Using Ratios to Assess Risk and Profitability

MCQ Practice
What are the three types of comparisons commonly
used in financial statements?
A. Accounts Payable, Accounts Receivable & Cash
B. Historical, Industry & Future
C. Vertical analysis, Horizontal analysis and Ratio
Analysis
D. Profitability, Liquidity and Debt

MCQ Practice
What are the three types of comparisons commonly
used in financial statements?
A. Accounts Payable, Accounts Receivable & Cash
B. Historical, Industry & Future
C. Vertical analysis, Horizontal analysis and
Ratio Analysis
D. Profitability, Liquidity and Debt

Receivables Turnover Ratio

Measures how many times receivables are
collected during the year
Low ratio indicates trouble collecting its
accounts receivable
High ratio indicates quick collection of
receivables into cash
Too high might mean our credit policies are too
tight!

Average Collection Period

Days it takes to convert receivables into cash
Shorter collection period is better
But we might be missing some sales by not
extending credit to some customers who might be
credit worthy

Inventory Turnover Ratio

Measures how many times average inventory
is sold during the year
Low ratio means we might have some inventory
that is obsolete or dated
High ratio indicates that inventory is selling quickly
Extremely high ratio might indicate lost sales due
to inventory shortages

Average Days in Inventory

Days it takes to sell inventory
Lower is better
Generally

Current Ratio
Compares current assets to current liabilities
High ratio indicates sufficient assets to cover
current liabilities
Personally, I like to see current ratios in at least the
1.5:1 to 2:1 range!

Acid-Test Ratio
More conservative measure of ability to pay
current liabilities
Ignores current assets such as inventories and
prepaid expenses
These are items we cannot turn to cash SUPER
quick

Debt to Equity Ratio

Indicates the risk of bankruptcy
The less debt a company has, the less likely
bankruptcy is

Higher ratio (more debt than equity) indicates

higher risk