Ratio Analysis Flashcards
Define “ratio analysis” (for financial management)
The development of quantitative relationships between various elements of a firm’s financial, operating and other information.
Describe the benefits provided by ratio analysis
Provides measures and enables comparisons of a firms operating and financial activities and position:
- For a single firm over time;
- Across firms.
Facilitates identifying operating and financial strengths and weaknesses of a firm.
When a ratio requires using a Balance Sheet value together with an Income Statement value, how should the Balance Sheet value be determined?
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.
Define “liquidity measures”. (aka solvency measures)
Measurements of the ability of a firm to pay its obligations as they become due; useful in working capital management.
What does “working capital” measure? How is it expressed as a formula?
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.
What does the “working-capital ratio” (also called the “current ratio”) measure? How is it expressed as a formula?
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.
What does the “acid test ratio” (also called the “quick ratio”) measure? How is it expressed as a formula?
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.
What does the “defensive-interval ratio” measure? How is it expressed as a formula?
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.
What does the “times-interest-earned ratio” measure? How is it expressed as a formula?
Measures the ability of current earnings to cover interest payments for a period; expressed as:
(Net Income + Interest Expense + Income Tax Expense)/Interest Expense.
Describe operational activity measures.
Ratios (and other measures) that measure the efficiency with which a firm carries out its operating activities.
What does the “operating cycle length” measure? How is it expressed as a formula?
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.
What does the “accounts receivable turnover ratio” measure? How is it expressed as a formula?
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.
What does the “number of days’ sales in average receivables ratio” measure? How is it expressed as a formula?
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.
What does the “inventory turnover ratio” measure? How is it expressed as a formula?
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.
What does the “number of days’ supply in inventory ratio” measure? How is it expressed as a formula?
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.
Describe profitability measures.
Ratios (and other measures) that measure aspects of a firm’s operating (profit/loss) results on a relative basis.
What does the “gross profit margin ratio” measure? How is it expressed as a formula?
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
What does the “net profit margin on sales” measure? How is it expressed as a formula?
Measures how much (percentage) of each sales dollar that ends up as net income; expressed as:
Profit Margin = Net Income/Net Sales.
What does the “return on total assets” (also called the “return on investment”) measure? How is it expressed as a formula?
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.)
What does the “return on owners’ (all stockholders’) equity ratio” measure? How is it expressed as a formula?
Measures the rate of return (earnings) on all stockholders’ investment; expressed as:
ROE = Net Income/Average Stockholders’ Equity.
Describe the “Common Stock dividend payout rate” measure.
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.
What does the “residual income” measure? How is it expressed as a formula?
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).
What does the “economic value added (EVA)” measure? How is it expressed as a formula?
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)].
What does the “price-earnings ratio” (“P/E ratio”; also called the “multiple”) measure? How is it expressed as a formula?
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.
Describe equity or investment-leverage measures.
Measures of relative sources of equity and equity value.
What does the “debt to equity ratio” measure? How is it expressed as a formula?
Measures the relative amounts of assets provided by creditors (debt) and shareholders; expressed as:
Debt to Equity = Total Liabilities/Total Shareholders’ Equity.
What does the “owners’ equity ratio” measure? How is it expressed as a formula?
Measures the proportion of assets provided by shareholders; expressed as:
Owners’ Equity Ratio = Shareholders’ Equity/Total Assets.
What does the “debt ratio” measure? How is it expressed as a formula?
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.
What does the “book value per common share” measure? How is it expressed as a formula?
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.)
