Financial Ratios M7 Flashcards
What happens to the ratio if the numerator and denominator drops by the same amount?
- If the numerator is smaller than the denominator it carries the most weight and the ratio direction will follow the numerator.
- If the denominator is smaller than the numerator it carries the most weight and the ratio direction will follow the denominator.
What is company trade securities considered?
Current Assets.
Proper Bad Debt write-off Journal
Write-off of an unusually large receivable would result in no change to the ratio. Net accounts receivable (gross accounts receivable – allowance for doubtful accounts) would not change, as a write-off results in a debit to allowance for doubtful accounts and a credit to accounts receivable.
What does investors use each financial statement for?
- Liquidity ratios and coverage ratios focus on balance sheet account balances.
- Income statement information is primarily used for profitability analysis.
- The statement of retained earnings is primarily a reconciliation of the retained earnings account.
- The statement of cash flows assesses cash inflows and cash outflows.
What is the directional relationship between the ratio numerator, denominator and results?
- If the results goes down that means the numerator goes down and/or the denominator had to go up.
- If the results goes up that means the numerator went up and/or the denominator had to go down.
ACTIVITY RATIO USES
Activity ratios measures how effective a firm is in using it’s assets.
ACTIVITY RATIOS: Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of goods sold / Average inventory
How to analyze Inventory turnover?
- If cost of goods sold decreases, the inventory turnover ratio would also decrease.
- If the Inventory Turnover Ratio increased significantly, this means a smaller amount of inventory is on hand TY vs. LY if sales remain the same
ACTIVITY RATIOS: Accounts Receivable Turnover Ratio
Accounts Receivable Turnover Ratio: net sales / by average accounts receivable (net)
How to Analyze Accounts Receivable Turnover Ratio?
- The accounts receivable turnover ratio is calculated as sales (net) / average accounts receivable (net). More aggressive collection policies will result in a decrease in the receivables balance, which in turn causes the turnover ratio to increase.
- A deterioration in the aging of receivables implies a greater receivables balance, which would cause the turnover ratio to decline.
- If sales remain the same while this ratio increases, receivables have likely declined.
- Recording fictitious sales generally has the same impact on revenues and receivables: both would be overstated by the same dollar amount.
- A substantially lower accounts receivable turnover ratio may indicate collectability issues.
ACTIVITY RATIOS: Asset Turnover Ratio
Asset turnover: Sales (net) / average total assets
How to analyze the Asset Turnover Ratio?
- If Asset Turnover goes up, this indicates that either the net sales jumped or the Asset base went down.
ACITVITY RATIOS: Days Sales in Accounts Receivable
Days Sales in AR = ending accounts receivable (net) / the credit sales (net) / 365
OR
Average net receivables × (365 / Net credit sales)
Days sales in accounts receivable = $1,200 / ($7,200 / 365) = 60.8 days
ACTIVITY RATIOS: Accounts Payable Turnover
Accounts payable turnover cost of goods sold ÷ average accounts payable
What does LIQUIDITY RATIOS measure?
A firm’s short-term ability to pay its debt.
How to analyze Liquidity ratios?
- Liquidity ratios and coverage ratios focus on balance sheet account balances.
- Income statement information is primarily used for profitability analysis.
- The statement of retained earnings is primarily a reconciliation of the retained earnings account.
- The statement of cash flows assesses cash inflows and cash outflows.
LIQUIDITY RATIOS: Current and Quick Ratio
Current Ratio: Current Asset/Current Liability
- If inventory goes down from period to period than current assets will go down
Quik Ratio: Cash and Equivalents + Short-Term Receivables + Net Receivables / Current Liabilities
- Since Inventory is not included in Quick Ratio it should hold steady if inventory on hand decreases
How to analyze current ratio?
Liquidity Ratio
A decrease in inventory would decrease the Current Ratio, while leaving the Quick Ratio unchanged as Quick Ratio does not have inventory in it.
How to analyze the Quick Ratio?
- Improved collections and a decrease in overall credit sales would likely reduce the AR balance, which is used to calculate the Quick Ratio. Therefore, the Quick Ratio should decrease.
What does PROFITABILITY RATIOS measures?
Profitability Ratios measures success or failure of the company for a period of time.
PROFITABILITY RATIOS: Return on Asset
ROA:
Net Income / Avg. Total Asset
OR
(Net income / Net sales ) × (Net sales/ Average total assets)
PROFITABILITY RATIOS: Proft Margin
Profit Margin: (or use Operating income instead of net in some cases)
Net Income/Net Sales
PROFITABILITY RATIOS: Gross Proft Margin
- Gross Profit Margin%:
(net) - COGS / Sales (net) - Gross Margin:
Net Sales - COGS
How to analyze the Gross Profit Margin?
- If the cost of goods sold increased and sales remained constant, the gross profit percentage would decrease.
PROFITABILITY RATIOS: Return on Equity
Return on Equity:
Net Income/Avg. Total Equity
NET FIXED ASSETS TO EQUITY
Net Fixed Assets/Equity
What are LONG-TERM DEBT PAY ABILITY RATIO USES?
Measures security for long-term creditors and investors
LONG-TERM DEBT PAYING RATIOS: Times Interest Earned
Times Interest Earned:
Income before interest expense and taxes / Interest Expense
or
Earnings Before Interest and Taxes/ Interest Expense
How to analyze The Times Interest Earned Ratio?
- If the Times Interest Earned ratio goes down, this indicates that the interest expense increased or EBIT went down.
DEBT-TO-EQUITY RATIO
Debt-to-Equity: Total liabilities / Common shareholders’ equity
How to analyze Debt to Equity Ratio?
- If Debt-to-Equity Ratio goes up, this indicates that Liabilities increased during the period.
How to analyze if there are unrecorded liabilities?
A decrease in accounts payable as a percentage total current liabilities most likely indicates possible unrecorded liabilities.
Total Debt Ratio
Total Liabilities/Total Assets
How to analyze Total Debt Ratio?
- If Total Debt Ratio goes up, this indicates that Debt has increased.
