Chapter 8: Ratio Analysis

"Acid test ratio" is another name for which of the following liquidity ratios?

The quick ratio, also known as the acid test ratio, is a more conservative measure of an organization's ability to meet current obligations than the current ratio.

Which of the following types of ratios is intended to measure how efficiently an organization is able to use its assets to generate revenue?

Activity ratios—also called efficiency ratios—measure how efficiently an organization is able to use its assets to generate revenue, in the form of either sales or cash.

The general interpretation of the asset turnover ratio is that

Asset turnover measures the amount of sales generated per dollar of assets—or how efficiently assets are used to produce sales. In general, a higher ratio means greater efficiency. The number can be meaningful for all types of businesses, although it tends to be higher for low-margin businesses and lower for high-margin businesses. It measures asset efficiency in generating sales, not profits (which the ROA ratio measures).

What is a financial statement that compares every line item to a single base value called?

Common-size financial statements (or common-size analysis) compare every item in a statement to a single base value. In a common-size income statement, all income statement values are displayed as a percentage of sales; in a common-size balance sheet, all balance sheet values are displayed as a percentage of total assets.

Which of the following accurately describes the degree of total leverage ratio?

Degree of total leverage combines the effect of operating leverage and financial leverage on the organization. It is obtained by multiplying the results of the DOL and DFL ratios.

One of the complications of using the debt ratio to compare organizations is that some external sources may

Different external sources may use different combinations of line items for the total debt amount. Some sources may equate total liabilities with total debt. For the ratio to provide a clearer picture of the organization's use of leverage, though, it may be more meaningful to exclude such short-term liabilities as accounts payable or all non-interest-bearing liabilities.

Which of the following market ratios represents the cash flow to be gained, in the absence of capital gains, for each dollar invested in an organization by its shareholders?

Dividend yield is what an organization pays out each year in dividends relative to its share price. In the absence of capital gains, this is the return on investment for the stock. Put another way, it indicates the cash flow to be gained for each dollar invested in an organization.

Which of the following statements concerning Economic Value Added (EVA®) is accurate?

EVA measures the profit an organization must generate to satisfy its investors and lenders. It is based on the concept that value is created only if the organization earns a rate of return that exceeds its cost of capital. There are three ways to improve a low EVA: Improve operating efficiency, invest additional capital in higher-earning assets, or eliminate assets earning a rate of return less than the cost of capital. Calculations of EVA can be complex and alternate definitions and components may be used, so care must be taken when comparing EVA results for multiple firms or investments.

Which of the following statements about operating leverage is accurate?

High operating leverage equals a high proportion of fixed costs. Leverage is created by a more substantial profit-per-sale once fixed costs are paid. Low operating leverage equals a high proportion of variable costs. Variable costs are incurred only when a sale is made, so a lower sales volume can cover the smaller fixed costs. The break-even point can be reached more easily, but there is less potential for large profits from each incremental sale beyond that point.

Which of the following market ratios tells what the market is willing to pay for each dollar of the company's earnings?

The P/E—an organization's price per share divided by its earnings per share—tells what the market is willing to pay for each dollar of the company's earnings. The higher the P/E, the more the market is willing to pay.

The two main types of leverage examined by leverage ratios are:

Leverage ratios examine two types of leverage: financial leverage (or whether and how much debt and equity are used to finance assets) and operational leverage (the extent to which an organization's operations involve fixed rather than variable costs).

Which of the following types of ratios is intended to measure the extent to which an organization relies on financial and operational force multipliers to increase its value?

Leverage ratios measure the types of force multipliers—in the forms of financial and operational leverage—an organization uses to increase its value and the extent to which it relies on them.

The current ratio, quick ratio and cash ratio are all examples of which type of ratio?

Liquidity Ratios

Which of the following types of ratios is intended to measure an organization's ability to pay off its short-term debt obligations while still funding ongoing operations?

Liquidity ratios measure an organization's ability to pay off its short-term debt obligations while still funding ongoing operations. These ratios measure that ability by comparing, in various ways, the organization's liquid assets to its short-term liabilities.

Which of the following types of ratios measures what investors and potential investors think of an organization's current performance and future prospects?

Market ratios are indicators of how the marketplace at large values an organization and what its view is of the organization's current performance and future prospects.

Which of the following statements about operational leverage is accurate?

Operational leverage is employed in the hope that the capital investments made will increase revenues by an even greater sum than the investment costs. The risk is the business risk that fixed costs will exceed revenue in the event of a sales downturn.

Which of the following statements concerning the different types of EPS (earnings per share) is accurate?

Organizations with a simple capital structure issue only common stock and nonconvertible senior securities and need to publish only a basic EPS. Organizations with a complex capital structure also issue financial instruments or contracts that represent potential additional dilutive common shares. These organizations are required by the SEC to also publish a diluted EPS.

Which of the following market ratios tends to be higher for organizations with valuable intangible assets and lower for organizations in capital-intensive industries?

Price to book relates market value to shareholders' equity. In general, the more important intangible assets (e.g., brand name, market share) are to the organization's value (e.g., pharmaceuticals and consumer products), the higher the price to book ratio tends to be, while capital-intensive industries (e.g., utilities, retail) tend to have lower price to book ratios.

Which of the following market ratios compares stock price to a variable that is generally subject to fewer accounting estimates than earnings but is most meaningful when comparing organizations with similar profit margins?

Price to sales is similar to P/E or price to book, but it compares stock price to total sales figures, which may be subject to fewer accounting estimates than earnings. Price to sales is more meaningful when compared only with other organizations in the same or similar industries—those having similar profit margins, so that similar volumes of sales translate to similar levels of profit.

Which of the following types of ratios is intended to measure an organization's ability to generate earnings as compared to its expenses and other costs over a specified time period?

Profitability ratios are the "bottom line" measures, assessing an organization's ability to generate more earnings than the costs and expenses it incurs over a set period of time.

Which of the following profitability ratios measures how effectively an organization makes use of all its resources—those financed by debt as well as equity?

ROA (return on assets, which divides net income by total assets) measures how efficiently all assets are being employed and thus how effectively an organization makes use of all its resources—those financed by debt as well as equity. The higher the ROA, the more efficiently all assets are being deployed.

Which of the following profitability ratios evaluates the efficiency and profitability of the long-term funds used by an organization?

ROCE (return on capital employed) divides EBIT by capital employed (total assets minus current liabilities) to evaluate the efficiency and profitability of an organization's capital investments.

Which of the following profitability ratios measures an organization's profit-generating efficiency from the perspective of its shareholders?

ROE (return on equity, which divides net income by shareholders' equity) measures how efficiently an organization generates profits from the shareholder's perspective, showing the return shareholders are receiving on their investment in the organization. A higher ROE indicates a better return on investment for shareholders.

Which of the following profitability ratios provides a metric for comparing asset purchase decisions, funding decisions for projects or programs, or investment decisions?

ROI (return on investment, which subtracts the costs of an investment from its gains and then divides the result by the costs) evaluates a specific investment rather than an entire organization's performance.

What is a key limitation of using ROI to evaluate an investment?

ROI examines an investment in terms of its costs and gains. It does not take risk into consideration—it neither evaluates a level of risk nor figures in any allowance for whether greater risk ought to provide greater returns.

The DFL (degree of financial leverage) ratio tells

The DFL ratio shows the amount of increase in returns (as measured in EPS or net income) that will result from an increase in operating income (as measured in EBIT).

What are the three metrics used by the DuPont analysis to determine ROE?

The DuPont analysis evaluates operating efficiency, asset efficiency and financial leverage by determining an organization's profit margin, total assets turnover and equity multiplier.

The DuPont analysis deconstructs the components of which of the following profitability measures?

The DuPont analysis first deconstructs ROA to better show the elements that contribute to its value and then uses that deconstruction to both reveal the relation between ROA and ROE and to more closely examine and evaluate the dynamics of the various elements that define ROE.

What might an analyst learn from an organization's EBITDA margin that wouldn't be as clear from its gross or net profit margins?

The EBITDA margin is a measure of an organization's ability to manage its cash-based operating expenses. It enables a view of operations, while excluding the capital structure of the business (debt vs. equity financing). Because it excludes noncash operating expenses, EBITDA may offer a better measure of the amount of cash flow generated from operations available for investors.

Which of the following market ratios is most useful for comparing organizations with different financial leverage?

The EBITDA multiple uses only "capital-structure-neutral" values in its calculations and so can better compare organizations with different financial leverage.

Which of the following statements about the cash conversion cycle is accurate?

The cash conversion cycle shows the number of days it takes to complete a cycle of selling inventory, collecting receivables and paying accounts payable. It describes how a company is managing its working capital and its ability to pay off current liabilities. A lower value (shorter cycle) generally means that the company's working capital position is more liquid. The formula is DIO + DSO - DPO.

The most stringent liquidity ratio, which measures current liabilities against only the most liquid assets, is called the

The cash ratio measures current liabilities against only the most liquid assets by removing both accounts receivable and inventory from the equations used by the current and quick ratios.

Why is the cash ratio used less often than the current or quick ratio?

The cash ratio measures current liabilities against only the most liquid assets. A company would rarely maintain such high levels of cash assets, since such funds could be more profitably employed elsewhere.

Each of the profit margin ratios takes a different measure of profit shown on the _____________ (financial statement) divided by _______________.

The profit measures used by the profit margin ratios (gross profit, EBITDA, EBIT, pretax profit, net profit) are all line items from the income statement, as is total sales, which they are each divided by to determine how efficiently sales income is turned into profits.

Ranked in order from the most stringent to the least stringent test of liquidity, the three common liquidity ratios are

The current ratio is the most commonly used but least stringent test of an organization's liquidity. The quick ratio removes inventories from the equation, making it a more stringent test. The cash ratio considers only cash and equivalents and marketable securities, making it the most stringent test.

Company X has total debt of $12,000 and total assets of $36,000. Company Y has total debt of $6,000 and total assets of $30,000. What is the debt ratio for each company, and which company is at less financial risk?

The debt ratio is Debt / Assets. For Company X, 12,000 / 36,000 = 33%. For Company Y, $6,000 / 30,000 = 20%. The higher the percentage, the more leverage is employed and the greater the financial risk.

The first two components of the DuPont equation, which are equivalent to the ratio for ROA (return on assets), are

The first two DuPont components deconstruct the ROA ratio (Net Income / Total Assets) into Net Income/sales x Sales/Total Assets.

Which of the following statements about the fixed asset turnover ratio is accurate?

The fixed asset ratio is used more commonly in manufacturing industries or others that rely heavily on fixed asset investment. Fixed assets are generally defined as net (that is, after depreciation) PP&E (property, plant and equipment). The types and amounts of lease agreements will affect the PP&E totals, which should be taken into consideration, but needn't render the ratio meaningless. The ratio divides sales by average fixed assets.

Which of the following statements about coverage ratios is accurate?

The interest coverage ratio measures the ability of the organization's operating income to cover interest expenses. The lower the ratio, the more heavily the company will feel its debt burden. The cash coverage ratio measures the multiple of the current level of debt that an organization can support given its current amount of available cash.

Which of the following line item variables is used in both the degree of operating leverage and degree of financial leverage ratios?

The percentage change in EBIT is the numerator of the DOL ratio and the denominator of the DFL ratio. The numerator of the DFL ratio can be either of two indicators of returns: percentage change in EPS or net income. The denominator of the DOL ratio is percentage change in sales.

Which of the following line items must be known in order to calculate an organization's quick ratio?

The quick ratio is calculated by subtracting inventories from current assets and dividing the result by current liabilities.

The various margin ratios offer increasingly strict (or more narrowly defined) measures of the profit margins derived from operating activities. Which of the following lists them in the proper order, from least strict to most strict?

The ratios go from top to bottom on the income statement in order, viewing sales margins for each profit measure in turn. Hence the percentages for each successive margin will generally be smaller than those that precede it. The proper order then is gross margin, EBITDA margin, EBIT margin, pretax profit margin and net profit margin.

For the previous quarter, Company A shows a current ratio of 1.5, while its competitor, Company B, shows a current ratio of 1.2. Their industry's average is 1.0. Based on that information alone, which of the following statements would be accurate?

Their ratios indicate that Both Company A and Company B have more assets than liabilities and so can meet current obligations. Creditors prefer a higher current ratio: If current liabilities increase without a corresponding increase in current assets, a company may have difficulty paying off its short-term debt obligations.

Which of the following accurately states the working capital turnover ratio?

Working Capital Turnover = Sales / (Current Assets - Current Liabilities). Working capital (current assets minus current liabilities) is the sum of what is available to fund ongoing operations and purchase inventory. Measuring it against sales totals for the same period measures the relationship between the money used to fund operations and the sales generated from these operations.