FM - Ratio Analysis Flashcards
Ratio analysis
The development of quantitative relationships between various elements of a firm’s financial and other information.
- uses monetary measures as well as other quantitative measures.
- Solvency.
- Operational activity.
- Investment leverage.
- Ratio analysis and related measures can be used to compare the performance and position of a firm over time and to compare the performance and position of multiple firms.
- When both an income statement value and a balance sheet value are used to create a ratio, the average balance sheet value should be used.
Liquidity (also known as Solvency)
Measures the ability of the firm to pay its obligations as they become due.
Working Capital Ratio
= Current Assets / Current Liabilities
a. An increase in current assets (alone) increases the WCR.
b. A decrease in current assets (alone) decreases the WCR.
c. An increase in current liabilities (alone) decreases the WCR.
d. A decrease in current liabilities (alone) increases the WCR.
e. If the WCR equals 1.00, equal increases or equal decreases in current assets and liabilities will not change the WCR; it will remain 1.00
f. If the WCR exceeds 1.00 then:
i. Equal increases in current assets and liabilities decrease the WCR.
ii. Equal decreases in current assets and liabilities increase the WCR.
Acid Test ratio
(also known as quick ratio)—Measures the quantitative relationship between highly liquid assets and current liabilities in terms of the “number of times” that cash and assets that can be converted quickly to cash cover current liabilities. It is computed as:
Acid test Ratio = (Cash + (Net) Receivables + Marketable Securities) / Current Liabilities
Defensive-interval ratio
measure of how long available cash and other highly liquid assets could support normal cash requirements.
Defensive-Interval Ratio =
(Cash + (Net) Receivable + Marketable Securities) / Average Daily Cash Expenditures
Average collection period
Measures the number of days on average it takes an entity to collect its accounts receivable; the average number of days required to convert accounts receivable to cash. It is computed as:
Average Collection Period = (Days in Year × Average Accounts Receivable) / Credit Sale for Period
-the average collection period focuses on liquidity, that is, how long before accounts receivable can be expected to convert to cash (i.e., be collected). That approach or perspective would be important in cash budgeting, for example.
Times interest earned ratio
measures the ability of current earnings to cover interest payments for a period. It is measured as:
Times‐Interest‐Earned Ratio = (Net Income + Interest Expense + Income Tax Expense) / Interest Expense
Times preferred dividends earned ratio
Measures the ability of current earnings to cover preferred dividends for a period. It is computed as:
Times Preferred Dividends Earned Ratio = Net Income / Annual Preferred Dividend Obligation
Accounts receivable turnover
Measures the number of times that accounts receivable turnover (are incurred and collected) during a period. Indicates the quality of credit policies (and the resulting receivables) and the efficiency of collection procedures. It is computed as:
Accounts Receivable Turnover = (Net) Credit Sales / Average (Net) Accounts Receivable (e.g. Beginning + Ending/2)
-is an indicator of the quality of credit policy and credit collections.
Number of days’ sales in average receivables
Measures the average number of days required to collect receivables; it is a measure of the average age of receivables. It is computed as:
Number of Days Sales In Average Receivables = 300 or 360 or 365 (or other measure of business days in a year) / Accounts Receivable Turnover (computed in A, above)
-the number of days’ sales in average receivables focuses on how well the granting of credit and the collection of sales on account are being managed. That approach or perspective is important in policy and performance review.
Inventory turnover
Measures the number of times that inventory turns over (is acquired and sold or used) during a period. Indicates over or under stocking of inventory or obsolete inventory
Inventory Turnover = Cost of Goods Sold / Average Inventory (e.g. Beginning + Ending/2)
-If the cost of goods sold increases while average inventory remains constant, there has been a more efficient use of inventory.
Number of days’ supply in inventory
(also number of days’ sales in inventory) - Measures the number of days inventory is held before it is sold or used. Indicates the efficiency of general inventory management. It is computed as:
Number of Days’ Supply in Inventory = 300 or 360 or 365 (or other measure of business days in a year) / Inventory Turnover (computed in 2, above)
Accounts payable turnover
Measures the number of times that accounts payable turnover (are incurred and paid) during a period. Indicates the rate at which an entity pays its average accounts payable and, thereby, how well it manages paying its obligations. It is computed as:
Accounts Payable Turnover = Credit Purchases/Average Accounts Payable (e.g., (Beginning + Ending)/2)
If the amount of credit purchases is not available, an entity may use cost of goods sold, adjusted by changes in inventory.
(Cost of Goods Sold +Ending Inventory - Beginning Inventory)/Average Accounts Payable
Number of days’ purchases in average payables
Measures the average number of days required to pay accounts payable; it is a measure of the average age of payables. It is computed as:
Number of Days Purchases in Average Payables = 300 or 360 or 365 (or other measure of business days in a year) / Accounts Payable Turnover (computed in E, above).
Capital turnover
Measures how well the number of times that the average owners’ equity is represented by sales (revenue) during a period. It shows how well the entity is using owners’ equity to generate revenue. (This is different than return on owners’/shareholders’ equity, which uses net income [not revenue] as the numerator. It is computed as:
Capital Turnover = Annual Sales (or Revenue)/Average Owners’ Equity.
