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