Financial Ratio Analysis - Chapter 3
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Questions and Answers

What do activity ratios primarily measure?

  • The firm's ability to pay short-term obligations
  • The financial risk associated with debt
  • The overall profitability of a firm
  • The effectiveness of the firm's investment decisions (correct)

    • Which of the following is considered a profitability ratio?

  • Net Working Capital
  • Return on Equity (correct)
  • Debt Ratio
  • Current Ratio

    • Debt management ratios help assess what aspect of a firm's finances?

  • Liquidity position
  • Operational efficiency
  • Market value of stocks
  • Interest payment obligations (correct)

    • What does a higher current ratio indicate?

    <p>Higher ability to meet short-term obligations</p> Signup and view all the answers

    Which ratio is a measure of the firm's financial risk due to debt?

    <p>Debt to Equity Ratio</p> Signup and view all the answers

    What does the times interest earned ratio measure?

    <p>A firm's ability to cover interest expenses</p> Signup and view all the answers

    Which of the following is NOT a type of financial ratio?

    <p>Operational Ratios</p> Signup and view all the answers

    In terms of asset management efficiency, what do activity ratios evaluate?

    <p>How effectively a firm utilizes its assets</p> Signup and view all the answers

    What is the primary focus of liquidity ratios?

    <p>Short-term debt repayment capabilities</p> Signup and view all the answers

    Which of the following ratios would likely indicate a company has a high financial risk?

    <p>Debt Ratio</p> Signup and view all the answers

    What does the Accounts Receivable Turnover (ARTO) ratio indicate?

    <p>The effectiveness of a firm in managing its accounts receivable.</p> Signup and view all the answers

    Which statement is true regarding Inventory Turnover (ITO)?

    <p>Higher ITO signifies better use of inventory to generate sales.</p> Signup and view all the answers

    What does a higher Net Profit Margin (NPM) indicate?

    <p>Higher income available to common stockholders after all expenses.</p> Signup and view all the answers

    The Return on Total Assets (ROA) measures what aspect of a firm's performance?

    <p>Company's ability to generate earnings from its total assets.</p> Signup and view all the answers

    What does the Dividend Payout Ratio (DPR) indicate about a firm's financial strategy?

    <p>The percentage of net earnings distributed as cash dividends to shareholders.</p> Signup and view all the answers

    Which ratio evaluates the efficiency of a firm’s fixed asset utilization?

    <p>Fixed Asset Turnover</p> Signup and view all the answers

    Which profitability ratio emphasizes the control of costs relative to sales revenue?

    <p>Operating Ratio</p> Signup and view all the answers

    What does a higher Dividend Yield indicate for shareholders?

    <p>A more attractive return rate on their investments.</p> Signup and view all the answers

    Which ratio helps assess the overall effectiveness of a firm in generating sales from its assets?

    <p>Total Asset Turnover</p> Signup and view all the answers

    Which profitability ratio indicates a firm's ability to control its cost of goods sold?

    <p>Gross Profit Margin</p> Signup and view all the answers

    A high Return on Common Equity (ROE) indicates what regarding a firm’s performance?

    <p>Strong profitability and efficient use of shareholder equity.</p> Signup and view all the answers

    The Earnings Per Share (EPS) metric is essential for assessing what aspect of a company?

    <p>The portion of the company's profit allocated to each outstanding share of common stock.</p> Signup and view all the answers

    What does a higher Price Earnings Ratio (PER) signify about investor perception?

    <p>Investors expect higher growth from the company's future earnings.</p> Signup and view all the answers

    What is the primary purpose of calculating the Operating Profit Margin (OPM)?

    <p>To measure the productivity of assets in generating operational returns.</p> Signup and view all the answers

    Study Notes

    Chapter 3: Financial Ratio

    • Financial analysis includes securities analysis, investment analysis, and corporate financial analysis.
    • Corporate financial analysis aims to assess periodic operating results and financial status.
    • It also develops plans and strategies, ultimately aiming to maintain company performance.
    • Financial ratios are important tools for assessing a company's performance at a specific point in time or over a period.
    • They show relationships among financial statements and are used by investors and managers.

    Types of Ratios

    • Liquidity Ratios: Measure a firm's working capital management and ability to meet short-term obligations. Higher liquidity is preferred.

      • Current Ratio (CR): Current assets divided by current liabilities. A higher ratio is better, indicating stronger liquidity.
      • Quick Ratio (Acid Test): (Current assets - Inventory) divided by Current Liabilities. A higher ratio is generally better, as it measures the ability to meet short-term obligations without relying on selling inventory.
      • Net Working Capital: Current assets minus current liabilities. A positive value is better, indicating stronger liquidity.

    • Activity Ratios: Measure the effectiveness of a firm's investment decisions and asset utilization.

      • Average Collection Period (ACP): Measures the time it takes to collect on credit sales. Shorter periods are generally better.
      • Accounts Receivable Turnover (ARTO): Measures how efficiently the firm collects on credit sales. Higher is better.
      • Inventory Turnover (ITO): Measures how efficiently the firm manages inventory. Higher is better.
      • Fixed Asset Turnover (FATO): Measures how efficiently the firm utilizes its fixed assets. Higher is better.
      • Total Asset Turnover (TATO): Measures how efficiently the firm uses all its assets to generate sales. Higher is better.

    • Leverage Ratios: Indicate the extent a firm uses debt to finance investments, measuring financial risk.

      • Debt Ratio: Total debt divided by total assets. A lower ratio is typically better.
      • Debt to Equity Ratio: Total debt divided by net worth. A lower ratio is usually better, indicating a lower reliance on debt.
      • Time Interest Earned (TIE): EBIT divided by interest expense. A higher ratio suggests a greater ability to meet interest payments.

    • Profitability Ratios: Analyze the combined effects of liquidity, asset management, and debt on a firm's overall operating performance.

      • Gross Profit Margin (GPM): Gross profit divided by net sales. Higher is better, reflecting better control over cost of goods sold.
      • Operating Profit Margin (OPM): Earnings before interest and taxes (EBIT) divided by net sales. Higher is better, indicating better productivity of assets and efficiency in providing returns.
      • Basic Earnings Power (BEP): EBIT divided by total assets. Higher is better, reflecting better use of assets to generate earnings.
      • Operating Ratio: Total operating expenses divided by net sales. A lower ratio is better. Lower implies better operating efficiency and control on operating costs.
      • Net Profit Margin (NPM): Earnings after tax (EAT) divided by net sales. Higher is better, reflecting greater profitability.
      • Return on Common Equity (ROE): EAT divided by net worth. Higher is better, reflecting a good return on the company’s equity.
      • Return on Total Assets (ROA): EAT divided by total assets. Higher is better, indicating higher profitability from using total assets.

    • Market Ratios: Used for publicly traded firms in stock valuation and investment portfolio decisions. These depend on overall company performance.

      • Earnings Per Share (EPS): Calculation details provided for the ratio.
      • Dividend Per Share (DPS): Calculation details provided for the ratio.
      • Dividend Payout Ratio (DPR): Calculation details provided for the ratio.
      • Dividend Yield (DY): Calculation details provided for the ratio.
      • Book Values Per Share (BVPS): Calculation details provided for the ratio.
      • Price Earnings Ratio (PER): Calculation details provided for the ratio.

    Discussion

    • Activity Ratios: ACP, FATO, and TATO may indicate less efficiency in asset utilization, while ITO shows better inventory management.
    • Liquidity Ratios: A strong current ratio is a good sign, but a weak quick ratio (acid test) suggests potential short-term payment difficulties.
    • Profitability Ratios: Higher OPM, NPM, ROA, and ROE indicate better performance compared to industry averages.
    • Leverage Ratios: If these ratios are worse than industry benchmarks, it suggests a higher reliance on debt. This may present risk. Lower TIE ratios indicate a less efficient ability to pay interest on debt.

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    Chapter 3 Financial Ratio PDF

    Description

    Explore the key concepts of financial ratio analysis as outlined in Chapter 3. This chapter focuses on liquidity ratios, their significance, and how they are used to assess a company's financial health. Understand vital ratios like the Current Ratio and Quick Ratio for better investment and management decisions.

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