investors are pleased with the firm’s opportunity for growth.)
3. Dividend payout=Cash dividends/Net income.(This ratio indicates the portion of current earnings being paid out in dividends)

Question 5

Long-term Debt Paying Ability Ratios: Coverage ratios are measures of security for long-term creditors/investors. Include:

Answer 5

1. Debt to equity=Total liabilities/Total equity; (The ratio indicates the degree of protection to creditors in case of insolvency. The lower this ratio, the better the company’s position)
2. Total debt ratio= Total liabilities/ Total assets; (This debt ratio indicates the percentage of a company’s assets that are financed by creditors)
3. Equity multiplier=Total assets/Total equity; (This ratio measures a company’s leverage. A higher ratio indicates a company has a greater proportion of its assets financed by debt rather than equity)
4. Times interest earned=Income before interest expense and taxes/Interest expense. (This ratio reflects the ability of a company to cover interest charges. It uses income before interest and taxes to reflect the amount of income available to cover interest expense )