LOS d: Calculate, classify, and interpret activity, liquidity, solvency, profitability, and valuation ratios.
Which ratio is used to measure a company's internal liquidity?
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Total asset turnover measures operating efficiency and interest coverage measures a company’s financial risk.
Given the following income statement:
Net Sales 200 Cost of Goods Sold 55 Gross Profit 145 Operating Expenses 30 Operating Profit (EBIT) 115 Interest 15 Earnings Before Taxes (EBT) 100 Taxes 40 Earnings After Taxes (EAT) 60
What are the interest coverage ratio and the net profit margin?
| Interest Coverage Ratio | Net Profit Margin |
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Interest coverage ratio = (EBIT / interest expense) = (115 / 15) = 7.67 Net profit margin = (net income / net sales) = (60 / 200) = 0.30
The following footnote appeared in Crabtree Company’s 20X7 annual report:
“On December 31, 20X7, Crabtree recognized a restructuring charge of $20 million, of which $5 million was for severance pay for employees who will be terminated in 20X8 and $15 million was for land that became permanently impaired in 20X7.”Based only on these changes, Crabtree’s net profit margin and fixed asset turnover ratio in 20X8 as compared to 20X7 will be?
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Net profit margin |
Fixed asset turnover |
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The restructuring charge and asset write-down are non-recurring transactions; thus, net income will be higher in 20X8, all else equal. In 20X8, fixed asset turnover will be the same as 20X7, all else equal. The asset impairment charge is a one-time charge, so fixed assets will not be reduced further in 20X8.
A firm has a cash conversion cycle of 80 days. The firm's payables turnover goes from 11 to 12, what happens to the firm's cash conversion cycle? It:
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CCC = collection period + Inv Period – Payment period. Payment period = (365 / payables turnover) = (365 / 11) = 33; (365 / 12) = 30. This means the CCC actually increased to 83.
Adams Co.'s common sized balance sheet shows that:
What are Adams' long-term debt to equity ratio and working capital?
Debt to Equity Working Capital
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If equity equals 45% of assets, and current liabilities equals 20%, then long-term debt must be 35%.
Working capital = CA ? CL = 45% - 20% = 25% of assets
Long-Term Debt / Equity = 0.35 / 0.45 = 0.78
WC = 2,000(0.25) = $500
Use the following data from Delta's common size financial statement to answer the question:
Earnings after taxes = 18% Equity = 40% Current assets = 60% Current liabilities = 30% Sales = $300 Total assets = $1,400
What is Delta's after-tax return on equity?
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Net income after taxes = 300 × 0.18 = 54
Equity = 1400 × 0.40 = 560
ROE = Net Income / Equity = 54 / 560 = 0.0964 = 9.6%
Paragon Company's operating profits are $100,000, interest expense is $25,000, and earnings before taxes are $75,000. What is Paragon's interest coverage ratio?
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ICR = operating profit ÷ I = EBIT ÷ I
= 100,000 ÷ 25000 = 4
If the inventory turnover ratio is 7, what is the average number of days the inventory is in stock?
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Average Inventory Processing Period = 365 / inventory turnover = 365 / 7 = 52 days.
The main difference between the current ratio and the quick ratio is that the quick ratio excludes:
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Current ratio = (current assets / current liabilities) = [cash + marketable securities + receivables + inventory] / current liabilities Quick ratio = [cash + marketable securities + receivables] / current liabilities
Given the following income statement:
Net Sales 200 Cost of Goods Sold 55 Gross Profit 145 Operating Expenses 30 Operating Profit (EBIT) 115 Interest 15 Earnings Before Taxes (EBT) 100 Taxes 40 Earnings After Taxes (EAT) 60
What are the gross profit margin and operating profit margin?
| Gross Profit Margin | Operating Profit Margin |
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Gross profit margin = gross profit / net sales = 145 / 200 = 0.725
An analyst has gathered the following information about a firm:
What is this firm’s operating profit margin?
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Operating profit margin = (EBIT / net sales) = ($150,000 / $500,000) = 30%
Which of the following items is NOT in the numerator of the quick ratio?
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Quick ratio = (cash + marketable securities + receivables) / current liabilities Current ratio = (cash + marketable securities + receivables + inventory) / current liabilities
Which of the following is a measure of a firm's liquidity?
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Equity turnover and net profit margin are each measures of a company's operating performance.
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
What is the quick ratio?
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Quick ratio = [100(cash) + 750(AR) + 300(marketable securities)] / [300(AP) + 130(short-term debt)] = (1,150 / 430) = 2.67
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
What is the current ratio?
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Current ratio = [100(cash) + 750(AR) + 300(marketable securities) + 850(inventory)] / [300(AP) + 130(short-term debt)] = (2,000 / 430) = 4.65
Assume a firm with a debt to equity ratio of 0.50 and debt equal to $35 million makes a commitment to acquire raw materials with a present value of $12 million over the next 3 years. For purposes of analysis the best estimate of the debt to equity ratio should be:
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The original debt / equity ratio = 35 / 70 = 0.5. Now adjust the numerator but not the denominator. Why? You have commitments (liabilities) but no new equity because (non-current) liabilities and assets are increased by the same amount. D/E = (35 + 12) / 70 = 0.671.
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
Determine the current ratio and the cash ratio.
| Current Ratio | Cash Ratio |
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Current ratio = [100(cash) + 750(accounts receivable)+ 300(marketable securities) + 850(inventory)] / [300(AP) + 130(short term debt)] = (2000 / 430) = 4.65 Cash ratio = [100(cash) + 300(marketable securities)] / [300(AP) + 130(short term debt)] = (400 / 430) = 0.93
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
What is the receivables turnover ratio?
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Receivables turnover = 1,500(sales) / 750(receivables) = 2.0
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
What is the receivables collection period?
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Receivables turnover = 1,500(sales) / 750(receivables) = 2.0 Average receivables collection period = 365 / 2 = 182.5 or 183
The cash conversion cycle is the:
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Cash conversion cycle = (average receivables collection period) + (average inventory processing period) ? (payables payment period)
An analyst has gathered the following information about a company:
Balance Sheet
Assets Cash 100 Accounts Receivable 750 Marketable Securities 300 Inventory 850 Property, Plant & Equip 900 Accumulated Depreciation (150) Total Assets 2750 Liabilities and Equity Accounts Payable 300 Short-Term Debt 130 Long-Term Debt 700 Common Stock 1000 Retained Earnings 620 Total Liab. and Stockholder's equity 2750 Income Statement
Sales 1500 COGS 1100 Gross Profit 400 SG&A 150 Operating Profit 250 Interest Expense 25 Taxes 75 Net Income 150
What is the inventory turnover ratio?
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Inventory turnover = 1,100(COGS) / 850(inventory) = 1.29
An analyst has gathered the following information about a firm:
What is their receivables balance?
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Cash ratio = (cash + marketable securities) / current liabilities 0.20 = ($10,000,000 + $2,000,000) / current liabilities current liabilities = $12,000,000 / 0.2 = $60,000,000 Quick ratio = [cash + marketable securities + receivables] / $60,000,000 0.25 = [$10,000,000 + $2,000,000 + receivables] / $60,000,000 ($60,000,000)(0.25) = $12,000,000 + receivables $15,000,000 = $12,000,000 + receivables $15,000,000 ? $12,000,000 = receivables $3,000,000 = receivables
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1600 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2910 Liabilities Accounts Payable 500 550 Long term debt 700 1002 Total liabilities 1200 1552 Equity Common Stock 400 538 Retained Earnings 1000 820 Total Liabilities & Equity 2600 2910 Income Statement
Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A (500) Interest Expense (151) EBT 1349 Taxes (30%) (405) Net Income 944
What is the current ratio for 2004?
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Current ratio = (CA / CL) = (1,660 / 550) = 3.018
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1300 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2910 Liabilities Accounts Payable 500 550 Long term debt 700 1102 Total liabilities 1200 1652 Equity Common Stock 400 538 Retained Earnings 1000 720 Total Liabilities & Equity 2600 2910 Income Statement
Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A 500 Interest Expense 151 EBT 1349 Taxes (30%) 405 Net Income 944
What is the quick ratio for 2004?
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Quick ratio = (cash + marketable securities + receivables) / CL = (450 + 0 + 660) / 550 = 2.018
Which of the following ratios would NOT be used to evaluate how efficiently management is utilizing the firm’s assets?
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The gross profit margin is used to measure a firm's operating profitability, not operating efficiency.
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1300 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2,910 Liabilities Accounts Payable 500 550 Long term debt 700 1102 Total liabilities 1200 1652 Equity Common Stock 400 538 Retained Earnings 1000 720 Total Liabilities & Equity 2600 2,910 Income Statement
Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A 500 Interest Expense 151 EBT 1349 Taxes (30%) 405 Net Income 944
What is the average receivables collection period?
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Average collection period = 365 / receivables turnover
Receivables turnover = sales / average receivables = 3,000 / 630 = 4.76
Average receivables collection period = 365 / 4.76 = 76.65
Earnings before interest and taxes (EBIT) is also known as:
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Operating profit = earnings before interest and taxes (EBIT) Gross profit = net sales – COGS Net income = earnings after taxes = EAT
To calculate the cash ratio, the total of cash and marketable securities is divided by:
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Current liabilities are used in the denominator for the: current, quick, and cash ratios.
An analyst has gathered the following data about a company:
What is their cash conversion cycle?
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Cash conversion cycle = average receivables collection period + average inventory processing period – payables payment period = 37 + 46 – 30 = 53 days.
Given the following information about a company:
What are the average receivables collection period, the average payables payment period, and the average inventory processing period respectively?
| Average Receivables Collection Period |
Average Payables Payment Period |
Average Inventory Processing Period |
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Average receivables collection period = (365 / 10) = 36.5 or 37 Average payables payment period = (365 / 12) = 30.4 or 30 Average inventory processing period = (365 / 8) = 45.6 or 46
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1300 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2910 Liabilities Accounts Payable 500 550 Long term debt 700 1102 Total liabilities 1200 1652 Equity Common Stock 400 538 Retained Earnings 1000 720 Total Liabilities & Equity 2600 2,910 Income Statement
Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A 500 Interest Expense 151 EBT 1349 Taxes (30%) 405 Net Income 944
What is the gross profit margin?
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Gross profit margin = (gross profit / net sales) = (2,000 / 3,000) = 0.666
Given the following income statement and balance sheet for a company:
Balance Sheet
Assets Year 2003 Year 2004 Cash 500 450 Accounts Receivable 600 660 Inventory 500 550 Total CA 1300 1660 Plant, prop. equip 1000 1250 Total Assets 2600 2910 Liabilities Accounts Payable 500 550 Long term debt 700 700 Total liabilities 1200 1652 Equity Common Stock 400 400 Retained Earnings 1260 1260 Total Liabilities & Equity 2600 2910 Income Statement
Sales 3000 Cost of Goods Sold (1000) Gross Profit 2000 SG&A 500 Interest Expense 151 EBT 1349 Taxes (30%) 405 Net Income 944
What is the operating profit margin?
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Operating profit margin = (EBIT / sales) = (1,500 / 3,000) = 0.5
Are the quick ratio and the debt-to-capital ratio used primarily to assess a company’s ability to meet short-term obligations?
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Quick ratio |
Debt-to-capital ratio |
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The quick ratio is a liquidity ratio. Liquidity ratios are used to measure a firm’s ability to meet its short-term obligations. The debt-to-capital ratio is a solvency ratio. Solvency ratios are used to measure a firm’s ability to meet its longer-term obligations.
An analyst has gathered the following data about a company:
What is their cash conversion cycle?
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Cash conversion cycle = average receivables collection period + average inventory processing period – payables payment period
= 95 + 183 – 274 = 4 days
The following data applies to the XTC Company:
What is the average collection period, the average inventory processing period, and the payables payment period for XTC Company?
| Average Collection Period |
Average Inventory Processing Period |
Payables Payments Period |
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Receivables turnover = $1,000,000 / $260,000 = 3.840 Inventory turnover = $800,000 / $400,000 = 2 Payables turnover ratio = $800,000 / $600,000 = 1.333
Average collection period = 365 / 3.840 = 95.05 or 95 days
Average inventory processing period = 365 / 2 = 183 days
Payables payment period = 365 / 1.333 = 273.82 or 274 days
What type of ratio is revenue divided by average working capital and what type of ratio is average total assets divided by average total equity?
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Revenue / Average working capital |
Average total assets / Average total equity |
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Revenue divided by average working capital, also known as the working capital turnover ratio, is an activity ratio. Average total assets divided by average total equity, also known as the financial leverage ratio, is a solvency ratio.
Which of the following is least likely a routinely used operating profitability ratio?
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Sales/Total Assets, or Total Asset Turnover is a measure of operating efficiency, not operating profitability.
Are the following ratios best classified as profitability ratios?
Ratio #1 – Cash plus short-term marketable investments plus receivables divided by average daily cash expenditures.Ratio #2 – Earnings before interest and taxes divided by average total assets.
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(Cash + short-term marketable investments + receivables) divided by average daily cash expenditures is known as the defensive interval ratio. The defensive interval ratio is a liquidity ratio that measures the firm’s ability to pay cash expenditures in the absence of external cash flows, but does not directly measure profitability. EBIT / average total assets is one variation of the return on assets ratio. Return on assets is a profitability ratio that measures the efficiency of managing assets and generating profits.
An analyst has collected the following data about a firm:
What is the average receivables collection period, the average inventory processing period, and the average payables payment period? (assume 360 days in a year)
| Receivables Collection Period |
Inventory Processing Period |
Payables Payment Period |
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Receivables collection period = 360 / 10 = 36 days Inventory processing period = 360 / 8 = 45 days Payables payment period = 360 / 12 = 30 days
An analyst has collected the following data about a firm:
What is the cash conversion cycle?
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Cash conversion cycle = receivables collection period + inventory processing period – payables payment period. Receivables collection period = (365 / 20) = 18
Inventory processing period = (365 / 16) = 23
Payables payment period = (365 / 24) = 15
Cash conversion cycle = 18 + 23 – 15 = 26
A company has a receivables turnover of 10, an inventory turnover of 5, and a payables turnover of 12. The company’s cash conversion cycle is closest to:
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Cash conversion cycle = receivables days + inventory processing days – payables payment period.
Receivables days = 365 / receivables turnover = 365 / 10 = 36.5 days.
Inventory processing days = 365 / inventory turnover = 365 / 5 = 73.0 days.
Payables payment period = 365 / payables turnover = 365 / 12 = 30.4 days.
Cash collection cycle = 36.5 + 73.0 – 30.4 = 79.1 days.
An analyst gathered the following data about a company:
If the company would like a current ratio of 2, they could:
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For the current ratio to equal 2.0, current assets would need to move to $600 (or up by $100) or current liabilities would need to decrease to $250 (or down by $50). Remember that CA ? CL = working capital (500 ? 300 = 200).
Goldstar Manufacturing has an accounts receivable turnover of 10.5 times, an inventory turnover of 4 times, and payables turnover of 8 times. What is Goldstar’s cash conversion cycle?
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The cash conversion cycle = average receivables collection period + average inventory processing period – payables payment period. The average receivables collection period = 365 / average receivables turnover or 365 / 10.5 = 34.76. The average inventory processing period = 365 / inventory turnover or 365 / 4 = 91.25. The payables payment period = 365 / payables turnover ratio = 365 / 8 = 45.63. Putting it all together: cash conversion cycle = 34.76 + 91.25 – 45.63 = 80.38.
Wells Incorporated reported the following common size data for the year ended December 31, 20X7:
| Income Statement | % |
| Sales | 100.0 |
| Cost of goods sold | 58.2 |
| Operating expenses | 30.2 |
| Interest expense | 0.7 |
| Income tax | 5.7 |
| Net income | 5.2 |
| Balance sheet | % | % | ||
| Cash | 4.8 | Accounts payable | 15.0 | |
| Accounts receivable | 14.9 | Accrued liabilities | 13.8 | |
| Inventory | 49.4 | Long-term debt | 23.2 | |
| Net fixed assets | 30.9 | Common equity | 48.0 | |
| Total assets | 100.00 | Total liabilities & equity | 100.0 |
For 20X6, Wells reported sales of $183,100,000 and for 20X7, sales of $215,600,000. At the end of 20X6, Wells’ total assets were $75,900,000 and common equity was $37,800,000. At the end of 20X7, total assets were $95,300,000. Calculate Wells’ current ratio and return on equity ratio for 20X7.
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Current ratio |
Return on equity |
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The current ratio is equal to 2.4 [(4.8% cash + 14.9% accounts receivable + 49.4% inventory) / (15.0% accounts payable + 13.8% accrued liabilities)]. This ratio can be calculated from the common size balance sheet because the percentages are all on the same base amount (total).
Return on equity is equal to net income divided by average total equity. Since this ratio mixes an income statement item and a balance sheet item, it is necessary to convert the common-size inputs to dollars. Net income is $11,211,200 ($215,600,000 × 5.2%) and average equity is $41,772,000 [($95,300,000 × 48.0%) + $37,800,000] / 2. Thus, 2007 ROE is 26.8% ($11,211,200 net income / $41,772,000 average equity).
Which of the following ratios would least likely measure liquidity?
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ROA = (EBIT / average total assets) which measures management's ability and efficiency in using the firm's assets to generate operating profits. Other ratios that measure liquidity (if a company can pay its current bills) besides the quick, cash, and current ratios are the: receivables turnover, inventory turnover, and payables turnover ratios.
Eagle Manufacturing Company reported the following selected financial information for 2007:
Accounts payable turnover
5.0
Cost of goods sold
$30 million
Average inventory
$3 million
Average receivables
$8 million
Total liabilities
$35 million
Interest expense
$2 million
Cash conversion cycle
13.5 days
Assuming 365 days in the calendar year, calculate Eagle's sales for the year.
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Set up the cash conversion cycle formula and solve for the missing variable, sales. Days in payables is equal to 73 [365 / 5 accounts payable turnover]. Days in inventory is equal to 36.5 [365 / ($30 million COGS / $3 million average inventory)]. Given the cash conversion cycle, days in inventory, and days in payables, calculate days in receivables of 50 [13.5 days cash conversion cycle + 73 days in payables – 36.5 days in inventory]. Given days in receivables of 50 and average receivables of $8 million, sales are $58.4 million [($8 million average receivables / 50 days) × 365].
Given the following information about a firm:
What are the gross and operating profit margins?
| Gross Operating Margin | Operating Profit Margin |
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Gross profit margin = ($1,000 net sales ? $600 COGS) / $1,000 net sales = 400 / 1,000 = 0.4 Operating profit margin = ($1,000 net sales ? $600 COGS ? $200 operating expenses) / $1,000 net sales = $200 / $1000 = 0.2
As of December 31, 2007, Manhattan Corporation had a quick ratio of 2.0, current assets of $15 million, trade payables of $2.5 million, and receivables of $3 million, and inventory of $6 million. How much were Manhattan’s current liabilities?
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Manhattan’s quick assets were equal to $9 million ($15 million current assets – $6 million inventory). Given a quick ratio of 2.0, quick assets were twice the current liabilities. Thus, the current liabilities must have been $4.5 million ($9 million quick assets / 2.0 quick ratio).
During 2007, Brownfield Incorporated purchased $140 million of inventory. For the year just ended, Brownfield reported cost of goods sold of $130 million. Inventory at year-end was $45 million. Calculate inventory turnover for the year.
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First, calculate beginning inventory given COGS, purchases, and ending inventory. Beginning inventory was $35 million [$130 million COGS + $45 million ending inventory – $140 million purchases]. Next, calculate average inventory of $40 million [($35 million beginning inventory + $45 million ending inventory) / 2]. Finally, calculate inventory turnover of 3.25 [$130 million COGS / $40 million average inventory].
An analyst has gathered the following information about a company:
What is the value of this firm’s average inventory processing period using a 365-day year?
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COGS = (0.65)($1,000,000) = $650,000 Inventory turnover = CGS / Inventory = $650,000 / $450,000 = 1.4444 Average Inventory Processing Period = 365 / 1.4444 = 252.7 days
Using a 365-day year, if a firm has net annual sales of $250,000 and average receivables of $150,000, what is its average collection period?
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Receivables turnover = $250,000 / $150,000 = 1.66667 Collection period = 365 / 1.66667 = 219 days
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