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  1. Ratios • Two types: • Liquidity ratios (Solvency ratios) • Profitability ratios • Single ratio by itself is not very meaningful

  2. Liquidity Ratios Measure the short-term ability of the business to pay its debts. WHO CARES? Short-term creditors such as bankers and suppliers.

  3. Liquidity Ratios • Current ratio • Acid-test ratio • Debt ratio • Equity ratio • Collection Period • Inventory turnover • Times Interest Earned ratio

  4. Current Ratio Indicates short-term debt-paying ability Current Assets Current Liabilities

  5. Acid-Test Ratio Indicates immediate short-term debt-paying ability Total current assets (less inventory and prepaid expenses) Current Liabilities

  6. Debt Ratio Proportion of total assets that are financed with borrowed money. Total Liabilities Total Assets

  7. Equity Ratio Proportion of total assets financed with shareholder’s money Total equity Total assets

  8. Collection Period How many days’ sales are represented by Account Receivables Accounts Receivable Average Charge sales / day

  9. Inventory Turnover Ratio Number of times a business has been able to sell and replace its inventory in one year Cost of Goods Sold Average Inventory

  10. Times Interest Earned Company’s ability to cover its interest expense Net Income Interest Expense

  11. Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

  12. Solvency Ratios • Debt to total assets ratio • Times interest earned ratio • Cash debt coverage ratio • Free cash flow

  13. Illustration 14-24 Debt to Total Assets Ratio Indicates % of total assets provided by creditors Total Liabilities Total Assets

  14. Illustration 14-25 Times Interest Earned Ratio Indicates company’s ability to meet interest payments as they come due Income Before Interest Expense & Income Tax Interest Expense

  15. Illustration 14-26 Cash Debt Coverage Ratio Indicates long-term debt-paying ability (cash basis) Cash provided by operations Average total liabilities

  16. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: • its ability to obtain debt and equity financing • its liquidity position • its ability to grow

  17. Profitability Ratios • Return on assets ratio • Profit margin ratio • Assets turnover ratio • Gross profit rate • Operating expenses to sales ratio • Cash return on sales ratio

  18. Illustration 14-30 Higher value suggests favorable efficiency. Return On Assets Ratio Reveals the amount of net income generated by each dollar invested Net income Average total assets

  19. Illustration 14-31 Higher value suggests favorable return on each dollar of sales. Profit Margin Ratio Indicates net income generated by each dollar of sales Net income Net sales

  20. Illustration 14-32 Asset Turnover Ratio Indicates how efficiently assets are used to generate sales Net sales Average total assets

  21. Illustration 14-34 Gross Profit Rate Indicates margin between selling price and cost of good sold Gross profit Net sales

  22. Illustration 14-35 Operating Expensesto Sales Ratio Indicates the cost incurred to support each dollar of sales Operating expenses Net sales

  23. Illustration 14-36 Cash Return on Sales Ratio Indicates net cash flow generated by each dollar of sales Cash provided by operations Net sales

  24. Estimates • Financial statements are based on estimates. • allowance for uncollectible accounts • depreciation • costs of warranties • contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.

  25. Cost • Traditional financial statements are based on historical cost and are not adjusted for price level changes. • This needs to be considered when relying on them for analysis. • Also, by the time financial statements are prepared for a company, time has passed (i.e. December 31 numbers are being reported to the public on March 20th ! The amount listed for Assets is likely no longer the same or what was profitable at December 31 may no longer be !)

  26. Alternative Accounting Methods • One company may use the FIFO method, while another company in the same industry may use LIFO. • If the inventory is significant for both companies, it is unlikely that their current ratios are comparable. • In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.