Chapter 6: Financial Statement Analysis
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1.Determine a firm's total asset turnover [TAT] if its net profit margin [NPM] is 5 percent, total assets are $8 million, and ROI is 8 percent.1.602.05
2.50
4.00
2.Felton Farm Supplies, Inc., has an 8 percent return on total assets of $300,000 and a net profit margin of 5 percent. What are its sales?$3,750,000
$480,000
$300,000
$1,500,000
3.Which of the following would NOT improve the current ratio?Borrow short term to finance additional fixed assets.
Issue long-term debt to buy inventory.
Sell common stock to reduce current liabilities.
Sell fixed assets to reduce accounts payable.
4. The gross profit margin is unchanged, but the net profit margin declined over the same period. This could have happened ifcost of goods sold increased relative to sales.
sales increased relative to expenses.
the U.S. Congress increased the tax rate.
dividends were decreased.
5.Palo Alto Industries has a debt-to-equity ratio of 1.6 compared with the industry average of 1.4. This means that the companywill not experience any difficulty with its creditors.
has less liquidity than other firms in the industry.
will be viewed as having high creditworthiness.
has greater than average financial risk when compared to other firms in its industry.
6.Kanji Company had sales last year of $265 million, including cash sales of $25 million. If its average collection period was 36 days, its ending accounts receivable balance is closest to . [Assume a 365-day year.]$26.1 million
$23.7 million
$7.4 million
$18.7 million
7.A company can improve [lower] its debt-to-total assets ratio by doing which of the following?Borrow more.
Shift short-term to long-term debt.
Shift long-term to short-term debt.
Sell common stock.
8.Which of the following statements [in general] is correct?A low receivables turnover is desirable.
The lower the total debt-to-equity ratio, the lower the financial risk for a firm.
An increase in net profit margin with no change in sales or assets means a poor ROI.
The higher the tax rate for a firm, the lower the interest coverage ratio.
9.Retained earnings for the "base year" equals 100.0 percent. You must be looking ata common-size balance sheet.
a common-size income statement.
an indexed balance sheet.
an indexed income statement.
10.Krisle and Kringle's debt-to-total assets [D/TA] ratio is .4. What is its debt-to-equity [D/E] ratio?.2
.6
.667
.333
11.A firm's operating cycle is equal to its inventory turnover in days [ITD]plus its receivable turnover in days [RTD].
minus its RTD.
plus its RTD minus its payable turnover in days [PTD].
minus its RTD minus its PTD.
12.When doing an "index analysis," we should expect that changes in a number of the firm's current asset and liabilities accounts [e.g., cash, accounts receivable, and accounts payable] would move roughly together with for a normal, well-run company.net sales
cost of goods sold
earnings before interest and taxes [EBIT]
earnings before taxes [EBT]
The following item is NEW to the 13th edition.
13.The process of convergence of accounting standards around the world aims to
.narrow or remove national accounting differencesmove non-US accounting standards towards US Generally Accepted Accounting Principles [US GAAP]
create one set of rules-based accounting standards for all countries
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Current Assets / Current Liabilities
What is the Current Ratio?
The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables. The current ratio formula [below] can be used to easily measure a company’s liquidity.
Image: CFI’s Financial Analysis Fundamentals Course
Current Ratio Formula
The Current Ratio formula is:
Current Ratio = Current Assets / Current Liabilities
Example of the Current Ratio Formula
If a business holds:
- Cash = $15 million
- Marketable securities = $20 million
- Inventory = $25 million
- Short-term debt = $15 million
- Accounts payables = $15 million
Current assets = 15 + 20 + 25 = 60 million
Current liabilities = 15 + 15 = 30 million
Current ratio = 60 million / 30 million = 2.0x
The business currently has a current ratio of 2, meaning it can easily settle each dollar on loan or accounts payable twice. A rate of more than 1 suggests financial well-being for the company. There is no upper-end on what is “too much,” as it can be very dependent on the industry, however, a very high current ratio may indicate that a company is leaving excess cash unused rather than investing in growing its business.
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Current Ratio Template
Download the free Excel template now to advance your finance knowledge!
Current Ratio Formula – What are Current Assets?
Current assets are resources that can quickly be converted into cash within a year’s time or less. They include the following:
- Cash – Legal tender bills, coins, undeposited checks from customers, checking and savings accounts, petty cash
- Cash equivalents – Corporate or government securities with 90 days or less maturity
- Marketable securities – Common stock, preferred stock, government and corporate bonds with a maturity date of 1 year or less
- Accounts receivable – Money owed to the company by customers and that is due within a year – This net value should be after deducting an allowance for doubtful accounts [bad credit]
- Notes receivable – Debt that is maturing within a year
- Other receivables – Insurance claims, employee cash advances, income tax refunds
- Inventory – Raw materials, work-in-process, finished goods, manufacturing/packaging supplies
- Office supplies – Office resources such as paper, pens, and equipment expected to be consumed within a year
- Prepaid expenses – Unexpired insurance premiums, advance payments on future purchases
Current Ratio Formula – What are Current Liabilities?
Current liabilities are business obligations owed to suppliers and creditors, and other payments that are due within a year’s time. This includes:
- Notes payable – Interest and the principal portion of loans that will become due within one year
- Accounts payable or Trade payable – Credit resulting from the purchase of merchandise, raw materials, supplies, or usage of services and utilities
- Accrued expenses – Payroll taxes payable, income taxes payable, interest payable, and anything else that has been accrued for but an invoice is not received
- Deferred revenue – Revenue that the company has been paid for that will be earned in the future when the company satisfies revenue recognition requirements
Why Use the Current Ratio Formula?
This current ratio is classed with several other financial metrics known as liquidity ratios. These ratios all assess the operations of a company in terms of how financially solid the company is in relation to its outstanding debt. Knowing the current ratio is vital in decision-making for investors, creditors, and suppliers of a company. The current ratio is an important tool in assessing the viability of their business interest.
Other important liquidity ratios include:
- Acid-Test Ratio
- Quick Ratio
Below is a video explanation of how to calculate the current ratio and why it matters when performing an analysis of financial statements.
Video: CFI’s Financial Analysis Courses
Additional Resources
Thank you for reading this guide to understanding the Current Ratio Formula. To keep educating yourself and advancing your finance career, these CFI resources will be helpful:
- Quick Ratio Template
- Net Asset Liquidation
- Liquidation Value Template
- What is financial modeling?