FIN 5203 Chapter 3
What are the 3 Short-term solvency, or Liquidity, Measures?
1) Current Ratio 2) Quick (or Acid-Test) Ratio 3) Cash Ratio
What are the 5 questions to keep in mind when looking at ratios?
1) How was it computed? 2) What is it intended to measure, and why might we be interested? 3) What is the unit of measurement? 4) What might a high or low value be telling us? How might such values be misleading? 5) How could this measure be improved?
Financial Ratios are traditionally grouped into which categories?
1) Short-term solvency, or liquidity, ratios 2) Long-term solvency, or financial leverage, ratios 3) Asset Management, or turnover, ratios 4) Profitabilitiy ratios 5) Market Value ratios
What are the 3 Long-term Solvency measures?
1) Total Debt Ratio 2)Times Interest Earned 3) Cash Coverage
In EBITDA, Amortization refers to
A noncash deduction similar conceptually to depreciation, except it applies to an intangible asset (such as a patent) rather than a tangible asset (such as a machine). It does NOT refer to the repayment of debt here
On a Common-Size Balance Sheet, each item is expressed as
A percentage of Total Assets
Who might be interested in the Cash Ratio?
A very short-term creditor
The Total Debt Ratio takes into account
All debts of all maturities to all creditors
A useful way of standardizing the income statement is to express each item
As a percentage of total sales
What is the Days' Sales in Receivables ratio frequently called?
Average Collection Period (ACP)
What would make more sense to use in calculating inventory?
Average Inventory
What is the Cash Coverage Ratio equation?
Cash Coverage Ratio = (EBIT + Depreciation)/Interest
What is the Cash Ratio equation?
Cash Ratio = Cash/Current liabilities
Financial Ratios, and other such ratios, are ways of
Comparing and investigating the relationships between different pieces of financial information
What do Short-Term Solvency ratios focus on?
Current Assets and Current Liabilities
What is the equation for Current ratios?
Current Ratio = Current Assets/Current liabilities
What is the Days' Sales in Inventory equation?
Days' Sales in Inventory = 365 Days/Inventory Turnover
What is equation for Days' Sales in Receivables?
Days' Sales in Receivables = 365 Days/Receivables Turnover
What are two useful variations on the Total Debt Ratio?
Debt-Equity Ratio and the Equity Multiplier
What is the Debt-Equity Ratio equation?
Debt-Equity ratio = Total Debt/Total Equity
One problem with rations that leads to much confusion is that
Different people and different sources frequently don't compute them in exactly the same way
What is EBITD?
Earnings before interest and taxes (EBIT) plus Depreciation
What is EBITDA?
Earnings before interest, taxes, depreciation, and amortization
What is the Equity Multiplier equation?
Equity Multiplier = Total Assets/Total Equity
True or False: A current ratio of less than 1 is normal in a healthy firm?
False: it is unusual for a healthy firm to a current ratio of less than 1
Long-term Solvency ratios are often called
Financial Leverage Ratios or Leverage Ratios
If our Total Asset Turnover equals .65 times, what does this mean?
For every dollar in assets, we generated $.65 in sales
Short-Term Solvency Ratios, as a group, are
Intended to provide information about a firm's liquidity
What is the TIE Ratio often called?
Interest Coverage Ratio
What is often the least liquid current asset?
Inventory
How is the Quick, or Acid-test, ratio different from the Current ratio?
Inventory is omitted
What does a high current ratio indicate to the firm?
It indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets
Under what condition would an apparently low current ratio not be a bad sign for a company?
It is not a bad sign for a company with a large reserve of untapped borrowing power
What does Days' Sales in Inventory tell us?
It tells us, roughly speaking, how long inventory sits, on average, before it is sold
What is another name for Short-Term Solvency ratios?
Liquidity Measures
Suppose a firm were to pay off some of its suppliers and short-term creditors. And suppose the firm buys some inventory. What happens to the current ratio?
Nothing happens because cash goes down while inventory goes up - total current assets are unaffected
What is the Quick Ratio equation?
Quick ratio = (Current Assets - Inventory)/Current Liabilities
What is the equation for Receivables Turnover?
Receivables Turnover = Sales/Accounts Receivable
What are relatively large inventories often a sign of?
Short-term trouble; the firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory
Common-Size Statements are
Standardized financial statements that work with percentages instead of total dollars
What is the Times Interest Ratio (TIE) equation?
TIE = EBIT/Interest
A problem with the TIE ratio is
That it is based on EBIT, which is not really a measure of cash available to pay interest because depreciation, a noncash expense, has been deducted out
What does a current ratio of less than 1 mean?
That net working capital (current assets less current liabilities) is negative
Suppose a firm were to pay off some of its suppliers and short-term creditors. And suppose the firm buys some inventory. What happens if the firm sells some merchandise?
The current ratio increases, i.e. the current ratio would usually rise because inventory is normally shown at cost, and the sale would normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises
Long-term solvency ratios are intended to address
The firm's long-run ability to meet its obligations, or, more generally, its Financial Leverage
What is one advantage of looking at current assets and current liabilities?
Their book values and market values are likely to be similar
Suppose a firm were to pay off some of its suppliers and short-term creditors. What would happen to the current ratio?
This is a trick question: What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger. If it is less than 1, it will get smaller
What is the equation for the Total Asset Turnover?
Total Asset Turnover = Sales/Total Assets
What is the Total Debt Ratio equation?
Total Debt Ratio = (Total Assets - Total Equity)/Total Assets
True or False: For comparison purposes, ending figures should be used and using ending figures is common in reporting industry averages
True
How do we decide whether to use Ending Inventory or Average Inventory?
Whether we use the ending inventory or average inventory depends on the purpose of the calculation. It depends on whether we are worried about the past, in which case averages are appropriate, or the future, in which case ending figured might be better.
Are Liquidity ratios important to Financial Managers? Why or Why not?
Yes; Because financial managers are constantly working with banks and other short-term lenders, an understanding of these ratios is essential
The Current Ratio is
a measure of short-term liquidity and the unit of measurement is either dollars or times
Times Interest Earned (TIE) Ratio measures
how well a company has its interest obligations covered
Receivables Turnover is defined
in the same way as inventory turnover
The Cash Coverage Ratio is a basic measure of
the firm's ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations