WILEY Reading 26

Explain what a company's liquidity ratios evaluate.

A company's ability to meet its short-term obligations. Liquidity measures how quickly a company can convert assets into cash at prices close to fair values. A current ratio indicates a level of liquidity (a higher ratio is desirable, within reason). An amount over 1.0 indicates the company's current assets equal the current liabilities. Therefore, the company can meet its current obligations with its current assets. The current ratio assumes inventory and accounts receivable can readily be converted into cash at close to their fair values.

Classify the ratio categories.

Activity ratios measure how productive a company is in using its assets and how efficiently it performs its everyday operations. Liquidity ratios measure the company's ability to meet its short-term cash requirements. Solvency ratios measure a company's ability to meet long-term debt obligations. Profitability ratios measure a company's ability to generate an adequate return on invested capital. Valuation ratios measure the quantity of an asset or flow associated with ownership of a specific claim.

Identify the limitations of ratio analysis.

Companies may have divisions that operate in different industries. One set of ratios may suggest that there is a problem, but another may indicate that the potential problem is only short term. There are no set ranges within which particular ratios for a company must lie. Firms enjoy significant latitude in the choice of accounting methods that are acceptable given the jurisdiction in which they operate. Comparing ratios of firms across international borders is even more difficult, in that most countries use IFRS.

Give the formula used to calculate the cash conversion cycle, and explain what it measures?

DOH + DSO - Number of days of payables CCC provides length of time between the point a company invests in working capital and the point the company collects cash proceeds from sales. It is the time between outlay of cash and the collection of cash. A shorter cycle is desirable (indicates greater liquidity). A longer cash conversion cycle indicates lower liquidity. It implies that the company finances its inventory and accounts receivable for a longer period of time.

Give the ratio used to calculate: 1. Inventory Turnover 2. Days of Inventory on Hand (DOH)

Inventory Turnover Ratio Cost of goods sold / Average inventory This ratio measures the effectiveness of a company's inventory management and is benchmarked against the industry average. Days of Inventory on Hand (DOH) No. of days in period / Inventory turnover

Give the ratio to calculate the following: 1. Receivables Turnover (and Days of Sales Outstanding (DOS)) 2. Working Capital Turnover 3. Fixed Asset Turnover 4. Total Asset Turnover

Receivables Turnover: Revenue / Average receivables Days of Sales Outstanding (DOS) No. of days in period / Receivables turnover Working Capital Turnover Revenue / Average working capital Fixed Asset Turnover Revenue / Average net fixed assets Total Asset Turnover Revenue / Average total assets

Name two retail ratios, two service company ratios, and two hotel ratios.

Retail Ratios Same store sales Sales per square foot (meter) Service Company Ratios Revenue per employee Net income per employee Hotel Ratios Average daily rate Occupancy rate

Differentiate between a sensitivity analysis and a scenario analysis.

Sensitivity analysis shows the range of possible outcomes as underlying assumptions are altered. Scenario analysis shows the changes in key financial quantities that result from given events such as a loss of supply of raw materials or a reduction in demand for the firm's products.

Define solvency and explain what solvency ratios measure.

Solvency refers to a company's ability to meet its long-term debt obligations. Solvency ratios measure the relative amount of debt in a company's capital structure and the ability of earnings and cash flows to meet debt-servicing requirements.

Give the ratios for the following: 1. Price to Cash Flow 2. Price to Sales 3. Price to Book Value

These are some of the commonly used valuation ratios used in addition to price-to-earnings: Price per Share / Cash Flow per Share Price per Share / Sales per Share Price per Share / Book Value per Share

Explain the significance of the debt-to-asset ratio.

This ratio shows the proportion of the firm's total assets that have been financed by debt.