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What is the purpose of Liquidity Ratios?
To measure the entity’s ability to pay maturing obligations
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What is the purpose of Activity Ratios?
To measure how effectively an enterprise is using its assets
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What is the purpose of Profitability Ratios?
To measure the success or failure of an enterprise for a given period of time.
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What is the purpose of Coverage Ratios?
They measure the security or protection for long-term investors and creditors.
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What is the formula for Working Capital? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- Current Assets – Current Liabilities
- Liquidity
- The higher the number, the better, but it must be >$1
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What is the formula for the Current Ratio? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- Current Assets / Current Liabilities
- Liquidity
- At or better than the industry ratio; A positive trend is good
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What is the formula for the Acid Test (Quick) Ratio? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- (Current Assets – Inventory) / Current Liabilities OR
- (Cash & Cash Equivalents + Marketable Securities + Net A/R) / Current Liabilities
- Liquidity
- At or better than the industry ratio; A positive trend is good
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What is the formula for the Cash Ratio? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- (Current Assets – Inventory – Net A/R) / Current Liabilities OR
- (Cash & Cash Equivalents + Marketable Securities) / Current Liabilities
- Liquidity
- Positive trend is good
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Assume the Cash Ratio is sitting above 1.0. How might this be bad for the company?
Lots of cash on hand is good for paying bills, but does not earn a good return on investment (banks pay low interest compared to investing in the growth of the company).
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Why do some investors prefer the Cash Ratio where inventory and A/R are ignored?
- Because inventory might not get sold
- And A/R might not get collected
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What is the formula for A/R Turnover? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- Net Credit Sales / Average A/R where
- Average A/R is A/R - Allowance for Doubtful Accts
- Activity
- The higher the number indicates the success of the firm in collecting outstanding receivables
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What is the formula for the A/R Turnover in Days? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- 365 / A/R Turnover
- The lower the number, the better the outcome (fewer days required to collect)
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What is the formula for Inventory Turnover? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- COGS / Average Inventory
- Activity
- the higher the number, the better the performance
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What is the formula for the Inventory Turnover in Days? Is this a Liquidity, Activity, Profitability, or Coverage ratio? What is a good outcome?
- 365 / Inventory Turnover
- Activity
- The lower the number the better (fewer days that inventory remains in the warehouse)
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