Chapter03

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Unformatted text preview: nts, then this would be a cause for concern. To give an example of current versus quick ratios, based on recent financial statements Wal-Mart and Manpower, Inc., had current ratios of .84 and 1.67, respectively. However, Manpower carries no inventory to speak of, whereas Wal-Mart’s current assets are virtually all inventory. As a result, Wal-Mart’s quick ratio was only .22, and Manpower’s was 1.67, the same as its current ratio. CASH RATIO A very short-term creditor might be interested in the cash ratio: Cash ratio Cash ___________________ Current liabilities [3.3] You can verify that this works out to be .18 times for Prufrock. Long-Term Solvency Measures Long-term solvency ratios are intended to address the firm’s long-run ability to meet its obligations, or, more generally, its financial leverage. These ratios are sometimes called 50 PART 1 Overview ros82361_ch03.indd ros82361_ch03.indd 50 5/27/08 10:14:58 AM Confirming Pages financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations. TOTAL DEBT RATIO The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is: Total debt ratio T____________________________ Total equity _otal assets Total assets $________________ 2,591 _ 3,588 $3,588 .28 times [3.4] In this case, an analyst might say that Prufrock uses 28 percent debt.1 Whether this is high or low or whether it even makes any difference depends on whether or not capital structure matters, a subject we discuss in a later chapter. Prufrock has $.28 in debt for every $1 in assets. Therefore, there is $.72 in equity ($1 .28) for every $.28 in debt. With this in mind, we can define two useful variations on the total debt ratio, the debt-equity ratio and the equity multiplier: Debt-equity ratio Total debt/Total equity $.28/$.72 .39 times Total assets/Total equity $1/$.72 1.39 times [3.5] [3.6] The online Women’s Business Center has more information on financial statements, ratios, and small business topics www.onlinewbc.gov. Equity multiplier The fact that the equity multiplier is 1 plus the debt-equity ratio is not a coincidence: Equity multiplier Total assets/Total equity $1/$.72 1.39 times (Total equity Total debt)/Total equity 1 Debt-equity ratio 1.39 times The thing to notice here is that given any one of these three ratios, you can immediately calculate the other two, so they all say exactly the same thing. TIMES INTEREST EARNED Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we’ll stick with the most traditional: Times interest earned ratio EBIT _________ Interest $691 ______ $141 4.9 times [3.7] As the name suggests, this ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. For Prufrock, the interest bill is covered 4.9 times over. CASH COVERAGE A problem with the TIE ratio is that it is based on EBIT, which is not really...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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