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financial ratios

Terms in this set (35)

when are analytical procedures required
1. during planning stage at beginning of audit- to identify unusual areas that may require more audit work/areas where risk can occur
2. during final review stage at end of audit- to make sure the auditor didn't miss anything

analytical procedures are not required in the middle of the audit as substantive analytical procedures
ratio analysis
auditors often use ratio analysis in performing analytical procedures
types of ratios
1. liquidity ratios
2. activity ratios
3. profitability ratios
4. investor ratios
5. long-term debt paying ability ratios (coverage ratios)
liquidity ratios
measures an entity's short term ability to pay maturing obligations as they come due

lower liquidity ratios indicate entity may have a hard time meeting ST obligations

current ratio
quick ratio
current ratio
current assets/current liabiities
quick ratio
cash+cash equivalents+short term marketable securities+AR/current liabilities

CA-inventory-prepaid assets/current liabilities
activity ratios
measures how effectively an entity is using its assets

AR turnover
days sales in AR
inventory turnover
days in inventory
AP turnover
days payables outstanding
cash conversion cycle
AR turnover
sales/average AR

higher the better- you want to collect AR quickly
faster AR turnover gives credibility to current ratio
days sales in AR
indicates average number of days required to collect AR

ending AR/sales/365

365/AR turnover
inventory turnover
COGS/average inventory

- higher the better- want to sell inventory quickly
- inventory turnover is a measure of entity performance- higher turnover= better performance
- engagement partner would consider this ratio in the final review stage of the audit because it is an indicator of entity performance
days in inventory
indicates average number of days required to sell inventory

ending inventory/COGS/365

365/inventory turnover
AP turnover
COGS/average AP

- lower the better- keep cash working for company as long as possible
- also low turnover may indicate delay in payment due to shortage in cash
days payables outstanding
indicates average length of time trade payables are outstanding before they are paid

ending AP/COGS/365

365/AP turnover
cash conversion cycle
days sales in AR+days in inventory-days payables outstanding

lower the better
indicates average length of time from when the company pays cash for an inventory purchase to when the company receives cash for a sale
profitability ratios
measures entity's financial performance for a given period of time

profit margin
return on assets
return on sales
return on equity
gross margin
operating cash flow ratio
profit margin
net income/sales
return on assets
net income/average total assets
return on sales
operating income (income before interest income, interest expense and taxes)/sales
return on equity
net income/average total equity
gross margin
gross profit/sales
operating CF ratio
CF from operations/current liabilities
investor ratios
measures that are of interest to investors

basic earnings per share
price earnings ratio
dividend payout ratio
basic earnings per share
income available to common shareholders (NI-preferred dividends-taxes)/weighted average common shares outstanding
price earnings ratio
price per share/basic earnings per share

indicates investment potential of entity
rise in this ratio indicates that investors are pleased with the firm's opportunity for growth
dividend payout ratio
cash dividends/NI

indicates portion of current earnings paid out in dividends
long-term debt paying ability ratios (coverage ratios)
measures of security for long-term creditors/investors
long-term solvency

debt to equity
total debt ratio
equity multiplier
times interest earned
debt to equity
total liabilities/total equity

indicates the degree of protection to creditors in the case of insolvency
lower the better
total debt ratio
total liabilities/total assets

indicates % of company's assets that are financed by creditors
equity multiplier
total assets/total equity

measures a company's leverage
higher ratio indicates a company has a higher portion of assets financed by debt rather than equity
times interest earned
EBIT/interest expense

reflects company's ability to cover interest expense
limitations of ratios
- depend entirely on the reliability of data on which they are based
- few industry benchmarks for comparison
- dissimilar business units make analysis difficult
- manipulation of ratios by management can occur
- inflation can reduce comparability of BS items
- choice of different GAAP principles (LIFO vs. FIFO) affect ratios and reduce comparability
- generalizations are difficult to make
- ratios may use accounting data that do not reflect fair value (fixed assets)
other anlayses
common size analysis
analysis of industry statistics
trend analysis
common size analysis
- comparing percentages
- to draft common size BS, divide each balance by total assets
- result is that each balance sheet component is expressed as a percentage of the whole with total assets representing 100%
- to draft common size IS, divide each IS amount by total revenue
- common size FS are compared with industry norms or with those of competitors
analysis of industry statistics
ratio analysis is useful when comparing against norms in an industry

benchmarking may be performed against competitors of industry averages
trend analysis
ratio analysis can be used to analyze trends over time
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