Principles of Managerial Finance

CHAPTER 2 Financial Statements and Analysis 75

Ratio Too high Too low

Current ratio

Inventory turnover

Times interest earned

Gross profit margin

Return on total assets

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ments dated at the same point in time during the
year. (4) Audited financial statements should be
used. (5) Data should be checked for consistency of
accounting treatment. (6) Inflation and different as-
set ages can distort ratio comparisons.

Use ratios to analyze a firm’s liquidity and ac-
tivity.Liquidity, or ability of the firm to pay
its bills as they come due, can be measured by the
current ratio and the quick (acid-test) ratio. Activ-
ity ratios measure the speed with which accounts
are converted into sales or cash—inflows or out-
flows. The activity of inventory can be measured
by its turnover, that of accounts receivable by the
average collection period, and that of accounts
payable by the average payment period. Total asset
turnover measures the efficiency with which the
firm uses its assets to generate sales. Formulas for
these liquidity and activity ratios are summarized
in Table 2.8.

Discuss the relationship between debt and fi-
nancial leverage and the ratios used to analyze
a firm’s debt. The more debt a firm uses, the greater
its financial leverage, which magnifies both risk and
return. Financial debt ratios measure both the de-
gree of indebtedness and the ability to service debts.
A common measure of indebtedness is the debt ra-
tio. The ability to pay fixed charges can be mea-
sured by times interest earned and fixed-payment

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coverage ratios. Formulas for these debt ratios are

summarized in Table 2.8.

Use ratios to analyze a firm’s profitability and

its market value. The common-size income

statement, which shows all items as a percentage of

sales, can be used to determine gross profit margin,

operating profit margin, and net profit margin.

Other measures of profitability include earnings per

share, return on total assets, and return on common

equity. Market ratios include the price/earnings ra-

tio and the market/book ratio. Formulas for these

profitability and market ratios are summarized in

Table 2.8.

Use a summary of financial ratios and the

DuPont system of analysis to perform a com-

plete ratio analysis.A summary of all ratios—liquid-

ity, activity, debt, profitability, and market—as

shown in Table 2.8 can be used to perform a com-

plete ratio analysis using cross-sectional and time-

series analysis approaches. The DuPont system of

analysis, summarized in Figure 2.2, is a diagnostic

tool used to find the key areas responsible for the

firm’s financial performance. It enables the firm to

break the return on common equity into three com-

ponents: profit on sales, efficiency of asset use, and

use of leverage. The DuPont system of analysis

makes it possible to assess all aspects of the firm’s ac-

tivities in order to isolate key areas of responsibility.

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SELF-TEST PROBLEMS (Solutions in Appendix B)

ST 2–1 Ratio formulas and interpretations Without referring to the text, indicate for

each of the following ratios the formula for calculating it and the kinds of prob-

lems, if any, the firm is likely to have if that ratio is too high relative to the

industry average. What if the ratio is too low relative to the industry? Create a

table similar to the one that follows and fill in the empty blocks.