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Accounting


Accounting


CURRENT RATIO The most common ratio using current-asset and

data is the current ratio, which is current assets divided by current

Recall the makeup of current assets and current liabilities. Inventory is

to receivables through sales, the receivables are collected in cash, and the

cash is used to buy inventory and pay current liabilities. A company’s

current assets and current liabilities represent the core of its day-to-day

operations. The current ratio measures the company’s ability to pay current

assets with current liabilities. Generally a higher current ratio indicates

a stronger financial position. A higher current ratio suggests that the

business has sufficient liquid assets to maintain normal business

ACID-TEST RATIO The acid-test (or quick) ratio tells us whether the entity

could pay all its current liabilities if they came due immediately. ч That

is, could the company pass this acid test? To do so, the company would have

to convert its most liquid assets to cash.

To compute the acid-test ratio, we add cash, short-term investments, and net

current receivables (accounts and notes receivable, net of allowances) and

divide by current liabilities. Inventory and prepaid expenses are the two

current assets not included in the acid-test computations because they are

the least liquid of the cur rent assets. A business may not be able to

convert them to cash immediately to pay current liabilities. The acid-test

ratio uses a narrower asset base to measure liquidity than the current ratio

does. An acid-test ratio of 0.90 to 1.00 is acceptable in most industries.

INVENTORY TURNOVER is a measure of the number of times a company sells its

average level of inventory during a year. A high rate of turnover indicates

relative ease in selling inventory; a low turnover indicates difficulty in

selling. In general, companies prefer a high inventory turnover. A value of

6 means that the company’s average level of inventory has been sold six

times during the year. This is generally better than a turnover of 3 or 4.

However, a high value can mean that the business is not keeping enough

inventory on hand, and inadequate inventory can result in lost sales if the

company cannot fill a customer’s order. Therefore, a business strives for

the most profitable rate of inventory turnover, not necessarily the highest

To compute the inventory turnover ratio, we divide cost of goods sold by the

average inventory for the period. We use the cost of goods sold—not sales—in

the computation because both cost of goods sold and inventory are stated at

cost. Sales are stated at the sales value of inventory and therefore are not

ACCOUNTS RECEIVABLE TURNOVER. Accounts receivable turnover measures a

company’s ability to collect cash from credit customers. In general, the

higher the ratio, the more successfully the business collects cash and the

better off its operations. However, a receivable turnover that is too high

may indicate that credit is too tight, causing the loss of sales to good



customers. To compute the accounts receivable turnover, we divide net credit

sales by average net accounts receivable. The resulting ratio indicates how

many times during the year the average level of receivables was turned into

DAYS’ SALES IN RECEIVABLES Businesses must convert accounts receivable to

cash. All else equal, the lower the Accounts Receivable balance, the more

successful the business has been in converting receivables into cash, and

The days’-sales-in-receivables ratio tells us how many days’ sales remain in

Accounts Receivable. To compute the ratio, we follow a two-step process.

First, divide net sales by 365 days to figure the average sales amount for

one day. Second, divide this average day’s sales amount into the average net

This relationship between total liabilities and total assets—called the DEBT

RATIO—tells us the proportion of the company’s assets that it has financed

with debt. If the debt ratio is 1, then debt has been used to finance all

debt ratio of 0.50 means that the company has used debt to finance half its

and that the owners of the business have financed the other half. The higher

the debt ratio, the higher the strain of paying interest each year and the

principal amount at maturity. The lower the ratio, the lower the business’s

future obligations. Creditors view a high debt ratio with caution. If a

business seeking financing already has large liabilities, then additional

debt payments may be too much for the business to handle. To help protect

themselves, creditors generally charge higher interest rates on new

borrowing to companies with an already-high debt ratio.

TIMES-INTEREST-EARNED RATIO. The debt ratio measures the effect of debt on

the company’s financial position (balance sheet) but says nothing about its

ability to pay interest expense. Analysts use a second ratio—the

times-interest-earned ratio—to relate income to interest expense. To compute

this ratio, we divide in come from operations by interest expense. This

ratio measures the number of times that operating income can cover interest

expense. For this reason, the ratio is also called the interest-coverage

ratio. A high times-interest-earned ratio indicates ease in paying interest

expense; a low value suggests difficulty.

RATE OF RETURN ON NET SALES. In business, the term return is used broadly

and loosely as an evaluation of profitability. Consider a ratio called the

rate of return on net sales, or simply return on sales. (The word net is

usually omitted for convenience, even though the net sales figure is used to

compute the ratio.) This ratio shows the percentage of each sales dollar

earned as net income. Companies strive for a high rate of return. The higher

the rate of return, the more net sales dollars are providing income to the

business and the fewer net sales dollars are absorbed by expenses.

RATE OF RETURN ON TOTAL ASSETS. The rate of return on total assets, or

return on assets, measures a company’s success in using its assets to earn a

Creditors have loaned money to the company, and the interest they receive is

return on their investment. Shareholders have invested in the company’s

and net income is their return. The sum of interest expense and net income

is thus the return to the two groups that have financed the company’s

operations, and this amount is the numerator of the return-on-assets ratio.

Average total assets is the denominator.

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY. A popular measure of

profitability is rate of return on common stockholders’ equity, which is

shortened to return on stockholders’ equity, or simply return on equity. -

ratio shows the relationship between net income and common stockholders’ in-

vestment in the company—how much income is earned for every $1 invested by

the common shareholders. To compute this ratio, we first subtract preferred

dividends from net income. This calculation provides net income available to

the common stockholders, which we need to compute the ratio. We then divide

net income available to common stockholders by the average stockholders’

equity during the year. Common stockholders’ equity is total stockholders’

EARNINGS PER SHARE OF COMMON STOCK. Earnings per share of common stock, or

simply earnings per share (EPS), is perhaps the most widely quoted of all

financial statistics. EPS is the only ratio that must appear on the face of

the income statement. EPS is the amount of net income per share of the

company’s outstanding common stock. Earnings per share is computed by

dividing net income available to common stockholders by the number of common

shares outstanding during the year. Preferred dividends are subtracted from

net income because the preferred stockholders have a prior claim to their

PRICE/EARNINGS RATIO. The price/earnings ratio is the ratio of the market

a share of common stock to the company’s earnings per share. This ratio,

abbreviated P/E, appears in the Wall Street Journal stock listings. P/E

ratios play an important part in decisions to buy, hold, and sell stocks.

$1 of earnings. The higher a stock’s P/E ratio the higher its downside

risk—the risk that the stock’s market price will fall. Many investors

interpret a sharp increase in a stock’s

P/E ratio as a signal to sell the stock.

DIVIDEND YIELD. Dividend yield is the ratio of dividends per share of stock

to the stock’s market price per share. This ratio measures the percentage of

a stock’s market value that is returned annually as dividends, an important

concern of stock holders. Preferred stockholders, who invest primarily to

receive dividends, pay special attention to this ratio.

BOOK VALUE PER SHARE OF COMMON STOCK. Book value per share of common stock

is simply common stockholders’ equity divided by the number of shares of

common stock outstanding. Common shareholders’ equity equals total

stockholders’ equity less preferred equity.




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