Chapter 3

Liquidity Ratios

A group of ratios that allows one to measure the firm's ability to pay off short-term obligations as they come due. Primary attention is directed to the current ratio and the quick ratio.

Profitability Ratios

A group of ratios that indicates the return on sales, total assets, and invested capital. Specifically, we compute the profit margin (net income to sales), return on assets, and return on equity.

debt utilization ratios

A group of ratios that indicates to what extent debt is being used and the prudence with which it is being managed. Calculations include debt to total assets, times interest earned, and fixed charge coverage.

asset utilization ratios

A group of ratios that measures the speed at which the firm is turning over or utilizing its assets. They measure inventory turnover, fixed asset turnover, total asset turnover, and the average time it takes to collect accounts receivable.

Disinflation

A leveling off or slowdown of price increases.

Inflation

A phenomenon of prices increasing with the passage of time.

LIFO

A system of writing off inventory into cost of goods sold in which the items purchased last are written off first. Referred to as last-in, first-out inventory method.

FIFO

A system of writing off inventory into cost of goods sold, in which the items purchased first are written off first. Referred to as first-in, first-out inventory method.

Accounts Receivable balance

AR/Avg Daily sales Avg daily sales = (total sales/360) * Avg collection period days

Average Collection Period

Accounts receivable / average daily credit sales(sales/360); calculates how many days it takes to collect the company's accounts receivable

Deflation

Actual declining prices

trend analysis

An analysis of performance that is made over a number of years in order to ascertain significant patterns.

Du Pont system of analysis

An analysis of profitability that breaks down return on assets between the profit margin and asset turnover. The second, or modified, version shows how return on assets is translated into return on equity through the amount of debt that the firm has. Actually, return on assets is divided by (1- Debt/Assets) to arrive at return on equity.

Which of the following organizations provide industry data that can be used to evaluate a company's operating performance?

Bloomberg, Moody's Corporation, & Value Line Investment Survey FactSet

Quick Ratio

Current assets - inventory / current liabilities. This ratio is sometimes called the acid test ratio and is a more stringent measure of liquidity because it eliminates inventory (the least liquid asset) from current assets.

Current Ratio

Current assets / current liabilities; a measure of the firm's ability to pay off its current assets

A bondholder is likely to be primarily influenced by which of the following ratio categories?

Debt utilization ratios

What does a fixed charge coverage ratio of 8 times indicate?

Earnings before fixed charges and taxes covers the fixed charge obligation 8 times

Fixed Charge Coverage Ratio

Income before fixed charges and taxes / fixed charges. A common fixed charge in addition to interest expense is a lease expense. This ratio is considered more rigorous than the times interest earned ratio.

Return on Equity (ROE)

Net income / owners' equity; also called return on investment (ROI). ROE shows how much income is generated by each dollar the owners have invested in the firm.

profit margin

Net income / sales; Shows the overall percentage profit by the company on $1 of sales.

Return on Assets (ROA)

Net income/assets or profit margin * Asset Turnover; Shows how much income the firm produces for every $100 invested in assets.

times interest earned ratio

Operating income / interest expense; a measure of the safety margin a company has with respect to the interest payments it must make to creditors. A high number indicates that there is less risk of default.

How to find Net income?

Profit margin * Sales

Receivable turnover ratio

Sales / Accounts Receivable; indicates how many times a firm collects its accounts receivable in one year. It also indicates how quickly a firm is able to collect payments on its credit sales.

Fixed Asset Turnover Ratio

Sales / fixed assets; indicates how efficiently the company is using its fixed assets to generate one dollar of sales.

Total Asset Turnover Ratio

Sales / total assets; measures how efficiently an organization utilizes all of its assets to create one dollar of sales. It indicates whether a company is using its assets productively.

Inventory turnover ratio

Sales / total inventory; indicates how many times a firm sells and replaces its inventory over the course of a year.

What does an average collection period of 30 days indicate for a company?

The company collects on its issued trade credit in 30 days.

What does a total asset turnover ratio of 1.5 times represent?

The company generated $1.50 in sales for $1 in total assets.

Replacement Cost

The cost of replacing the existing asset base at current prices as opposed to original cost.

Debt to total assets ratio

Total debt / total assets; indicates how much of the firm is financed by debt and how much by owners' equity.

True or False: Bankers' and trade creditors' emphasis is on the firm's current ability to meet debt obligations.

True

If the current ratio is 2 times, then the firm's current asset balance is __________its current liabilities balance.

two times greater than (Current ratio = CA/CL)