HBX- Accounting 6 Flashcards

Question

Explain the purpose of the ratio Days Inventory and state the formulas.

Answer 1

* Days Inventory is closely tied to the inventory turnover. The only difference is that it is expressed as the average number of days the inventory is held before it is sold rather than how many times the inventory turned over during the period. Analyzing ratios expressed in days can often be more intuitive as we can more easily conceptualize the average number of days it takes to sell inventory. * Two Ways to Calculate * **DAYS INVENTORY = AVERAGE INVENTORY / (COST OF GOODS SOLD/365)** * **DAYS INVENTORY = 365 / INVENTORY TURNOVER**

Answer 2

Inventory Turnover is calculated by dividing the annual Cost of Goods Sold (or Cost of Sales in this case) by the average inventory value for the year. In this case, we are using a two-point average of beginning and end of year asset values so the calculation is as follows: Cost of Sales / Average Inventory = 106,606 / 1,278 = 83.45 Days Inventory is calculated by dividing Average Inventory by the average daily Cost of Sales which is Cost of Sales divided by 365. Average Inventory / Average Daily Cost of Sales = 1,278 / 292 = 4.37 There are several formulas that could help you arrive at the correct answer, but one solution is presented below: Inventory Turnover: =C15/AVERAGE(B4:C4) Days Inventory: =AVERAGE(B4:C4)/(C15/365)

Answer 3

* The Accounts Receivable Turnover, often called AR turnover, is similar to the inventory turnover, but **provides an indication of a business’ efficiency in collecting receivables from customers**. AR turnover represents the number of times per year a company is collecting its outstanding accounts receivable. Uncollected receivables represent cash that is tied up and can’t be used for other purposes. An AR turnover that is too low could indicate that the business’ customers are having trouble paying. Inefficient cash collections could lead to eventual cash flow problems. * **AR TURNOVER = CREDIT SALES / AVERAGE ACCOUNT RECEIVABLES** *\*Notice how again we used the average AR balance, as we did with inventory. This is for the same reasons mentioned previously.* * **_A higher AR turnover represents more efficient cash collections_.** Note that in the absence of information about credit sales, we will often simply use sales as a substitute. There are some limitations to simply using sales, especially if a company does have a large discrepancy between total sales and credit sales.

Answer 4

* **The average collection** **period**, sometimes referred to as _Days Sales Outstanding_ or _Days Sales in Receivables_, **is the average number of days it took for a business to collect payment from a customer.** It is closely tied to the AR turnover. The AR turnover and average collection period ratios are parallel to Inventory turnover and days inventory ratios. Both reveal information about the efficiency of managing a specific account in terms of number of times per year the account is turned over or the number of days values remain in the account.**The average collection period is very useful because it can be compared to the cash collection policy of the firm.** If payment is expected from customers within 30 days, but the average collection period is 40 days, it may be a sign of concern. Businesses can influence their collection period by altering the payment terms they offer, but will have to balance the desire for greater cash collection efficiency with the impact that it will have on sales, as customers generally find value in receiving credit terms from a supplier. * **AVERAGE COLLECTION PERIOD =** * *AVERAGE ACCOUNTS RECEIVABLE / AVERAGE CREDIT SALES PER DAY** * \*Assuming all sales were made on credit, Credit Sales per Day can be calculated as Sales / 365. Again, in the absence of information about credit sales, we will often simply use sales as a substitute anyway.* * **AVERAGE COLLECTION PERIOD = 365 /** **ACCOUNTS RECEIVABLE TURNOVER** The average collection period for H&M was 6.86 days. This is a relatively small collection period likely due to H&M receiving most payments from customers by cash or credit card. Credit card companies typically transfer the actual cash to the vendor within a few days. A business that sells to other businesses and provides credit terms, will have a much larger collection period.

Answer 5

**Accounts Receivable Turnover** is calculated by dividing the annual credit sales by the average accounts receivable balance. In this case, we assume that all of Apple's revenue is from sales made on credit terms. Again we will use a 2-point average of beginning and end of year accounts receivable balances. Credit Sales / Average Accounts Receivable = 170,910 / 12,016 = 14.22 Average Collection Period is calculated by dividing Average A/R by the average daily Credit Sales, which is Credit Sales divided by 365. Average Accounts Receivable / Average Daily Credit Sales = 12,016 / 468 = 25.66 There are several formulas that could help you arrive at the correct answer, but one solution is presented below: Accounts Receivable Turnover: =C14/AVERAGE(B3:C3) Average Collection Period: =AVERAGE(B3:C3)/(C14/365)

Answer 6

* Accounts Payable Turnover, or AP turnover, is very similar to both inventory turnover and AR turnover. The same process is followed but for the accounts payable account. **We are looking at how long it takes us to pay our vendors** (suppliers of inventory/services or other non-inventory items) * **ACCOUNTS PAYABLE TURNOVER = CREDIT PURCHASES / ACCOUNTS PAYABLE** * **ACCOUNTS PAYABLE TURNOVER = COGS / AVERAGE ACCOUNTS PAYABLE** * One input for this ratio is credit purchases. If this ratio is being calculated by someone outside of the business, credit purchases can be a difficult number to determine. He or she likely won’t know exactly what credit purchases are. **_A common way to estimate credit purchases is to use_** **_cost_** **_of goods sold_.** This will usually be slightly different than actual credit purchases because fluctuations in inventory and other current asset accounts would mean that more or less was sold or used than was actually purchased. That said, COGS is probably a reasonable proxy for purchases for merchandising companies such as retailers, wholesalers, and distributors. **However for manufacturing companies, labor and overhead are included in** **cost** **of goods sold, but they aren’t part of actual purchases. We can adjust for inventory fluctuations by adding or subtracting the change in inventory to the COGS amount**, similar to what we did when creating the statement of cash flows. Added labor can be a bit more difficult to figure out. For simplicity in this course, we’ll use Cost of Goods Sold as a surrogate for credit purchases. This is still a very useful number, especially when used to identify trends over time rather than to draw specific conclusions from the ratio for an isolated year. * Another assumption being made by this approach is that all goods are bought on credit and not paid for with cash. If a business pays cash for some purchases, other adjustments may have to be made. * **_A smaller AP turnover, meaning it is taking longer to pay suppliers, isn’t necessarily a bad thing as long as payment is being made within the terms or expectations of the supplier_.** Generous payment terms from a supplier can be a huge benefit to a business because it acts as free short term financing. However, companies are often offered a discount for paying quickly, so there is a trade off between discounts for paying early and taking advantage of free short term financing.

Answer 7

* Another way to gauge our accounts payable is to look at days purchases outstanding. Again this simply shows the AP turnover measured in average days outstanding. A days purchases outstanding that is longer than the allowed terms from the vendor could indicate that the business is struggling to pay its obligations. * **DAYS PURCHASES OUTSTANDING = AVERAGE ACCOUNTS PAYABLE / (ANNUAL CREDIT PURCAHSES/365)** \*where credit purchases data is available * **DAYS PURCHASES OUTSTANDING = AVERAGE ACCOUNTS PAYABLE / (COGS/365)** \*where credit purchases data is NOT available * **DAYS PURCHASES OUTSTANDING = 365 / ACCOUNTS PAYABLE TURNOVER** \*Another formula to look at * For H&M, using COGS as a proxy for credit purchases, the days purchases outstanding in 2012 was 31.86 days. This means that, on average, H&M pays its suppliers back within about 31.86 days.

Answer 8

Accounts Payable Turnover is calculated by dividing the annual credit purchases by the average accounts payable balance. In this case, we do not have access to Apple's credit purchases so we are using Cost of Sales as a proxy. Again we will use a 2-point average of beginning and end of year accounts payable balances. Cost of Sales / Average Accounts Payable = 106,606 / 21,771 = 4.90 Days Purchases Outstanding is calculated by dividing Average Accounts Payable by the average daily Cost of Sales, which is Cost of Sales divided by 365. Average Accounts Payable / Average Daily Cost of Sales = 21,771 / 292 = 74.54 There are several formulas that could help you arrive at the correct answer, but one solution is presented below: Accounts Payable Turnover: =C17/AVERAGE(B7:C7) Days Payable Outstanding: =AVERAGE(B7:C7)/(C17/365)

Answer 9

* This metric is a measure of **how long it takes a business from the time it has to pay for inventory from its suppliers until it collects cash from its customers.** This number has a large impact on the cash needs of a business. * **CASH CONVERSION CYCLE =** * *DAYS INVENTORY + AVERAGE COLLECTION PERIOD - DAYS PURCHASES OUTSTANDING** * A business that is growing and has a positive cash conversion cycle will need more and more cash to fund operations as it gets bigger.

Answer 10

The correct answer is -44.50. The correct answer formula is: =F6+F7-F8 The Cash Conversion Cycle is the number of days between when your company pays for inventory purchases and when your company collects from customers. It is calculated by subtracting the Days Purchases Outstanding from the total of the Days Inventory and the Average Collection Period. For the year ending June 30, 2013 it was: Days Inventory + Average Collection Period - Days Purchases Outstanding = 4.37 + 25.66 - 74.54 = -44.50

Answer 11

* **Increase in inventory ending balance** * Asset Turnover = Sales / Average Assets An increase in the inventory ending balance will cause Average Assets, the denominator, to increase, and thus will decrease Asset Turnover.

Answer 12

* Inventories were less marketable compared with last year. * Inventory Turnover = Cost of goods sold / Average inventory As the inventories became less marketable, the company would be less efficient in operating its inventories, and thus the Inventory Turnover would decrease.

Answer 13

* **Company A has a lower Inventory Turnover than Company B.** * Days Inventory = Average Inventory / (COGS / 365) Days Inventory is inversely related to Inventory Turnover. A company with a lower Inventory Turnover would have a higher Days Inventory.

Answer 14

* **Company A is more efficient in collecting receivables from customers than Company B.** * Average Collection Period = 365 / (Credit Sales / Average AR Balance) A lower Average Collection Period means the company is more efficient in collecting from their customers.

Answer 15

**Company A has a lower Accounts Payable Turnover than Company B.** Days Purchases Outstanding = 365 / (Credit Purchases / Average Accounts Payable Balance) Days Purchases Outstanding is inversely related to Accounts Payable Turnover. A company with a higher Days Purchases Outstanding would have a lower Accounts Payable Turnover.

Answer 16

* Leverage (Leverage = Assets / Equity) * Debt to Equity Ratio (Debt to Equity Ratio = Average Total Liabilities / Average Total Equity)

Answer 17

* The last section of the DuPont Framework is financial leverage, which is also known as the equity multiplier. **This measures the impact of all non-equity financing, or debt of all sorts, on the firm's ROE.** If all of the assets are financed by equity, the multiplier is one. As liabilities, which are forms of debt, increase, the multiplier increases from one, demonstrating the leverage impact of the debt. * **LEVERAGE = ASSETS / EQUITY** * While increased leverage has the potential to increase returns, it also increases the riskiness of the investment. When a business makes a loss, the debt amplifies the impact of the loss on equity holders. Moreover, if the business were to fail, debt holders would receive their money back before any money went to the equity holders. Leverage is calculated by dividing average total assets by average equity. H&M's leverage for 2012 was 1.37, meaning that for every krona of equity outstanding, it had .37 krona funding from various liabilities. * You can think of it this way. If a firm receives a $100 equity investment and has no debt, it can use that $100 to buy assets that generate income. If the firm takes out an additional $100 of debt, however, it can use the extra capital to purchase even more revenue-generating assets, resulting in even more profits for the shareholders, provided the business generates a higher return on its assets than the cost of the debt.

Answer 18

In the DuPont Framework, the leverage ratio is calculated by dividing the average total assets by the average equity. Average Total Assets / Average Equity = 191,532 / 120,879.50 = 1.58 The suggested correct answer formula is: =AVERAGE(B6:C6)/AVERAGE(SUM(B12:B14),SUM(C12:C14))

Answer 19

* Another very common indicator of leverage is the debt to equity ratio. **This number is very similar to the equity multiplier, but we use total liabilities in the numerator rather than assets.** * **DEBT TO EQUITY = AVERAGE TOTAL LIABILITIES / AVERAGE TOTAL EQUITY** * Debt to equity for H&M was 0.37 for 2012.

Answer 20

The Debt to Equity Ratio is calculated by dividing the total liabilities by the total equity. In this case, total liabilities includes Accounts Payable, Accrued Expenses, Other Current Liabilities, Long Term Debt, and Other Long Term Liabilities. Total equity includes Common Stock, Retained Earnings, and AOCI & Other Equity. For 2012, total liabilities are $57,854 and total equity is $118,210. Total liabilities / total equity = $57,854 / $118,210 = 0.49 The suggested correct answer formula is: =SUM(B7:B11)/SUM(B12:B14) For 2013, total liabilities are $83,451 and total equity is $123,549. Total liabilities / total equity = $83,451 / $123,549 = 0.68 The suggested correct answer formula is: =SUM(C7:C11)/SUM(C12:C14) For the average, average total liabilities are $70,653 and average total equity is $120,880. Total liabilities / total equity = $70,653 / $120,880 = 0.58 The suggested correct answer formula is: =AVERAGE(SUM(B7:B11),SUM(C7:C11))/AVERAGE(SUM(B12:B14),SUM(C12:C14)) Note that there is no requirement to calculate ratios using beginning and ending balances before calculating a ratio using average balances, but some managers may find it useful to see how the ratio differs under these different calculation methods.

Answer 21

* The current ratio **helps us understand the business’ ability to pay its** **short term** **obligations**, and is measured as current assets divided by current liabilities. The ratio focuses on the business’ more liquid assets and liabilities, or those that are convertible to cash or coming due, within a year. Remember that *_short term_* _assets_ (Essentially these are the assets that a business has in cash or will turn into cash to help pay approaching obligations.) are like (Cash, Inventory, accounts receivable. *_Current liabilities_* (are items that must be paid, in cash, in the short term.) include accounts payable & wages payable. * **CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES** * **If current assets aren’t larger than current liabilities, which would lead to a ratio less than 1, it could indicate that a business may have trouble meeting its obligations in the near term.** Generally, the higher the current ratio the better position the business is in to meet its approaching liabilities. But if the current ratio is too high, it might indicate that the business is not managing its working capital efficiently. * *Let’s look at how the current ratio would be calculated for H&M. H&M had current assets of 37.23 billion krona and current liabilities of 14.01 billion* *krona**. This results in a current ratio of 2.66, meaning that**for every krona in current liabilities, H&M has 2.66******krona******in at least somewhat liquid assets to be able to pay those liabilities.***

Answer 22

The Current Ratio is calculated by dividing Current Assets by Current Liabilities at a point in time. For this ratio, we do not use the average amounts. Current Assets include Cash, Equivalents, Marketable Securities, Accounts Receivable, Inventory, and Other Current Assets. Current Liabilities include Accounts Payable, Accrued Expenses, and Other Current Liabilities. Current Assets / Current Liabilities = 73,286 / 43,658 = 1.68 The suggested correct answer formula is: =SUM(B2:B5)/SUM(B12:B14)

Answer 23

**Current assets continued to grow without a proportionate increase** **to** **its liabilities.** There has been some increase in working capital coming from increases in cash, accounts receivable, and other current assets, and the biggest increase in short term marketable securities.

Answer 24

**Looks the same on the surface but underlying changes are resulting in higher cash.** Although the change in the current ratio is very small, there are significant underlying movements. Increases in accounts receivable have been offset by increases in accounts payable & accrued expenses. The biggest change could be the reduced investment in inventory which could be a reason cash has increased.

Answer 25

* **H&M likely has better ability to pay off its short-term liabilities than Cardullo's.** * Current ratio indicates a company's liquidity. A higher current ratio means a higher proportion of current assets available to cover current liabilities.

Answer 26

* **Cardullo's has** **better** **ability to pay off its short-term liabilities in 2013 than in 2012.** * Current ratio indicates a company's liquidity. A higher current ratio means a higher proportion of current assets available to cover current liabilities.

Answer 27

* The quick ratio is similar to the current ratio except only highly liquid current assets are used in the numerator. One way to calculate this is to use current assets less inventory (because inventory tends to be less liquid than other current assets). **The quick ratio is an even more stringent test than the current ratio to _see if a business can meet its current obligations_ because it depends only on the most readily available current assets.** Some businesses may have trouble turning their inventory into cash, so this gives us an idea of their ability to meet current obligations even if their inventory can’t be sold immediately. This ratio is also sometimes called an acid test ratio. * **QUICK RATIO = CURRENT ASSETS - INVENTORY / CURRENT LIABILITIES** * H&M’s quick ratio for 2012 was 1.57. Notice that this is significantly lower than the current ratio of 2.66. This is due to H&M’s large stock of inventory.

Answer 28

The Quick Ratio is calculated by dividing the most liquid Current Assets by Current Liabilities at a point in time. One way to calculate Quick assets removes inventories from current assets. At September 28, 2013: (Current Assets - Inventory) / Current Liabilities = 71,522 / 43,658 = 1.64 The suggested correct answer formula is: =(SUM(B2:B5)-B4)/SUM(B12:B14)

Answer 29

* For this, we use a common income number called:**_is a good way to gauge how capable a business is of making the interest payments on its debt._** The interest coverage ratio, also known as times interest earned, EBIT (Earnings Before Interest and Taxes). This number has to be calculated from the income statement by: * adding back interest expense and tax expense for the period to net income. * We then divide by interest expense for the period. * **This ratio tells us the number of times a company can cover its interest expense using its earnings before interest and taxes.** * **INTEREST COVERAGE RATIO = EBIT / INTEREST EXPENSE** * *OR** * *TIMES INTEREST EARNED = EBIT / INTEREST EXPENSE** * Because H&M had relatively low interest expense for the period, it has a very large times interest earned of 4,458. This means that H&M has a high enough EBIT to cover its interest expense 4,458 times.

Answer 30

To calculate Earnings Before Interest and Taxes (EBIT), we start with Net Income and then add back Interest Expense and Income Tax Expense. Net Income + Interest Expense + Income Tax Expense = 37,037 + 136 + 13,118 = 50,291 The suggested correct answer formula is: =B16+B11+B15 To calculate the Interest Coverage Ratio, we divide EBIT by Interest Expense. EBIT / Interest Expense = 50,291 / 136 = 370 The suggested correct answer formula is: =E6/B11

Answer 31

* **Outcomes of the analysis would depend on when you are looking at the statements.** * Ratio analysis could differ significantly by looking at peak times as opposed to the entire fiscal year.

Answer 32

Toy retailer

Answer 33

**Most ratios, however, are in some ways influenced by** **managerial** **judgment in recording transactions.** While accounting standards attempt to minimize the differences between companies, situations exist where two companies will reasonably elect different ways of accounting for items that appear very similar. Understanding these differences is essential to analyzing companies using ratio analysis. **In some cases, you'll need to make adjustments to financial statements to account for the differences before they can be used for comparisons. _Three of these differences include:_** * **Revenue Recognition** (How do you account for a liberal return policy where the customer can return an item for any reason for a full refund? Or what about a membership fee where a business is providing a service to a customer over time, but the customer can cancel the membership and receive a full refund at any time? What if the fee is non-refundable? The way a business answers these questions and the resulting revenue recognition will have a large impact on the amount of revenue that they recognize for a given period.) * **Capitalizing Expenditures.** How does a business deal with improvements and upgrades that extend the useful life of previously existing assets? Does a business purchase and capitalize assets or lease their assets? How does the level of what is considered material differ between businesses? The financials could look very different for operationally similar firms depending on these choices. * **Depreciation.** We looked previously at how many assumptions are included when a business determines how a long-lived asset will be depreciated. What if these assumptions were to change during the lifetime of the asset? We mentioned how improvements can change some of these assumptions, but other factors such as market conditions can also change management’s estimates. How will this impact the financial statements?

Answer 34

* **The current ratio**- helps us understand the business’ ability to pay its short-term obligations CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES * **The quick ratio-** is an even more stringent test than the current ratio to see if a business can meet its current obligations because it depends only on the most readily available current assets QUICK RATIO CURRENT ASSETS - INVENTORY / CURRENT LIABILITIES * **The interest coverage ratio**, also known as times interest earned- is a good way to gauge how capable a business is of making the interest payments on its debt INTEREST COVERAGE RATIO = EBIT / INTEREST EXPENSE OR TIMES INTEREST EARNED = EBIT / INTEREST EXPENSE

Answer 35

One common problem when comparing financial statements from different companies is that different sizes and scales of businesses can make it difficult to compare them. One helpful tool is to prepare **common size financial statements.** * divide each number on the balance sheet by total assets * each number in the income statement by sales This converts the financial statement items into ratios that help us see trends and can easily be compared from one company to another.

Answer 36

The correct answer is Company B. Company B is likely a high volume retailer because its low profit margin indicates that it isn't adding a lot of value to products, and the high asset turnover means that it is selling through a lot of inventory.

Answer 37

* **The efficiency with which assets are used to generate revenue** * DuPont framework measures a business' operating efficiency using Asset Turnover, which indicates how well a business is using its assets to produce sales. A business that can create more revenue with fewer assets is considered to be more efficient.

Answer 38

* **The debt is implied in the numerator (total assets)** * As liabilities (including debt) increase, the equity multiplier will be higher than one. Increasing leverage has the potential of higher returns but the investment become riskier too.

Answer 39

**Company A is more efficient in utilizing its assets than Company B.** Company A has a higher ROE than Company B because it has a higher Asset Turnover Ratio, which means Company A is more efficient in utilizing its assets.

Answer 40

To complete these cases, it is best to start by looking for something that stands out as being very different. In this case, one of the most notable differences is that Company C has zero inventory, so we start there. **Company C** has zero inventory, which indicates it is likely a service industry. It also has very high plant & equipment. So this must be in the **airline industry.** **Company A** has high inventory which indicates it is retail. It also has high plant & equipment which means it has many and large stores. The low receivables collection period indicates that the company makes most of its sales in cash or credit card. It also has a high inventory turnover, which means it sells its inventory quickly. All of these signs point to **a grocery retail chain.** **Company B** has a very high inventory turnover, indicating that whatever inventory they have moves quickly. The relatively low plant and equipment combined with the high inventory turnover suggests that a lot of sales are made online and there are relatively few brick and mortar stores. The high receivables collection period is usually due to an extension of credit, so the company likely makes a lot of sales business-to-business, rather than directly to the consumer. So this is in the **electronic consumer products industry.**

Answer 41

* When a top number on a fraction increases (or just is bigger), the final # gets bigger * When the bottom number on a fraction increases (or is bigger), the final # gets smaller

HBX- Accounting 6 Flashcards

(66 cards)