CPA F2 M8 Study Spring 2020

ration analysis overview "quickly identify red flags

quickly identify red flags: (relative to itself)historical trends, (relative to the industry) industry standard
ratios are financial indicators that distill "relevant" info about a business entity
compared with ratios of a different period, also compared

pass key for ratios:

increase in numerator / denominator = increase in resulting ratio (direct relationship)
numerator / increase in denominator = decrease in resulting ratio (inverse relationship)

Liquidity Ratios: short term risk of distress (the higher the ratio, the lower the risk)

current ratio: current assets / current liabs
both num and denom are from BS so use current year numbers
quick ratio: (cash and cash equivalents + short term marketable securities + receivable (net)) / current liabs
*more liquid and conservative than curr

Activity Ratios: turnover, want the ratios to be > the standard
num=IS use current year
denom=BS use average (sometimes they want you to use year-end numbers, so read carefully)

accounts receivable turnover: sales (net)/ average accounts receivable (net)
*higher the better
days sales in AR: ending AR (net)/ (sales (net)/365)
*lower the better
inventory turnover: COGS/ average inventory
*higher the better
days in inventory: ending

Profitability Ratios *greater than the standard

profit margin: net income / sales (net)
*higher than the standard
return on assets: net income / average total assets
*higher than the standard
Dupont return on assets: profit margin * asset turnover
*explains why ROA is what it is
1. can assets generate

Coverage Ratios: long term solvency - capital structure

debt to equity: total liabs / total equity
*dependent on risk that management is will and able to assume
*low ratio = good, but without risk there's no return
total debt ratio: total liabs / total assets
*as debt goes up, more risk assumed, more reward (h

Investor Ratios:

EPS: income available to common shareholders / weighted average common shares outstanding
*higher the better
price earnings ratio: price per share / basic earnings per share
*if high, expensive probably due to growth
*if low, probably underrated and cheap

Limitations of Ratios

easy to compute, but depend entirely on reliability of data
additional info (compare to benchmark or standard)
horizontal analysis: % change over a period of time (trend)
vertical analysis: % of sales or total assets, allows for comparability with other e

beg inv: 100,000
end inv: 300,000
net sales: 2,000,000
net purchases: 700,000
what is inventory turnover?

COGS/ave. inventory
100,000 beg inv
+ 700,000 net purchases
- 300,000 end inv
500,000 COGS
ave inv: 100,000+300,000/2 = 200,000
500,000/200,000 = 2.5

If Hutton Inc. sold $100 of inventory for $100 of cash, which of the following ratios would decrease

net profit margin
is calculated as net income divided by net sales. If inventory is sold at cost, net income does not change but net sales increases. Thus, numerator doesn't change but the denominator increases, causing net profit margin to decrease

Which of the following measures would generally be considered beneficial?

times interest earned
measures the ability of a company to cover interest charges. the grater the liability the less risk of bankruptcy

At the end of Y2, Hutton borrowed $100 of cash by issuing long term note payable. What would the effect on the following ratios be?

current ratio: increase
debt to asset ratio: increase
assets will go up because we're getting 100$, and debt will go up since we have to pay it back at some point.

current assets include:

cash, accounts receivable (net), inventory

working capital is...

total current assets - total current liabilities

working capital turnover

sales / average working capital
average working capital = current assets + current liabs

Stent Co. had total assets of $760,000, capital stock of $150,000 and retained earnings of $215,000. What was stent's debt to equity ratio?

A = L+ SE
760,000 = L + (150,000 + 215,000)
L = 395,000
debt to equity ratio: 395,000 / 365,000 = 1.08

If Hutton used $100 of cash to buy $100 of inventory, what would be the effect of the following ratios?

current ratio: no effect
quick ratio: decrease
using cash will decrease assets, and getting inventory will increase assets, so current ratio won't be affected because the numerator is current assets
using cash will decrease assets and thus decrease the qu

AR turnover: ten times during the year
asset turnover: two times during the year
average receivables during the year: 200,000
What was average total assets during the year

200,000* 10 times = 2,000,000 / 2 times = 1,000,000