Chapter 4
Analysis of Financial Statements
ANSWERS TO ENDOFCHAPTER QUESTIONS
41
a.
A liquidity ratio is a ratio that shows the relationship of a firm’s cash and other
current assets to its current liabilities.
The current ratio is found by dividing current
assets by current liabilities.
It indicates the extent to which current liabilities are
covered by those assets expected to be converted to cash in the near future.
The
quick, or acid test, ratio is found by taking current assets less inventories and then
dividing by current liabilities.
b.
Asset management ratios are a set of ratios that measure how effectively a firm is
managing its assets.
The inventory turnover ratio is sales divided by inventories.
Days sales outstanding is used to appraise accounts receivable and indicates the
length of time the firm must wait after making a sale before receiving cash.
It is
found by dividing receivables by average sales per day.
The fixed assets turnover
ratio measures how effectively the firm uses its plant and equipment.
It is the ratio of
sales to net fixed assets.
Total assets turnover ratio measures the turnover of all the
firm’s assets; it is calculated by dividing sales by total assets.
c.
Financial leverage ratios measure the use of debt financing.
The debt ratio is the ratio
of total liabilities to total assets, it measures the percentage of funds provided by non
equity holders.
The timesinterestearned ratio is determined by dividing earnings
before interest and taxes by the interest charges.
This ratio measures the extent to
which operating income can decline before the firm is unable to meet its annual
interest costs.
The EBITDA coverage ratio is similar to the timesinterestearned
ratio, but it recognizes that many firms lease assets and also must make sinking fund
payments.
It is found by adding EBITDA and lease payments then dividing this total
by interest charges, lease payments, and sinking fund payments over one minus the
tax rate.
d.
Profitability ratios are a group of ratios, which show the combined effects of liquidity,
asset management, and debt on operations.
The profit margin on sales, calculated by
dividing net income by sales, gives the profit per dollar of sales.
Basic earning power
is calculated by dividing EBIT by total assets.
This ratio shows the raw earning
power of the firm’s assets, before the influence of taxes and leverage.
Return on total
assets is the ratio of net income to total assets.
Return on common equity is found by
dividing net income by common equity.
Answers and Solutions:
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e.
Market value ratios relate the firm’s stock price to its earnings and book value per
share.
The price/earnings ratio is calculated by dividing price per share by earnings
per sharethis shows how much investors are willing to pay per dollar of reported
profits.
The price/cash flow is calculated by dividing price per share by cash flow per
share.
This shows how much investors are willing to pay per dollar of cash flow.
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 Spring '10
 VanWass
 Finance, Balance Sheet, Liquidity, Financial Ratio, total assets, Computron

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