Ratio Analysis

Question 1

Define “ratio analysis” (for financial management)

Answer 1

The development of quantitative relationships between various elements of a firm’s financial, operating and other information.

Question 2

Describe the benefits provided by ratio analysis

Answer 2

Provides measures and enables comparisons of a firms operating and financial activities and position:

1. For a single firm over time;
2. Across firms.

Facilitates identifying operating and financial strengths and weaknesses of a firm.

Question 3

When a ratio requires using a Balance Sheet value together with an Income Statement value, how should the Balance Sheet value be determined?

Answer 3

When a Balance Sheet value is used together with an Income Statement value in a ratio, the Balance Sheet value must be an average balance for the period covered by the Income Statement, not the year-end (or other point-in-time) balance.

Question 4

Define “liquidity measures”. (aka solvency measures)

Answer 4

Measurements of the ability of a firm to pay its obligations as they become due; useful in working capital management.

Question 5

What does “working capital” measure? How is it expressed as a formula?

Answer 5

Measures the extent to which current assets exceed current liabilities and, thus, are uncommitted in the short term; expressed as:

Working Capital = Current Assets - Current Liabilities.

Question 6

What does the “working-capital ratio” (also called the “current ratio”) measure? How is it expressed as a formula?

Answer 6

Measures the quantitative relationship between current assets and current liabilities in terms of the “number of times” current assets can cover current liabilities; expressed as:

Working Capital Ratio = Current Assets/Current Liabilities.

Question 7

What does the “acid test ratio” (also called the “quick ratio”) measure? How is it expressed as a formula?

Answer 7

Measures the relationship between highly liquid assets and current liabilities; expressed as:

Acid Test Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Current Liabilities

Note: Inventory is excluded from the numerator.

Question 8

What does the “defensive-interval ratio” measure? How is it expressed as a formula?

Answer 8

Measures the relationship between highly liquid assets and the average daily use of cash; expressed as:

Defensive-Interval Ratio = (Cash [Cash Equivalents] + Net Accounts Receivable + Marketable Securities)/Average Daily Cash Expenditures.

Question 9

What does the “times-interest-earned ratio” measure? How is it expressed as a formula?

Answer 9

Measures the ability of current earnings to cover interest payments for a period; expressed as:

(Net Income + Interest Expense + Income Tax Expense)/Interest Expense.

Question 10

Describe operational activity measures.

Answer 10

Ratios (and other measures) that measure the efficiency with which a firm carries out its operating activities.

Question 11

What does the “operating cycle length” measure? How is it expressed as a formula?

Answer 11

Measures the average length of time to invest cash in inventory, convert the inventory to receivables, and collect the receivables; it measures the time to go from cash back to cash and is expressed as:

Operating Cycle Length = Number of Days’ Sales in Average Receivables + Number of Days’ Supply in Inventory.

Question 12

What does the “accounts receivable turnover ratio” measure? How is it expressed as a formula?

Answer 12

Measures the number of times that accounts receivable turnover (are incurred and collected) during a period; expressed as:

Accounts Receivable Turnover = Credit Sales/Average Net Accounts Receivable. Useful in assessing credit policies and collection efficiency.

Question 13

What does the “number of days’ sales in average receivables ratio” measure? How is it expressed as a formula?

Answer 13

Measures the average number of days required to collect receivables; measures the average age of receivables.

Number of Days Sales in Average Receivables = 365 (or other days)/Accounts Receivable Turnover.

Question 14

What does the “inventory turnover ratio” measure? How is it expressed as a formula?

Answer 14

Measures the number of times that inventory is acquired and sold or used during a period; expressed as:

Inventory Turnover = Cost of Goods Sold/Average Inventory. Useful in assessing overstocking/understocking of inventory and obsolete inventory.

Question 15

What does the “number of days’ supply in inventory ratio” measure? How is it expressed as a formula?

Answer 15

Measures the number of days inventory is held before it is sold or used; indicates the efficiency of inventory management.

Number of Days Supply in Inventory = 365 (or other days)/Inventory Turnover.

Question 16

Describe profitability measures.

Answer 16

Ratios (and other measures) that measure aspects of a firm’s operating (profit/loss) results on a relative basis.

Question 17

What does the “gross profit margin ratio” measure? How is it expressed as a formula?

Answer 17

Measures how much (percentage) of each sales dollar that is available to cover operating expenses and provide a profit; expressed as:

Gross Profit Margin = Gross Profit/Net Sales

Question 18

What does the “net profit margin on sales” measure? How is it expressed as a formula?

Answer 18

Measures how much (percentage) of each sales dollar that ends up as net income; expressed as:

Profit Margin = Net Income/Net Sales.

Question 19

What does the “return on total assets” (also called the “return on investment”) measure? How is it expressed as a formula?

Answer 19

Measures the rate of return on total assets and indicates the efficiency with which invested resources (assets or total equity) are used; expressed as:

Net Income + Interest Expense + Income Taxes/Average Total Assets.

(NOTE: Some versions may not add back Interest Expense and/or Income Taxes.)

Question 20

What does the “return on owners’ (all stockholders’) equity ratio” measure? How is it expressed as a formula?

Answer 20

Measures the rate of return (earnings) on all stockholders’ investment; expressed as:

ROE = Net Income/Average Stockholders’ Equity.

Question 21

Describe the “Common Stock dividend payout rate” measure.

Answer 21

Measures the extent (percent) of earnings distributed to common shareholders; expressed as:

C/S Dividend Payout Rate = C/S Cash Dividends/Net Income Available for Common Shareholders.

Also, can be computed on a per share basis.

Question 22

What does the “residual income” measure? How is it expressed as a formula?

Answer 22

Measures the excess of an entity’s dollar amount of income over the dollar amount of its required return on average investment (based on its hurdle rate of return); expressed as:

Residual Income = Net Income - (Average Invested Capital x Hurdle Rate).

Question 23

What does the “economic value added (EVA)” measure? How is it expressed as a formula?

Answer 23

Measures an entity’s economic profit (not its accounting profit) as accounting earnings before deducting interest less the dollar value of opportunity cost associated with long-term debt and shareholders’ equity; expressed as:

EVA = Earnings before interest - [Opportunity cost rate x (L-T debt + SE)].

Question 24

What does the “price-earnings ratio” (“P/E ratio”; also called the “multiple”) measure? How is it expressed as a formula?

Answer 24

also called the “multiple”) measure? How is it expressed as a formula? Measures the price of a share of common stock relative to its latest earnings per share; expressed as:

P/E Ratio = Market price per common share/Earnings per common share.

Notice, it measures the number of times (“multiples”) earnings per share is reflected in the market price.

Question 25

Describe equity or investment-leverage measures.

Answer 25

Measures of relative sources of equity and equity value.

Question 26

What does the “debt to equity ratio” measure? How is it expressed as a formula?

Answer 26

Measures the relative amounts of assets provided by creditors (debt) and shareholders; expressed as:

Debt to Equity = Total Liabilities/Total Shareholders’ Equity.

Question 27

What does the “owners’ equity ratio” measure? How is it expressed as a formula?

Answer 27

Measures the proportion of assets provided by shareholders; expressed as:

Owners’ Equity Ratio = Shareholders’ Equity/Total Assets.

Question 28

What does the “debt ratio” measure? How is it expressed as a formula?

Answer 28

Measures the proportion of assets provided by creditors and indicates the extend of leverage used in funding the entity; expressed as:

Debt Ratio = Total Liabilities/Total Assets.

Question 29

What does the “book value per common share” measure? How is it expressed as a formula?

Answer 29

Measures the per share amount of common shareholders’ claim to assets; expressed as:

BV per CS = Common Shareholders’ Equity/Number of Common Shares Outstanding.

(Can be similarly computed for Preferred Stock, add in divds in arrears.)