Define each of the following terms: a. Liquidity ratios: current ratio; quick, or acid test, ratio

Define each of the following terms: a. Liquidity ratios: current ratio; quick, or acid test, ratio

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December 18, 2021
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Define each of the following terms:

a. Liquidity ratios: current ratio; quick, or acid test, ratio

b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed assets turnover ratio; total assets turnover ratio

c. Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; EBITDA coverage ratio

d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on total assets (ROA); return on common equity (ROE)

e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/book (M/B) ratio; book value per share

f. Trend analysis; comparative ratio analysis; benchmarking

g. DuPont equation; window dressing; seasonal effects on ratios

Answer and ExplanationSolution by a verified expert

a
Here is a tip:
Financial ratios evaluate the overall condition and performance of a company.

Explanation
Liquidity ratios determine whether the company has sufficient assets to pay its current liabilities. It has two ratios:

Current ratio measures the ability of a company to repay its short-term liabilities due in 12 months. It is determined by dividing the sum of total current assets by the total current liabilities of the company.
Quick or acid test ratio is calculated by dividing the quick assets by the current liabilities. Quick assets involve cash and marketable assets such as securities or receivables. Inventories are not taken into account while calculating quick or acid test ratio.
Verified Answer
Liquidity ratios determine the ability of a company to pay its current liabilities on time without raising any external capital. The types of liquidity ratios are:

Current ratio: It is determined by dividing current assets by current liabilities.
Quick or acid test ratio: It is determined by dividing quick assets by current liabilities.

b
Here is a tip:
Financial ratios are the accounting tools that determine the financial health of the business.

Explanation
Asset management ratio helps the company in identifying its effectiveness in utilizing the resources in order to generate sales and income. High assets turnover ratios are desirable as they indicate that the company efficiently utilizes its assets, whereas a low turnover ratio indicates that the company may have obsolete assets in the record.

It includes various ratios to check the efficiency of assets. These ratios are:

Inventory turnover ratio measures the productivity of the company's sales in relation to its inventory. It is determined by dividing the cost of goods sold (COGS) by inventories.
Days' sales outstanding ratio indicates the number of times the average receivables are turned over during a year, that is, how quickly the company collects the outstanding balance from its customers. It is determined by dividing the receivables by the average sales per day.
Fixed assets turnover ratio indicates the extent of money tied up in fixed assets for each dollar of revenue and determines whether the company has over or under-invested in assets. It is determined by dividing the net sales by the net fixed assets.
Total assets turnover ratio calculates the extent of money tied up in total assets, fixed as well as current, for each dollar of revenue. It is determined by dividing the net sales by the total assets.
Verified Answer
Asset management ratios indicate the effectiveness of the utilization of assets in generating sales revenue. These ratios are also known as efficiency ratios.

The types of asset management ratios are:

Inventory turnover ratio measures the efficiency of using assets in sales generation.
Days sales outstanding ratio indicates the collection period in days for the account receivables.
Fixed assets turnover ratio indicates the effectiveness of the utilization of fixed assets in comparison to sales generation.
Total assets turnover ratio indicates the effectiveness of the utilization of fixed and current assets to generate sales.

c
Here is a tip:
Financial ratios are the accounting tools that determine the financial health and potential financial risks of a business.

Explanation
All businesses need finance from investors to run the day-to-day business expenses and expand. Stakeholders are interested in determining whether the company uses its capital efficiently and is profitable enough through financial leverage ratios.

The types of financial leverage ratios are:

Debt ratio determines the financial risks of a company. It is calculated by dividing the total liabilities by the total assets
Time-interest-earned ratio is determined by dividing the income before interest and tax expense by the interest expense. This ratio reflects how many times a company's pre-tax earnings cover its interest expense.
Earnings before interest, taxes, depreciation, and amortization (EBITDA) coverage ratio indicates whether the company earns sufficient profits to pay its interest expense from pre-tax earnings. It is determined by adding the lease payments to the EBITDA and dividing the result by the sum of interest, principal, and lease payments.
Verified Answer
Financial leverage ratios indicate the portion of the fund provided by debts. It measures the extent to which the company raises the funds using debt financing in relation to total assets and stockholders' equity.

The types of financial leverage ratios are:

Debt ratio compares the investment made through debt to total assets. In other words, it is the ratio that represents the percentage of assets financed with the debt.
Time-interest-earned ratio measures the company's ability to pay its interest on debt obligation from its earnings.
EBITDA coverage ratio measures the company's ability to pay its interest on debt obligation from earnings before interest, taxes, depreciation, and amortization.

d
Here is a tip:
Financial ratio analyzes the figures in the financial statements of a company and measures the profitable the company in comparison to others.

Explanation
When profitability ratios are compared to other companies, they provide significant information and help in taking decisions for investment in a company. High profitability ratios assess the ability of a company to earn returns for its shareholders.

Types of profitability ratios are:

Profit margin on sales is calculated by dividing the net income available for common stockholders by the net sales. It determines the net income or profit per dollar of sales.
Basic earning power ratio measures the power of a business to earn its pre-tax income and determines the efficiency of the business in earning operating income. It is calculated by dividing the earnings before interest and taxes by total assets.
Return on total assets is computed by dividing the net profits by total assets, which shows the efficiency of the company in generating profits by utilizing its resources.
Return on common equity is calculated by dividing the profit after tax by the common equity of the company. It can also be determined using the return on assets subtracted by the liabilities.
Verified Answer
Profitability ratios evaluate the ability of a company to generate income during a particular period. These ratios indicate the performance and determine the extent of efficiency in the utilization of funds.

Types of profitability ratios are:

Profit margin on sales is also termed as profit margin or net profit margin. It evaluates the net income earned by the company with each dollar of sales.
Basic earning power ratio is calculated by dividing earnings before interest and taxes by total assets.
Return on total assets is determined by dividing the net income by total assets.
Return on common equity measures efficiency by comparing the earnings with the equity.

e
Here is a tip:
Financial ratios are the accounting tools that determine the financial health and potential financial risks of a business.

Explanation
Market value ratio measures the worth of a business. Such a valuation is used by the investors to make decisions regarding the acquisition.

The market value ratios are:

Price-earnings ratio is calculated by dividing the price per share by the earnings per share. It gives an estimate of the amount the investors are willing to pay for the company's earnings.
Price to cash flow ratio is calculated by dividing the price per share by the company's operating cash flow per share, which shows the willingness of the investors to pay for the purchase of a company's share.
Market to book ratio is calculated by dividing the market's worth of a share by the book value per share, which helps the company in comparing the price of their share with the book value.
Book value per share is calculated by dividing the firm's total common equity by the total number of shares outstanding, which shows the effectiveness of the company in utilizing the assets per share.
Verified Answer
Market value ratio evaluates the current share price of a company with its market value and book value. These ratios help investors in making significant investment decisions.

The market value ratios are:

Price-earnings ratio compares the company's share price to its earnings. It represents the ability of the investors to pay per dollar of profits.
Price to cash flow ratio indicates the value of a share in relation to the operating cash flow per share.
Market to book ratio indicates the market value of a share in relation to the book value per share.
Book value per share determines the price per share that is recorded in the books.

f
Explanation
In order to know the efficiency and effectiveness of the company in performing the business, the company usually makes data comparisons of their financial statements and ratios with other companies in the same industry.

Trends analysis includes comparing of financial ratios of a business over time. It will disclose significant information regarding the improvements and weaknesses in the financial position and performance of a business.

In comparative ratio analysis, the figures on the financial statement of one company are compared to other similar companies. This is done to compare the performance of the company with its competitors.

Similar to comparative analysis, benchmarking refers to comparing the financial ratios of a company with other companies of the same industry. Under this, the performance of the company is compared with the benchmark companies of the industry.

Verified Answer
Trend analysis refers to the comparison of the same ratios in previous years to analyze whether the working of the company has improved or declined over the period.

Comparative ratio analysis compares the ratios of a company with similar companies in the industry for the same financial year.

Benchmarking does the same comparison as a comparative analysis to have an insight into the weaknesses. Steps are taken to fill these voids.

g
Explanation
The effect of management decisions and actions on their profitability, assets management, and financial leverage is an important issue for the investors due to which the DuPont equation is used.

DuPont equation subdivides the rate of return on equity into three parts, which are profit margin, asset turnover ratio, and equity multiplier. It helps to compare the operational efficiency of two firms in the same industry.

Window dressing involves the use of deception by adjustments near the end of periods to improve the results or position of a company. Generally, window dressing is done to improve the liquidity ratios of the company.

Seasonal effect majorly takes into consideration acquisition of inventories that is volume and amount of inventory procured at the time of peak season and offseason. This affects the ratio analysis also, seasonal period ratios cannot be compared with non-seasonal ratios because external factors, such as demand and so on, are not the same during both periods.

Verified Answer
DuPont equation breaks down the return on equity into three parts, which are net profit margin, asset turnover, and equity multiplier. This equation helps to analyze how the return on equity can be increased for the investors.

Window dressing is a process of making financial statements attractive by manipulating the figures. It is an unethical practice because it misleads the investors.

Seasonal effects on ratios distort the purpose of ratio analysis. Seasonal effects make the ratios incomparable.

a. Liquidity Ratios: Current Ratio; Quick, or Acid Test, Ratio

Liquidity ratios assess a company's ability to meet its short-term obligations. The key ratios are:

  1. Current Ratio: This ratio gauges the company's ability to settle short-term liabilities within a year. It is calculated by dividing total current assets by total current liabilities.
  2. Quick or Acid Test Ratio: This ratio assesses immediate liquidity by considering only quick assets (cash and marketable securities) against current liabilities, excluding inventory.

b. Asset Management Ratios: Inventory Turnover Ratio; Days Sales Outstanding (DSO); Fixed Assets Turnover Ratio; Total Assets Turnover Ratio

Asset management ratios evaluate how efficiently a company utilizes its resources for sales and income. The ratios include:

  1. Inventory Turnover Ratio: Measures sales efficiency relative to inventory, calculated as cost of goods sold divided by inventory.
  2. Days Sales Outstanding (DSO): Indicates the average collection period for accounts receivable, calculated by dividing receivables by average daily sales.
  3. Fixed Assets Turnover Ratio: Assesses the efficiency of fixed assets utilization by dividing net sales by net fixed assets.
  4. Total Assets Turnover Ratio: Evaluates the use of both fixed and current assets in generating sales, calculated by dividing net sales by total assets.

c. Financial Leverage Ratios: Debt Ratio; Times-Interest-Earned (TIE) Ratio; EBITDA Coverage Ratio

Financial leverage ratios assess a company's use of debt and its ability to cover financial obligations. The ratios are:

  1. Debt Ratio: Measures financial risk by dividing total liabilities by total assets.
  2. Times-Interest-Earned (TIE) Ratio: Assesses a company's pre-tax earnings coverage of interest expenses.
  3. EBITDA Coverage Ratio: Indicates if a company's profits cover interest expenses, including lease payments.

d. Profitability Ratios: Profit Margin on Sales; Basic Earning Power (BEP) Ratio; Return on Total Assets (ROA); Return on Common Equity (ROE)

Profitability ratios gauge a company's ability to generate income. The key ratios include:

  1. Profit Margin on Sales: Calculates net income relative to net sales.
  2. Basic Earning Power (BEP) Ratio: Measures pre-tax income efficiency by dividing earnings before interest and taxes by total assets.
  3. Return on Total Assets (ROA): Evaluates the efficiency of generating profits from total assets.
  4. Return on Common Equity (ROE): Assesses efficiency by comparing profit after tax to common equity.

e. Market Value Ratios: Price/Earnings (P/E) Ratio; Price/Cash Flow Ratio; Market/Book (M/B) Ratio; Book Value Per Share

Market value ratios assess a company's valuation and attractiveness to investors. The key ratios include:

  1. Price/Earnings (P/E) Ratio: Compares share price to earnings per share, indicating investor willingness to pay for earnings.
  2. Price/Cash Flow Ratio: Relates share price to operating cash flow per share, reflecting investor willingness to pay for cash flow.
  3. Market/Book (M/B) Ratio: Compares market value to book value per share.
  4. Book Value Per Share: Calculates the book value of common equity per share.

f. Trend Analysis; Comparative Ratio Analysis; Benchmarking

Trend analysis compares ratios over time, comparative ratio analysis compares them to similar companies, and benchmarking involves industry-wide comparisons:

  1. Trend Analysis: Compares a company's ratios over different periods to identify improvements or weaknesses.
  2. Comparative Ratio Analysis: Compares a company's ratios to those of similar companies in the same industry for the same financial year.
  3. Benchmarking: Compares a company's ratios to industry benchmarks, providing insights into performance relative to industry standards.

g. DuPont Equation; Window Dressing; Seasonal Effects on Ratios

These factors delve into the impact of management decisions and external factors on financial metrics:

  1. DuPont Equation: Breaks down return on equity into net profit margin, asset turnover, and equity multiplier, aiding in operational efficiency comparison.
  2. Window Dressing: Involves deceptive adjustments to financial statements to present a more favorable position, often aimed at improving liquidity ratios.
  3. Seasonal Effects on Ratios: Recognizes variations in ratios due to seasonal factors, making year-round and seasonal ratios incomparable.
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