Unit 2: Ratio Analysis

Question 1

Define:

Liquidity

Answer 1

A firm’s ability to pay its current obligations as they come due

Question 2

Define:

Net Working Capital = ?

Answer 2

Net Working Capital =

Current Assets – Current Liabilities

Question 3

Define:

Current Ratio = ?

Answer 3

Current Ratio =

Current Assets

————————————

Current Liabilities

*The use of LIFO lowers the current ratio

Question 4

Define:

Quick (Acid Test) Ratio = ?

Answer 4

Quick (Acid Test Ratio) =

(Cash + Marketable Securities + Net Receivables)

——————————————————————————

Current Liabilities

Question 5

Define:

Cash Ratio = ?

Answer 5

Cash Ratio =

(Cash + Marketable Securities)

—————————————————————

Current Liabilities

Question 6

Define:

Cash Flow Ratio = ?

Answer 6

Cash Flow Ratio =

(Cash flow from operations)

——————————————————

Current Liabilities

Question 7

Define:

Net Working Capital Ratio = ?

Answer 7

Net Working Capital Ratio =

(Current Assets - Current Liabilities)

—————————————————————————

Total Assets

Question 8

What are ‘Activity Ratios’ used for?

Answer 8

To measure how quickly two noncash items are converted into cash.

Question 9

Define:

A/R Turnover = ?

Answer 9

A/R Turnover =

(Net Credit Sales)

———————————————

Average A/R

Question 10

Define:

Days’ Sales Outstanding in Receivables

Answer 10

Days’ Sales Oustanding in Receivables =

(Days in year)

————————————————————

A/R Turnover Ratio

Question 11

Define:

Inventory Turnover = ?

Answer 11

Inventory Turnover =

(COGS)

———————————————————

Avg. Inventory

Question 12

Define:

Days’ Sales in Inventory = ?

Answer 12

Days’ Sales in Inventory =

(Days in year)

————————————————————

Inventory Turnover Ratio

Question 13

Define:

A/P Turnover = ?

Answer 13

A/P Turnover =

(Purchases)

————————————————————

Average A/P

Question 14

Define:

Days’ Purchases in A/P = ?

Answer 14

Days’ Purchases in A/P =

(Days in year)

————————————————————

A/P Turnover Ratio

Question 15

Define:

Operating Cycle = ?

Answer 15

Operating Cycle =

(Days’ Sales in Receivables) + (Days’ Sales in Inventory)

Question 16

Define:

Cash Cycle = ?

Answer 16

Cash Cycle =

(Operating Cycle) - (Days’ Purchases in Payables)

Question 17

Define:

F.A. Turnover Ratio = ?

Answer 17

F.A. Turnover =

(Net Sales)

————————————————————

Avg Net PPE

* Measures efficiency at using F.A. to generate sales

Question 18

Define:

Total Assets Turnover Ratio = ?

Answer 18

Total Assets Turnover =

(Net Sales)

————————————————————

Avg Total Assets

* Measures efficiency at using F.A. to generate sales

Question 19

For Turnover Ratios, why is a higher ratio preferable?

Answer 19

It implies effective use of assets to generate sales

Question 20

Define:

Solvency

Answer 20

A firm’s ability to pay its noncurrent obligations as they come due.

Question 21

Define:

Total Debt to Total Capital Ratio = ?

Answer 21

Total Debt to Total Capital =

(Total Debt)

———————————————————

Total Capital

Question 22

Define:

Debt to Equity Ratio = ?

Answer 22

Debt to Equity Ratio =

(Total Debt)

————————————————

Stockholder’s Equity

Question 23

Define:

Long-term Debt to Equity Ratio = ?

Answer 23

Long-term Debt to Equity Ratio =

(Long-term Debt)

———————————————

Stockholder’s Equity

Question 24

Define:

Debt Ratio = ?

Answer 24

Debt Ratio =

(Total Liabilities)

———————————————

Total Assets

Question 25

Define:

Times Interest Earned Ratio = ?

[Interest Coverage]

Answer 25

Interest Coverage =

(EBIT)

———————————————

Interest Expense

*Measures the ability to pay interest

*Denominator should include capitalized interest

Question 26

Define:

Earnings to Fixed Charge Ratio = ?

[Fixed Charge Coverage]

Answer 26

Earnings to Fixed Charge Ratio =

(EBIT + Interest portion of operating leases)

———————————————

(Int Expense + Int portion of operating leases + dividends on preferred stock)

Question 27

Define:

Cash Flow to Fixed Charges Ratio = ?

Answer 27

Cash Flow to Fixed Charges Ratio =

(Pre-tax operating cash flow)

———————————————

(Int Expense + Int portion of operating leases + dividends on preferred stock)

Question 28

Define Operating Leverage:

Answer 28

Operating Leverage:

Arises from use of a high level of plant & machinery, revealed through charges for depreciation, property taxes, etc.

Question 29

Define Financial Leverage:

Answer 29

Financial Leverage:

Arises from use of a high level of debt in financial structure, revealed through amounts paid out for interest.

Question 30

Define:

Degree of Leverage = ?

Answer 30

Degree of Leverage =

(Pre-fixed cost income amount)

———————————————

Post-fixed cost income amount

Question 31

Define Leverage

Answer 31

• The relative amount of fixed costs in the overall cost structure
• Creates risk because fixed costs must be covered

Question 32

Degree of Operating Leverage = ?

[Single period version]

Answer 32

Degree of Operating Leverage =

(Contribution Margin)

———————————————

Operating Income or EBIT

Question 33

Degree of Operating Leverage = ?

[Percentage-change version]

Answer 33

Degree of Operating Leverage =

(% change in operating income or EBIT)

———————————————

% change in sales

*A firm with high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales

*Such a firm is also able to expand production rapidly in times of higher product demand

*The more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume

Question 34

Degree of Financial Leverage = ?

[Single period version]

Answer 34

Degree of Financial Leverage =

(EBIT)

———————————————

EBT

Question 35

Degree of Financial Leverage = ?

[Percentage-change version]

Answer 35

Degree of Financial Leverage =

(% change in net income)

———————————————

% change in EBIT

*High Degree of financial leverage = greater risk, more residual profit for shareholders after debt service (interest on debt is tax deductible)