Chapter 7, Problem 1Q

Define each of the following terms:

1. a. Liquidity ratios: current ratio; quick, or acid test, ratio
2. b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO); fixed assets turnover ratio; total assets turnover ratio
3. c. Financial leverage ratios: debt ratio; times-interest-earned (TIE) ratio; EBITDA coverage ratio
4. d. Profitability ratios: profit margin on sales; basic earning power (BEP) ratio; return on total assets (ROA); return on common equity (ROE)
5. e. Market value ratios: price/earnings (P/E) ratio; price/cash flow ratio; market/book (M/B) ratio; book value per share
6. f. Trend analysis; comparative ratio analysis; benchmarking
7. g. DuPont equation; window dressing; seasonal effects on ratios

Summary Introduction

To determine: The definition of liquidity ratio, current ratio, and quick ratio.

Explanation of Solution

A liquidity ratio is a ratio showing the connection between a company's cash and other current assets to its current liabilities. By dividing current assets by current liabilities, the current ratio is found.

This shows the extent to which current liabilities are offset by those assets that are expected in the near future to be turned into cash. The quick ratio or acid testing is calculated by taking inventories decreased from current assets and then dividing them by current liabilities.

Summary Introduction

To determine: The definition of asset management ratio, inventory tur over ratio, DSO, fixed asset turnover ratio and total asset turnover ratio.

Explanation of Solution

Asset management ratios are a series of ratios that measure the effectiveness of a company's asset management. The inventory turnover ratio is COGS divided by stock. Day’s sales outstanding are used to evaluate receivable accounts and indicate the length of time the company has to wait for a sale before receiving cash.

It is found through the division of receivables by daily average sales. The fixed assets turnover ratio determines how efficiently the company uses its plant and equipment. It is the sales-to-net fixed assets ratio. The total assets turnover ratio calculates the turnover of all the assets of the company; it is computed by dividing revenue by total assets.

Summary Introduction

To determine: The definition of financial leverage ratios, debt ratios, TIE ratio, and EBITDA coverage ratio.

Explanation of Solution

The use of debt financing is calculated by financial leverage ratios. The debt ratio is the proportion of total debt to total assets, which is typically the number of notes payable and long-term bonds, representing the percentage of assets funded by debt holders. The ratio of debt to equity is the total debt divided by the total common equity.

The ratio of time-interest-earned is determined by the interest charges dividing earnings before interest and taxes. This ratio calculates the degree to which operating income can fall before the company is unable to meet its annual interest costs.

The EBITDA coverage ratio is similar to the time-interest-earned ratio, but it acknowledges that many firms are leasing assets and that sinking fund payment is also required. Adding EBITDA and lease payments divide this total by interest charges, lease payments, and sinking fund payments over one minus the tax rate.

Summary Introduction

To determine: The definition of profitability ratios, profit margin on sales, BEP, ROA, and ROE.

Explanation of Solution

Profitability ratios are a group of ratios that demonstrate the combined effects on operations of liquidity, asset management, and debt. The profit margin on sales, calculated by dividing net revenue by sales, provides sales profit per dollar. By dividing EBIT by total assets, the basic earning power is calculated. The ratio demonstrates the firm's pure earning power before the tax and leverage effect. Net asset return is the ratio of net income and total assets. Through dividing net income through common equity, the return on common equity is calculated.

Summary Introduction

To determine: The definition of market value ratios, P/E ratio, price/ cash flow ratio, M/B ratio, and book value per share.

Explanation of Solution

Market value ratios link the stock price of the company to its earnings and book value per share. The price/earnings ratio is calculated by dividing the price per share by earnings per share, which indicates how many investors are willing to pay per dollar of profits reported.

Price/cash flow is determined through the division of price per share by cash flow per share. It shows how much cash flow willing investors to pay per dollar. The market-to-book ratio is essentially the price of the company per share divided by the book value per share. The book value per share is common equity divided by the outstanding number of shares.

Summary Introduction

To determine: The definition of trend analysis, comparative ratio analysis, and benchmarking.

Explanation of Solution

Trend analysis is an analysis of the financial ratios of a company over time. It is used to estimate the likelihood that its financial situation will improve or deteriorate. Comparative ratio research is when a company compares its ratios in the same sector with other leading companies. Often known as benchmarking, this method.

Summary Introduction

To determine: The definition of DuPont equation, window dressing, and seasonal effects on ratios.

Explanation of Solution

The DuPont equation is a formula that demonstrates that the rate of return on assets can be found as the result of the profit margin times the total turnover of assets. Window dressing is a technique that companies use to make their accounts look better than they really are.

Seasonal factors may distort the analysis of the ratio. In preparation for a "season" of high demand, a firm may have excessive inventories at certain times of the year. As a result, an inventory turnover ratio taken at this time will be radically distorted as opposed to after the season.