Ratios

Ratios – vertical analysis (common size financial statements)

1. Balance Sheet = Total Assets

2. Income Statement = Total Net Sales

Liquidity ratios

1. Current ratio, also known as the working capital ratio:

   Total Current Assets/total current liabilities

2. Quick ratio, also known as the acid test ratio

   Cash and cash equivalent + marketable securities + receivables / total current liabilities

3. Cash ratio

Liquidity ratios - Cont’d

Debt covenants

1. Liquidity ratios are important because often a loan will have a debt covenant where the borrower agrees to maintain a current ratio, lender could call the loan immediately even if the borrower is current with the payments.

2. On the exam, you need to know if the borrower is in compliance with the debt covenant or is their noncompliance.

Liquidity ratios - Cont’d V2

1. The cash ratio is simply cash + marketable securities / Current liabilities.

Transaction effects on ratios – borrowing short-term

1. Current Ratio Note: if the ratio starts above or below 1 and the top and bottom numbers increase or decrease by the same amount, the ratios will change.

2. Manually calculate to determine the ratio change.

3. Cash flow ratio: measures a companies ability to generate cash from operations to cover short term liabilities. (cash flow ratio = operating cash flow/current liability)

Inventory turnover

1. Inventory turnover = cost of goods sold / average inventory. (Higher is better)

2. Average inventory = beginning inventory + ending inventory / 2.

3. Inventory conversion = ending inventory/cost of goods sold/365

   a. The inventory conversion period measures the degree to which resources have been devoted to inventory to support sales.

4. Note: The higher the inventory turnover rate, the lower number of conversion days.

Accounts receivable turnover

A. Operating cycle means sell and collect!

1. accounts receivable turnover = Net credit sales/Average receivables.

2. Days sales in receivables = Ending A/R / Sales/365

3. Operating cycle: the operating cycle is the time it takes to convert inventory into sales (receivables) and those same receivables into cash.

4. A company’s operating cycle can be determined by:

   a. taking the receivables collection period (lower is better) and

   b. adding the inventory conversion. Period. (lower is better)

Operating cycle - Cont’d

Net operating cycle Cash conversion cycle

1. Formula for Cash conversion cycle:

2. Number of days to sell + number of days to collect - the number of days to pay vendor. ( CCC = Inventory Conversion + Receivables Collection - Payables Deferral)

3. Accounts payable turnover ratio =

   a. COGS / Average A/P

4. Days to Pay = Ending A/P / COGS / 365

5. Net operating cycle: 125 days (Operating Cycle) minus 41 days (days to pay vendors) = 84 Days.

Contribution margin (CM)

1 CM = Net Sales minus variable cost

Example – flexible budgeting

1. Flexible budgets are based on the same per unit amounts as the master budget.

Example – flexible budgeting Cont’d

Example – flexible budgeting Cont’d V2