Ratio Analysis

Which statement below is an example of how ratios are used in the field of finance?

A firm’s ratios are compared with those of a benchmark peer group to determine the firm’s relative strength and performance.

Why are ratios considered flexible?

Because they are not regulated and can be changed or invented according to a firm’s needs

How might calculating financial ratios help shareholders?

Ratios can be used to determine whether a firm is maximizing shareholder wealth.

The firm Betsy’s Books conducts a financial analysis using ratios to know how it is performing in comparison to other similar firms. What is this process called?

Benchmarking

What type of ratio is used to assess a firm’s ability to meet short-term obligations without raising external capital?

Liquidity ratios

Why are several different types of ratios used to analyze a firm?

Because different types of ratios are needed to get information about different parts of a firm

What do leverage ratios describe?

What proportions of equity and debt a firm uses to finance its assets

A firm has paid off its short-term loans more quickly in the past couple of years. What might this trend indicate about the firm’s financial ratios?

Its liquidity ratio is increasing.

Which type of ratio is a current ratio?

Liquidity

What is the main difference between the current ratio and the quick ratio?

The current ratio includes inventory in current assets, and the quick ratio does not.

The firm Betsy’s Books has a market-to-book ratio of 1.2. What does this tell you about the firm?

This firm is expected to grow in the future.

What does the net margin measure?

The percent of revenue that is retained as profit for the firm

Which of these measures is a component of return on equity?

Net margin

How can the DuPont framework help a company assess its return on equity?

It allows the company to determine how its abilities to generate profits, manage assets, and use financing contribute to the return on equity.

Which action increases the return on equity of a firm if all else remains constant?

Increasing debt financing

What is a component of the DuPont framework?

Return on assets

What is one way that a firm can improve its return on equity?

Successfully cutting production costs to boost net margin

BigDog and SmallDog are two companies that have an identical return on equity. One difference between the two companies is that BigDog has 40% of assets financed by debt while SmallDog has 100% of assets financed by equity. What can you conclude about BigDog and SmallDog?

SmallDog has a higher ROA than BigDog.

Which actions, taken together, will certainly increase a firm’s ROE?

Decreasing equity financing and increasing net margin

A company currently has a ratio of 1.5 but hopes to improve the ratio to 2 to align more with the industry benchmark. To achieve this goal, costs were cut in production through an investment in efficient equipment, and the company achieved a higher profit margin. If this continues, you are certain that the firm will achieve its goal in two years. What is this an example of?

Progress measurement

For what purpose are market ratios used?

To evaluate the current share price of a public firm’s stock

You are considering starting a new business to sell Widgets in your hometown. You can import the Widgets at a low cost, and you hope to be able to sell them for significantly more. Which ratio can help you calculate how much profit you will earn from the sale of each Widget? (Assume you are only considering the cost of the Widget, not any other operating costs.) 

Gross margin

What allows an investor to determine which financial activities are contributing to changes in the return on equity?

DuPont framework

Knowing that you are taking this finance class, a friend asks you about two investment opportunities he is considering. He wants to know which of the firms is using its assets more efficiently to generate sales. Which set of information could help you determine this?

Firm A has an asset turnover of 4, and Firm B has an asset turnover of 2.5.

Which method of ratio analysis looks at a firm’s performance over time?

Trend analysis

You are a financial analyst of an investment bank, and you are doing research on equity. You are looking at a book publisher’s financial ratios in comparison to its competitors and the industry average. What is this an example of?

Cross-sectional analysis

Which type of ratio are suppliers interested in?

Liquidity ratios

What is the ratio that tells you on average how long it takes for a firm to collect accounts receivable?

Average collection period

What does a debt ratio of 40% indicate?

It indicates that 40% of assets are financed by debt.

What is operating margin useful for?

Comparing the profitability of firms with different capital structures

What does an average collection period of 70 tell you?

On average, a firm takes 70 days to collect accounts receivable.

What does high inventory turnover relative to the industry and competitors indicate?

The firm does not hold enough inventory and is making its customers wait longer to receive their purchased goods.

What is the difference between return on assets (ROA) and return on equity (ROE)?

ROE considers the capital structure of a company, while ROA does not.

MiniCo recently spun off of BigCo. Both companies have the same leverage and asset turnover ratios, but MiniCo is underperforming on its return on equity to shareholders. If MiniCo would like to improve its return on equity, which action would help?

Reduce costs to improve its overall profitability.