Ratio Analysis for Financial Management

Question 1

Ratio Analysis Defined:

Answer 1

Ratio Analysis:

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

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.

Types of Measures covered for Financial Purposes:

• Liquidity or Solvency measures
• Operational activity measures
• Profitability measures
• Equity or Investment Leverage Measures

Question 2

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

Answer 2

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 3

Titles of ratios frequently include the terms “on” and “to.” When used in ratio titles, these terms imply the use of which one of the following mathematical functions?

A. Subtraction.

B. Multiplication.

C. Division.

D. Squaring.

Answer 3

C. Division.

The terms “on” and “to” imply the use of division. For example, the ratio “Debt to Equity” implies that debt should be divided by equity, or the measure “Return on Assets” implies that income should be divided by assets.

Question 4

Which of the following statements concerning ratio analysis is/are correct?

I. Ratio analysis uses only monetary measures for analysis purposes.

II. Ratio analysis uses only measures from financial statements for analysis purposes.

A. I. only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 4

D. Neither I nor II.

Ratio analysis uses monetary measures as well as other quantitative measures.

• For example, in the earnings per share calculation, the number of shares of common stock, a non-monetary measure, is used.

Ratio analysis also uses financial statement measures in addition to measures that are not a part of financial statements.

• For example, the price-earnings ratio uses the market price of the stock, a measure not found in the financial statements.

Question 5

Liquidity Measures Defined and Identified:

Answer 5

Liquidity Measures (also called Solvency Measures): assess the ability of a firm to pay its obligations as they become due.

• These measures are particularly appropriate for management of working capital.

They include:

• Working Capital = CA-CL
• Working Capital Ratio (Current Ratio): # of times CA can cover CL
  
  • Formula: CA/CL
  • If WCR =1 ; equal increases or decreases in CA and CL will not change WCR
  • IF WCR exceeds 1 (INDIRECT); equal increases in CA and CL will decrease WCR; equal decreases in CA and CL will increase WCR
  • If WCR is less than 1 (DIRECT); equal increases in CA and CL will increase WCR; equal decreases in CA and CL will decrease WCR
• Acid Test Ratio (Quick Ratio): # of times that cash and assets can be converted quickly to cash to cover CL
  
  • Formula: (Cash + Net Receivables + Marketable Securities) / Current Liabilities
• Defensive Interval Ratio: # of days that cash and assets that can be quickly converted to cash can support operating costs.
  
  • Formula: (Cash + Net Receivables + Marketable Securities) / Avg Daily Cash Expenditures
• Average Collection Period: # of days on avg it takes to collect AR; to convert AR to cash.
  
  • Formula: (Days in Year x Avg AR) / Credit Sale for Period
• Times Interest Earned Ratio: ability of current earnings to cover interest payments for a period.
  
  • Formula: (Net Income + Interest Expense + Income Tax Expense) / Interest Expense
• _Times Preferred Dividends Earned Ratio: ​_ability of current earnings to cover preferred dividends for a period.
  
  • Formula: Net Income / Annual Preferred Dividend Obligation

Question 6

Bobcat Company has a current ratio of 2:1. Which one of the following transactions could Bobcat use to increase its current ratio?

A. Borrowing cash by giving a short-term note.
B. Paying off accounts payable.
C. Paying off long-term debt.
D. Factoring accounts receivable.

Answer 6

B. Paying off accounts payable.

His Current Ratio is Greater than 1 (INDIRECT) so:

• Equal increases in CA and CL will decrease the ratio
• Equal decreases in CA and CL will increase ratio

Paying off AP will result in equal reduction in CA (cash) and CL (accounts payable)

Question 7

A company has income after tax of $5.4 million, interest expense of $1 million for the year, depreciation expense of $1 million, and a 40% tax rate. What is the company’s times-interest-earned ratio?

A. 5.4
B. 6.4
C. 7.4
D. 10.0

Answer 7

D. 10.0

Times-Interest Earned ratio:

(NI + Int Exp+ Income tax Exp) / Int Exp

• ($5.4M + $1M + $3.6M) /$ 1M
  
  • $5.4 / .6 = 9M x .40 = $3.6 Income tax exp
• $10M / 1M = 10

Question 8

North Bank is analyzing Belle Corp.’s financial statements for a possible extension of credit. Belle’s quick ratio is significantly better than the industry average. Which one of the following factors should North consider as a possible limitation of using this ratio when evaluating Belle’s creditworthiness?

A. Fluctuating market prices of short-term investments may adversely affect the ratio.
B. Increasing market prices for Belle’s inventory may adversely affect the ratio.
C. Belle may need to sell its available-for-sale investments to meet its current obligations.
D. Belle may need to liquidate its inventory to meet its long-term obligations.

Answer 8

A. Fluctuating market prices of short-term investments may adversely affect the ratio.

The quick ratio (also called the acid-test ratio) is the relationship between current assets that can be converted quickly to cash and total current liabilities. Expressed as a formula, it is: Quick Ratio = Quick Assets/Current Liabilities. Quick assets normally include cash, accounts receivable, and short-term investments (also called marketable securities). Note that quick assets do not include all current assets; it excludes inventories and most prepaid items. Because short-term investments are reported on the balance sheet at fair market value at the balance sheet date, fluctuations in the market price over time would change the quick ratio. For example, if the balance sheet is dated December 31, the quick ratio would reflect the quick assets and current liabilities at that point in time. If the market value of short-term investments decreases after December 31, the quick ratio as of December 31 would overstate the ratio after the market value declines.

Question 9

Farrow Co. is applying for a loan in which the bank requires a quick ratio of at least 1. Farrow’s quick ratio is 0.8. Which of the following actions would increase Farrow’s quick ratio?

A. Purchasing inventory through the issuance of a long-term note.

B. Implementing stronger procedures to collect accounts receivable at a faster rate.

C. Paying an existing account payable.

D. Selling obsolete inventory at a loss.

Answer 9

D. Selling obsolete inventory at a loss.

Quick Ratio = (Cash + Net Rec + Marketable Sec) / CL

Selling obsolete inventory at a loss (or at a gain) would increase Farrow’s quick ratio. The quick ratio (also known as the acid test ratio) measures the number of times that cash and assets that can be converted quickly to cash cover current liabilities. It is calculated as: (Cash + Current Receivables + Marketable Securities)/Current Liabilities. Selling obsolete inventory would increase cash, in the numerator, without changing current liabilities, the denominator, which would increase the quick ratio.