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BEC Corporate Governance, Economics, and Financial Management > Ratio and Measures for Working Capital Management > Flashcards

Ratio and Measures for Working Capital Management Flashcards

1
Q

What is the definition of ration analysis?

A

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

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2
Q

What is the formula for Debt to Equity Ratio?

A

Debt to Equity Ratio = Total Debt (Liabilities)/Owner’s Equity

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3
Q

What is the formula for Return on Assets?

A

Return on Assets = Net Income/Assets

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4
Q

What is the formula for Accounts Receivable Turnover?

A

Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable (Beg+End/2)

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5
Q

Which of the following measures are used in ratio analysis? Monetary measures, non-monetary measures (quantitative), financial statement measures, and non-financial statement measures (quantitative).

A

All of them. Monetary measures as well as quantitative measures are all used. For example, in EPS calculation, # of shares (quantitative measure) is used.

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6
Q

What are the major types of ratio measure used in financial management?

A
  1. Liquidity/Solvency
  2. Operation Activity
  3. Profitability
  4. Equity/Investment Leverage
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7
Q

When ratios include verbiage of “on” and “to” which mathematical function is used to calculate these ratios? (example: adding)

A

Division. Examples: Return on Assets and Debt to Equity.

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8
Q

Ratio analysis and related measures can be used to compare what related to a firm?

A
  1. Position of a firm over time

2. Position and performance across multiple firms

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9
Q

Southern Corp. has a debt-to-equity ratio of 1.75, and total assets of $275 million. Southern is considering issuing another $20 million of debt and another $20 million of equity. What will be Southern’s debt-to-equity ratio after the issuance?
How do you solve for this equation?

A

First step: Determine how to solve this problem. In order to solve this problem, you will need to use the accounting equation A=L+OE.
Second Step: Determine assets, liabilities, and owner’s equity in equation.
Assets = 2.75 or 275 million
Liabilities = 1.75 or 175 million (provided from Debt to equity ratio)
Owner’s Equity = 1.0 or 100 million (remainder of Assets-Liabilities)
So, 2.75=1.75+1.00
Third Step: Increase liabilities and equity by 20 million or 0.2.
So, 1.95 L (1.75+0.2) and 1.2 (1.0+0.2)
Final step: Enter new liabilities and debt into debt to equity ratio
D/E=1.95/1.2 = 1.625

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10
Q

Liquidity measures the firm’s ability to pay its obligations as they become due. What is an interchangeable term for liquidity?

A

Solvency.

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11
Q

Working Capital measures the extent to which current assets exceed current liabilities (short-term). What is the formula for working capital?

A

WC=Current Assets - Current Liabilities

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12
Q

Working Capital ratio (current ratio) measures the quantitative relationship between current assets and current liabilities. Measures number of times current assets cover current liabilities. What is formula for working capital ratio?
Side note: WCR should ideally be greater than 1

A

WCR (Current Ratio) = Current Assets/Current Liabilities

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13
Q

What changes in current assets/current liabilities would increase working capital ratio?

A
  1. Increase in current assets

2. Decrease in current liabilities

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14
Q

What changes in current assets/current liabilities would decrease working capital ratio?

A
  1. Decrease in current assets

2. Increase in current liabilities

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15
Q

Acid Test ratio (or quick ratio) measures the quantitative relationship between highly liquid assets and current liabilities in terms of # of times that cash and assets can be converted quickly to cover current liabilities. Used to evaluate short term liquidity.
What is the formula for Acid Test ratio?

A

Acid Test ratio = Cash + Net Receivables + Marketable Securities/Current Liabilities

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16
Q

The defensive-interval ratio measures the quantitative relationship between highly liquid assets and the average daily use of cash in terms of # of days that cash and assets can be converted quickly to cash that can support operating costs.
What is the formula for Defensive-Interval Ratio?

A

Defensive-Interval Ratio= Cash + Net Receivable + Marketable Securities/Average Daily Cash Expenditures

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17
Q

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.

A

Average Collection Period = Days in Year x Average Accounts Receivable/Credit Sale for period

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18
Q

Times interest earned measures the ability of current earnings to cover interest payments for a period. What is the formula for times interest earned ratio?

A

Times Interest Earned Ratio = Net Income + Interest Expense + Income Tax Expense/Interest Expense

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19
Q

Times Preferred Dividends Earned Ratio measures the ability of current earnings to cover preferred dividends for a period. What is the formula for this ratio?

A

Times Preferred Dividends Earned Ratio = Net Income/Annual Preferred Dividend Obligation

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20
Q

Measures related to solvency of a firm are primarily concerned with what?

A

Paying debts

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21
Q

Would paying off accounts payable increase or decrease current ratio?

A

Increase current ratio. Yes, this would reduce current asset cash to reduce current liability accounts payable.

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22
Q

Would borrowing cash (short-term note), paying off long-term debt, and factoring accounts receivable all result in decrease in current ratio?

A

Borrowing cash - Reduces current asset cash
Paying off long-term debt - Reduces current asset cash, but does not reduce current liabilities
Factoring accounts receivable - No effect. Reduces accounts receivable an increases cash.

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23
Q

When given a problem to solve for acid-test (quick) ratio, what assets and liabilities are you looking for to solve an equation?

A

Highly liquid assets such as cash accounts, accounts receivable, and marketable securities. Exclude inventory, pre-paids, and other current assets. Look for current liabilities as well not long-term.

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24
Q

Which one of the four quantitative factors could be a potential indicator of corporate failure?

  1. High cash flow to total liabilities
  2. High retained earnings to total assets
  3. High fixed cost to total cost structure
  4. High fixed assets to noncurrent liabilities
A

Answer: High fixed cost to total cost structure
-Since fixed costs constitute a high proportion of a firm’s total costs, a significant reduction in revenues occur

  • High cash flow to total liabilities indicates a firm is able to meet its liabilities
  • High retained earnings just means it acquired assets through retained earnings as opposed to debt-
  • High fixed assets to noncurrent liabilities indicates strong financial position
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25
Q

Investments held available-for-sale are classified as non-current or current assets? How does this impact quick ratio?

A

Apply to both current and non-current assets. For current assets, one quick asset would be converted to another quick asset. Current assets and current liabilities would be reduced. Benefit quick ratio.

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26
Q

What is a limitation in using the quick ratio to evaluate creditworthiness?

A

Fluctuating market prices of short-term investments may adversely affect the ratio. This is because short-term investments (marketable securities) are highly liquid assets included in the quick ratio. Assets are reported on balance sheet at fair value. Changes in market price can affect quick ratio.

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27
Q

How do you calculate income tax expense in times interest earned ratio? You are given income after tax of 5.4 million and income tax rate of 40%.

A

First step: Calculate income before taxes
Formula: (1-Tax rate)X=Income after taxes
.60(1-.4)X=5.4 million
X=9.0 million
Formula: Income before taxes - Income after taxes = Income tax Amount

28
Q

Formula for quick ratio is highly liquid assets/current liabilities. Which of the following would be factored in the quick ratio equation?

Cash
$ 5,000
Accounts receivable
10,000
Inventory
20,000
Accounts payable
15,000
Short-term note payable
5,000
Long-term note payable
35,000
A

Highly liquid assets: Cash, Accounts Receivable
Current Liabilities: Accounts payable and short-term notes payable

Do no include inventory or long-term liabilities

Solve equation: 5,000+10,000/5,000+15,000 = 0.75

29
Q

What term measures the number of days after a typical credit sale is made until the firm receives the payment?

A

Average collection period.

30
Q

If total quick assets exceed current liabilities. In other words, quick and current ratio are greater than one. If payment of accounts payable of $64,500 occurred, how would this impact current and quick ratio?

A

Both would increase. The reason why is because with a ratio greater than one if you reduce the numerator and denominator by an equal amount, the ratio will increase. Current assets and current liabilities will both be reduced in this transaction.

31
Q

What is the formula to calculate average accounts receivable?
You are given annual total sales and selling price per product. You are also given average collection period.

A

Formula: Credit Sales per day x Average Collection Period

To calculate credit sales per day: annual number of units x selling price/365 day in a year

32
Q

You are given a scenario where you are trying to determine expected average collection period (# of days) for a company. The company has term of 3/10, net 30. Meaning pay within 10 days to get discount or pay within 30 to not be charged penalty. Half of all customers expected to take discount (10 days) and half of customers expected to pay within 30 days. What is the average collection period?

A

Average Collection period = 20 days (5+15)

.5 of customers are expected to pay 10 days
.5 of customers are expected to pay within 30 days

Equation is .5(10)+.5(30) = 5 + 15 = 20

33
Q

Operational activity ratios measure?

A

The efficiency with which a firm carries out its operating activities. Meaning accounts payable, accounts receivable, inventory, etc.

34
Q

Accounts receivable turnover measures the number of times that accounts receivable turnover are incurred or collected during a period. Indicates quality of credit policies and efficiency of collection procedures.
What is the formula for accounts receivable turnover?

A

Accounts Receivable Turnover = Net Credit Sales/Average Accounts Receivable (Beg+End/2)

35
Q

Number of days’ sales in average receivables (average collection period) measures the average number of days required to collect receivables.
What is the formula for Number of days’ sales in Average Receivables?

A

of days’ sales in Average Receivables = # of days (365 usually)/Accounts Receivable Turnover

36
Q

Inventory Turnover measures the # of times that inventory turns over (acquired, sold, used) during a period. Indicates over/under stocking of inventory or obsolete inventory.
What is the formula for inventory turnover?

A

Inventory Turnover = Costs of goods sold/Average Inventory (Beg + End)/2

37
Q

Number of days’ supply in inventory (days’ sales in inventory) measures the # of days inventory is held before it is sold or used. Indicates efficiency of general inventory management.
What is formula for Number of days’ supply in inventory?

A

of days’ supply in inventory = # of days (365 normal)/Inventory Turnover

38
Q

Accounts payable turnover measures the # of times that accounts payable turn over (incurred/paid) during a period. Indicates rate at which entity pays its average AP. Indicates how well it manages paying obligations.
What is the formula for Accounts payable turnover?

A

Accounts Payable Turnover = Credit Purchases/Average Accounts Payable (Beg + End/2)

39
Q

In Accounts payable turnover, if credit purchases are not available, COGS will be accounted for.
What is the alternative formula for accounts payable turnover?

A

Accounts Payable Turnover = (COGS + End Inv. - Beg Inv)/Average Accounts payable.

40
Q

Number of days’ purchases in average payables measures the average # of days required to pay accounts payable. Measure of average age of payables.
What is the formula for average age of payables?

A

of days’ purchases in average payables = # of days (365 normally)/Accounts payable turnover

41
Q

Capital turnover measures how well the # of times that the average Owner’s equity is represented by sales (revenue) during a period. Shows how well an entity is using equity to generate revenue. What is the formula for capital turnover?

A

Capital Turnover = Annual sales (revenue)/Average owner’s equity

42
Q

Define operating cycle length.

A

Measures average length of time between the acquisition of inventory and collection of cash from sale of that inventory, including time to collect accounts receivable if sales are made on account.

43
Q

List the four related events (transactions) that make up the operating cycle in order.

A
  1. Inventory Purchased on Account
  2. Inventory Sold on Account
  3. Pay account payable
  4. Collect Accounts Receivable
44
Q

What are the names of the four conversion periods (cycles) in operating cycle?

A
  1. Inventory Conversion Cycle
  2. Accounts Receivable Cycle
  3. Accounts Payable Cycle
  4. Cash Conversion Cycle
45
Q

Inventory Conversion Cycle is average period of time from the acquisition of inventory until it is resold (or used). Which events do the ICC start and stop? Also, what is the measurement for ICC?

A

Start: Inventory Purchased on Account
Stop: Inventory Sold on Account
Measurement: # of days’ supply in inventory

46
Q

Accounts receivable cycle is the average period of time from selling inventory on account until the account is collected. Which events do the ARC start and stop? Also, what is the measurement for ARC?

A

Start: Inventory sold on account
Stop: Collect Accounts Receivable
Measurement: # of days’ sales in accounts receivable

47
Q

Accounts payable cycle is the average period of time from the purchase of inventory on account until the account is paid. Which events do the APC start and stop? Also, what is the measurement for APC?

A

Start: Inventory purchased on account
Stop: Pay Account Payable
Measurement: # of days’ purchases in accounts payable

48
Q

Cash conversion cycle is the average period of time when cash is paid to suppliers and when cash is collected from customers. Which events do the CCC start and stop? Also, what is the measurement for CCC?

A

Start: Pay Account Payable
Stop: Collect Account Receivable
Measurement: Time to go from “cash-back to-cash”

49
Q

A firm would strive to reduce the # of days’ sales outstanding in order to reduce_______ and increase _______?

A

Reduce AR - To collect cash sooner

Increase Cash

50
Q

What is the formula to calculate COGS?

A 
Beg. Inv.
\+Purchases 
=COGAS
-End. Inv. 
=COGS
51
Q

You are given the following data. How do you solve for average days’ sales in inventory?

Net cash sales
$ 3,000
Cost of goods sold
18,000
Inventory at beginning of year
6,000
Purchases
24,000
A

Step 1: Formula for average days’ sales in inventory: # of days (360)/Inventory Turnover.
Step 2: # of days are given. Just need to solve for inventory turnover.

Inventory Turnover = COGS/Average Inv. (Beg + End)/2

Step 3: Solve for Ending Inventory since it is not provided in problem. Use COGS formula.

BI+Purchases=COGAS-EI=COGS

6,000+24,000=30,000-18,000(COGS)=12,000 (EI)

Step 4: Solve for Average Inv
(BI+EI)/2
6,000 + 12,000 = 18,000/2 = 9,000

Step 5: Solve for inventory turnover (COGS/Avg Inv)
18,000/9,000 = 2

Step 6: Solve for # of Days Inventory
(360/Inventory Turnover)

360/2=180

52
Q

What is the formula to calculate cash conversion cycle?

A

CCC=Operating cycle - Accounts Payable Conversion Cycle

CCC= Inventory conversion cycle + Accounts Receivable Conversion Cycle - Accounts payable conversion cycle

53
Q

What are two formulas to calculate # of days in operating cycle? Use # of days formulas.

A 
# of days sales in inventory (ICC) + # of days sales in trade accounts receivable (ARC)
or
# of days in accounts payable (APC) + time to go from "cash-back to cash" (CCC)
54
Q

How do you calculate inventory turnover when you are given beginning inventory, purchases, and ending inventory? (Hint: COGS formula)

A

First step: Inventory Turnover formula
Inv. Turnover = COGS/Average Inv.

Second Step: Calculate COGS
COGS = BI + Purchases - EI

Third step: Calculate Average Inventory
Beg. Inv. + End Inv./2 = Average Inventory

Fourth Step: Plug in COGS and average inventory to solve for inventory turnover.

55
Q

If a company sells goods on credit terms of “net 30” days. Also assuming they have efficient credit policies and collection practices. Why would 12 times per year be the most likely accounts receivable turnover?

A

First: AR Turnover ratio is Net Credit Sales/Average (Net) Accounts Receivable (Beg + End/2)
Second: Understand terms. Net 30 days means there is no discount offered. With good credit policies, most customers will be on 30 days. Therefore, Average AR in formula is 30.
Third: Net 30 days means 360 (30 x 12) days in a year. Therefore, net credit sales is 360.
Fourth (Formula): 360/30= 12

56
Q

What is the formula to calculate # of days in cash conversion cycle? Considering the # of days for inventory conv. cycle (ICC), accounts receivable cycle (ARC), and accounts payable cycle (APC) are NOT given.
You are given receivables, inventory, payables, sales, and COGS.

A

Formula # of days Cash Conv. Cycle

Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) - Days Payable Outstanding (DPO)

Same as ICC + ARC - APC

DIO = Avg. Inv./COGS per day 
DSO = Avg. AR/Sales per day 
DPO = Avg. Payable/COGS per day
57
Q

To calculate # of days in cash conv. cycle, the formula is days inventory outstanding + days sales outstanding - days payable outstanding, how do you calculate these three formulas?

A

Days Inventory Outstanding = Average Inventory (BI+EI/2)/COGS per day (COGS/365)

Days Sales Outstanding = Average AR (BAR+EAR/2)/Sales per day (Sales/365)

Days payable outstanding = Average Payables (BAP+EAP/2)/COGS per day (COGS/365)

CCC = DIO + DSO - DPO

58
Q

How do you calculate amount in COGS when given annual sales and gross annual profit percentage?

A

COGS % = Annual sales - Gross Profit %

59
Q

The beginning finished goods inventory for year 2 was 20% of year 2 sales. The ending finished goods inventory for year 2 was 18% of year 3 sales. Given this, how do you calculate average inventory?

A

Calculate BI by multiplying year 2 sales by 20%.
Calculate EI by multiplying year 3 sales by 18%
Add these two together and then divide by two to get Avg. Inv.

60
Q

Review the definitions for operating cycle, inventory conversion period, accounts receivable period, accounts payable deferral period,

A

Operating Cycle - period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final collection of cash from sale of the products.
Inventory Conversion Period - average time required to convert materials into finished goods and sell those goods
Accounts Receivable period - length of time required to collect accounts receivable.
Accounts payable deferral period - average length of time between the purchase of materials and the payment of cash for them.

61
Q

What formula would be used to solve for a firm’s average gross receivables balance?

A

Average daily sales x Average collection period

62
Q

Which ratio is most appropriate for evaluation of accounts receivable?

A

Days’ sales outstanding

63
Q

What is a formula to calculate average inventory? Given inventory turnover and cost of sales.

A

Average inventory = Cost of sales/inventory turnover

64
Q

What is the formula to calculate expected cost savings?

A

Increase/decrease in average inventory x interest rate

65
Q

How do you solve for expected cost savings when given the following variables?
Budgeted sales, budgeted cost of sales, interest rate, current inventory turnover, and proposed inventory turnover.

A

First step: Solve for expected cost savings.
Formula: Increase/decrease in average inventory x interest rate
Second Step: Calculate average inventory with current inventory turnover.
Avg. Inventory = Cost of sales/Inventory Turnover (current)
Third step: Calculate average inventory with proposed inventory turnover
Avg. Inventory = Cost of sales/Inventory Turnover (proposed)
Fourth Step: Calculate difference in average inventory and multiply that by interest rate
Avg. Inv. (current) - Avg. Inv. (proposed) = # x interest rate = cost savings in current year

BEC Corporate Governance, Economics, and Financial Management (19 decks)

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