# Study Guide 2 - What is ratio analysis? A relative...

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What is ratio analysis?A relative financial analysis, Makes comparisons on a fair basis.Purposes of Ratio analysis: Evaluate the financial conditions and performance, Monitor operating performance and financial conditions, Evaluatesolvency and liquidity or riskiness of loans, Evaluate performance of a firm and attractiveness of investmentRatio analysis can answer the following questions:Is there sufficient cash to meet the establishment's obligations for a given time period? Are theprofit of the hospitality operation reasonable? Is the level of debt acceptable in comparison with the stockholders’ investment? Is the inventoryusage adequate? How do the operation’s earnings compare with the market price of the hospitality property’s stock? Are account receivablereasonable in light of credit sales? Is the hospitality establishment able to service its debt?Ratios can be compared using three benchmarks: 1. Historical performance: ratio comparison over time periods for the same firm. 2.Compareacross the industry – compare one firm against another firm or the industry average. 3. Compare actual ratios with target ratios1. Liquidity Ratios:Reveal the firm’s ability to meet its short-term obligations-Sufficient cash and near cash assets to pay bills on time.-Common liquidity ratios- Current ratio (CR)Current ratio: CR =current assets (CA)/current liabilities (CL)* However, CR includes inventory, which is the least liquid item in CA and cannot be usedto pay bills.- CR includes all CA -CR may not measure the true ability to pay bills on time.- Acid-test ratio (quick ratio) (ATR)Acid test ratio (quick ratio) - an improvement over CR:ATR = (CA - inventory - prepaid expenses) / CL*Excluding the least liquid item (inventory) and prepaid expenses (money already gone)from the CA, we have “quick assets” in the numerator. Thus ATR is a more accurate measure of the ability to pay bills on time.- An improvement over CR-A more accurate measure of firms’ ability to pay bills on time- Operating cash flows to current liabilities ratio (OCFTCLR)Operating cash flow to current liabilities (OCFTCL) – It measures the ability of using operating cash flow to pay bills:OCFTCL = Operating cash flow / average CL* Average CL = (Beginning of year CL + Ending CL)/2- A firm’s ability to generate sufficient cash to pay the company’s CL- Accounts receivable turnover (ART)Accounts Receivable Turnover (ART) - how fast the firm is collecting sales money.ART = Total sales / average AR-Shows the number of times that Acct. Receivable is converted into cash during a period-The numerator represents total AR occurred during a periodwhile the denominatorindicates the average level of AR during the period.While a high ART improves liquidity, it may discourage patronage. Therefore, we should expect that:-Higher ART - stricter credit policy - decrease sales-Lower ART - lenient credit policy - increase sales2. Solvency ratios “Leverage ratios”:two sub-categoriesA)The degree of debt use or indebtedness – such as debt to equity ratio, debt ratio, etc.

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Term
Winter
Professor
Walker
Tags
Financial Ratio