Question 1. How Do You Calculate The Payback Period?
The payback period is calculated by counting the number of years it will take to recover the cash invested in a project.
Let’s assume that a company invests $400,000 in more efficient equipment. The cash savings from the new equipment is expected to be $100,000 per year for 10 years. The payback period is 4 years ($400,000 divided by $100,000 per year).
A second project requires an investment of $200,000 and it generates cash as follows: $20,000 in Year 1; $60,000 in Year 2; $80,000 in Year 3; $100,000 in Year 4; $70,000 in Year 5. The payback period is 3.4 years ($20,000 + $60,000 + $80,000 = $160,000 in the first three years + $40,000 of the $100,000 occurring in Year 4).
Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project’s total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment.
Question 2. What Is The Difference Between Gross Margin And Markup?
Gross margin or gross profit is defined as sales minus cost of goods sold. If a retailer sells a product for $10 which had a cost of $8, the gross profit or gross margin is $2. The gross profit ratio or the gross margin ratio expresses the gross profit or gross margin amount as a percentage of sales. In our example the gross margin ratio is 20% ($2 divided by $10).
Markup is used several ways. Some retailers use markup to mean the difference between a product’s cost and its selling price. In our example, the product had a cost of $8 and it had a markup of $2 resulting in a selling price of $10. The $2 markup is the same as the $2 gross profit. However, the markup percentage is often expressed as a percentage of cost. In our example the $2 markup is divided by the cost of $8 resulting in a markup of 25%. (Some retailers may use the term markup to mean the increase in the original selling. For example, if the $10 selling price was increased to $11 because of high demand and limited supply, they would say the markup was $1.)
Question 3. What Is The Gross Margin Ratio?
The gross margin ratio is also known as the gross profit margin or the gross profit percentage.
The gross margin ratio is computed by dividing the company’s gross profit dollars by its net sales dollars.
To illustrate the gross margin ratio, let’s assume that a company has net sales of $800,000 and its cost of goods sold is $600,000. This means its gross profit is $200,000 (net sales of $800,000 minus its cost of goods sold of $600,000) and its gross margin ratio is 25% (gross profit of $200,000 divided by net sales of $800,000).
A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.
Since gross margin ratios vary between industries, you should compare your company’s gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. For example, your company may use LIFO while most companies in your industry use FIFO. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company’s gross margin ratio should be larger than your industry’s in order to cover the higher selling and administrative expenses.
Question 4. What Is The Difference Between Vertical Analysis And Horizontal Analysis?
Vertical analysis reports each amount on a financial statement as a percentage of another item. For example, the vertical analysis of the balance sheet means every amount on the balance sheet is restated to be a percentage of total assets. If inventory is $100,000 and total assets are $400,000 then inventory is presented as 25 ($100,000 divided by $400,000). If cash is $8,000 then it will be presented as 2 ($8,000 divided by $400,000). The total of the assets will now add up to 100. If the accounts payable are $88,000 they will be presented as 22 ($88,000 divided by $400,000). If owner’s equity is $240,000 it will be presented as 60 ($240,000 divided by $400,000). The restated amounts from the vertical analysis of the balance sheet will be presented as a common-size balance sheet. A common-size balance sheet allows you to compare your company’s balance sheet to another company’s balance sheet or to the average for its industry.
Vertical analysis of an income statement results in every income statement amount being presented as a percentage of sales. If sales were $1,000,000 they would be restated to be 100 ($1,000,000 divided by $1,000,000). If the cost of goods sold is $780,000 it will be presented as 78 ($780,000 divided by sales of $1,000,000). If interest expense is $50,000 it will be presented as 5 ($50,000 divided by $1,000,000). The restated amounts are known as a common-size income statement. A common-size income statement allows you to compare your company’s income statement to another company’s or to the industry average.
Horizontal analysis looks at amounts on the financial statements over the past years. For example, the amount of cash reported on the balance sheet at December 31 of 2012, 2011, 2010, 2009, and 2008 will be expressed as a percentage of the December 31, 2008 amount. Instead of dollar amounts you might see 134, 125, 110, 103, and 100. This shows that the amount of cash at the end of 2012 is 134% of the amount it was at the end of 2008. The same analysis will be done for each item on the balance sheet and for each item on the income statement. This allows you to see how each item has changed in relationship to the changes in other items. Horizontal analysis is also referred to as trend analysis.
Vertical analysis, horizontal analysis and financial ratios are part of financial statement analysis.
Question 5. What Is A Current Asset?
A current asset is cash and any other company asset that will be turning to cash within one year from the date shown in the heading of the company’s balance sheet. (If a company has an operating cycle that is longer than one year, an asset that will turn to cash within the length of its operating cycle is considered to be a current asset.)
Current assets are generally listed first on a company’s balance sheet and will be presented in the order of liquidity. That means they will appear in the following order: cash (which includes currency, checking accounts, petty cash), temporary investments, accounts receivable, inventory, supplies, and prepaid expenses. (Supplies and prepaid expenses will not literally be converted to cash. They are included because they will allow the company to avoid paying cash for these items during the upcoming year.)
It is important that the amount of each current asset not be overstated. For example, accounts receivable, inventories, and temporary investments should have valuation accounts so that the amounts reported will not be greater than the amounts that will be received when the assets turn to cash. This is important because the amount of company’s working capital and its current ratio are computed using the current assets’ reported amounts.
Current assets are also referred to as short term assets.
Question 6. What Is Financial Leverage?
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage.
Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage.
Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money.
If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue’s land will sell for $1,500,000 and will result in a gain of $300,000. Sue’s $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well.
When assets decline in value the use of leverage works against you. Let’s assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary’s investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue’s investment.
Question 7. What Is The Debt To Total Assets Ratio?
The debt to total assets ratio is an indicator of financial leverage. It tells you the percentage of total assets that were financed by creditors, liabilities, debt.
The debt to total assets ratio is calculated by dividing a corporation’s total liabilities by its total assets. Let’s assume that a corporation has $100 million in assets, $40 million in liabilities, and $60 million in stockholders’ equity. Its debt to total assets ratio will be 0.4 ($40 million of liabilities divided by $100 million of assets), or 0.4 to 1. In this example, the debt to total assets ratio tells you that 40% of the corporation’s assets are financed by the creditors or debt (and therefore 60% is financed by the owners). A higher percentage indicates more leverage and more risk.
Another ratio, the debt to equity ratio, is often used instead of the debt to total assets ratio. The debt to equity ratio uses the same inputs but provides a different view. Using the information above, the debt to equity ratio will be .67 to 1 ($40 million of liabilities divided by $60 million of stockholders’ equity).
Question 8. What Is The Difference Between Gross Margin And Contribution Margin?
Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minus Cost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses.
Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. The Contribution Margin Ratio is the Contribution Margin as a percentage of Net Sales.
Let’s illustrate the difference between gross margin and contribution margin with the following information: company had Net Sales of $600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of $120,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $40,000 of variable and $150,000 of fixed expenses.
The company’s Gross Margin is: Net Sales of $600,000 minus its Cost of Goods Sold of $320,000 ($120,000 + $200,000) for a Gross Profit of $280,000 ($600,000 – $320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of $280,000 divided by $600,000, or 46.7%.
The company’s Contribution Margin is: Net Sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 for a Contribution Margin of $440,000. The Contribution Margin Ratio is 73.3% ($440,000 divided by $600,000).
Question 9. What Is A Current Liability?
A current liability is an obligation that is 1) due within one year of the date of a company’s balance sheet and 2) will require the use of a current asset or will create another current liability. If a company’s operating cycle is longer than one year, current liabilities are those obligation’s due within the operating cycle.
Current liabilities are usually presented in the following order:
- the principal portion of notes payable that will become due within one year
- accounts payable
- the remaining current liabilities such as payroll taxes payable, income taxes payable, interest payable and other accrued expenses
The parties who are owed the current liabilities are referred to as creditors. If the creditors have a lien on company assets, they are known as secured creditors. The creditors without a lien are referred to as unsecured creditors.
The amount of current liabilities is used to determine a company’s working capital (current assets minus current liabilities) and the company’s current ratio (current assets divided by current liabilities).
Question 10. What Is The Days’ Sales In Accounts Receivable Ratio?
The days’ sales in accounts receivable ratio, also known as the number of days of receivables, tells you the average number of days it takes to collect an account receivable. Since the days’ sales in accounts receivable is an average, you need to be careful when using it.
The calculation for determining the days’ sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by the accounts receivable turnover ratio for a specific year. If a company’s accounts receivable turnover ratio was 10, then the days’ sales in accounts receivable is 36 days (360 days divided by the turnover ratio of 10).
Since the accounts receivable turnover ratio used in the days’ sales in accounts receivable was based on 1) the credit sales during a one-year time period, and 2) the average accounts receivable balances during that one-year period, the 36 days calculated above is an average. It is possible that within the accounts receivable there are some accounts which are 120 days or more past due. This information might be hidden by the average, because the average included some accounts that paid early. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days’ sales in accounts receivable ratio.
Question 11. What Is The Quick Ratio?
The quick ratio is a financial ratio used to gauge a company’s liquidity. The quick ratio is also known as the acid test ratio.
The quick ratio compares the total amount of cash + marketable securities + accounts receivable to the amount of current liabilities. If a company has cash + marketable securities + accounts receivable with a total of $1,000,000 and the company’s total amount of current liabilities is $1,200,000, its quick ratio is 0.83 to 1. ($1,000,000 divided by $1,200,000 = 0.83)
The quick ratio differs from the current ratio in that some current assets are excluded from the quick ratio. The most significant current asset that is excluded is inventory. The reason is that inventory might not turn to cash quickly.
Question 12. What Is The Accounts Receivable Turnover Ratio?
The financial ratio accounts receivable turnover is a company’s annual sales divided by the company’s average balance in its Accounts Receivable account during the same period of time.
For example, if a company’s sales for the most recent year were $6,000,000 and its average balance in Accounts Receivable for the same twelve months was $600,000, its accounts receivable turnover ratio is 10. This indicates that on average the company’s accounts receivables turned over 10 times during the year, or approximately every 36 days (360 or 365 days per year divided by the turnover of 10).
Whether the accounts receivable turnover ratio of 10 is good or bad depends on the company’s past ratios, the average for other companies in the same industry, and by the specific credit terms given to this company’s customers.
It is important to note that the accounts receivable turnover ratio is an average, and averages can hide important details. For example, some past due receivables could be “hidden” or offset by receivables that have paid faster than the average. If you have access to the company’s details, you should review a detailed aging of accounts receivable to detect slow paying accounts.
Question 13. What Will Cause A Change In Net Working Capital?
Net working capital or working capital is defined as current assets minus current liabilities. Therefore, a change in the total amount of current assets without a change of the same amount in current liabilities will result in a change in the amount of working capital. Similarly, a change in the total amount of current liabilities without an identical change in the total amount of current assets will cause a change in working capital.
For instance, if the owner makes an additional investment of $20,000 in her company, the company’s total current assets will increase by $20,000 but there is no increase in its current liabilities. As a result, the company’s working capital increases by $20,000. (The other change is an increase in the owner’s capital account.)
If a company borrows $50,000 and agrees to repay the loan in 90 days, the company’s working capital has not increased. The reason is that the current asset Cash increased by $50,000 and the current liability Loans Payable also increased by $50,000.
The use of $30,000 to buy merchandise for inventory will not change the amount of working capital. The reason is that the total amount of current assets will not change. The current asset Cash decreases by $30,000 and the current asset Inventory increases by $30,000.
If a company sells a product for $3,400 which is in its inventory at a cost of $2,500 the company’s working capital will increase by $900. Working capital increased because 1) the current asset accounts Cash or Accounts Receivable will increase by $3,400 and Inventory will decrease by $2,500; 2) current liabilities will not change. Owner’s equity will increase by $900.
The use of $100,000 for the construction of a storage building will reduce working capital because the current asset Cash decreased and a long-term asset Storage Building has increased.
Question 14. What Is The Difference Between Accounts Payable And Accrued Expenses Payable?
I would use the liability account Accounts Payable for suppliers’ invoices that have been received and must be paid. As a result, the balance in Accounts Payable is likely to be a precise amount that agrees with supporting documents such as invoices, agreements, etc.
I would use the liability account Accrued Expenses Payable for the accrual type adjusting entries made at the end of the accounting period for items such as utilities, interest, wages, and so on. The balance in the Accrued Expenses Payable should be the total of the expenses that were incurred as of the date of the balance sheet, but were not entered into the accounts because an invoice has not been received or the payroll for the hourly wages has not yet been processed, etc. The amounts recorded in Accrued Expenses Payable will often be estimated amounts supported by logical calculations.
Question 15. If I Want A Gross Margin Of 25%, What Percent Should I Mark Up My Product?
To achieve a gross margin or gross profit percentage of 25%, you will need to mark up your product’s cost by 33.333%. The following illustrates how this is calculated.
Assume a product has a cost of $75 and a selling price of $100. Since the gross profit is defined as selling price minus the cost of goods sold, this product will have a gross profit of $25 ($100 minus $75). The gross margin or gross profit percentage is 25% (gross profit of $25 divided by selling price of $100). The mark up of $25 on the cost of $75 equals 33.333% ($25 divided by $75).
Let’s prove this with one more example. Assume you have a product that you purchased for $9. If you mark it up by 33.333%, you will have a markup of $3 and the product will sell for $12. The income statement will show a sale of $12 minus its cost of $9 for a gross profit of $3. The gross profit of $3 divided by the selling price of $12 equals a 25% gross margin or gross profit percentage or gross profit ratio.
Question 16. What Is The Current Ratio?
The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a company’s liquidity. In other words, a large amount of current assets in relationship to a small amount of current liabilities provides some assurance that the obligations coming due will be paid.
If a company’s current assets amount to $600,000 and its current liabilities are $200,000 the current ratio is 3:1. If the current assets are $600,000 and the current liabilities are $500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency.
It is wise to compare a company’s current ratio to that of other companies in the same industry. You are also wise to look at the trend of the current ratio for a given company over time. Is the current ratio improving over time, or is it deteriorating?
The composition of the current assets is also an important factor. If the current assets are predominantly in cash, marketable securities, and collectible accounts receivable, that is more comforting than having the majority of the current assets in slow-moving inventory.
Question 17. What Is Working Capital?
Working capital is the amount of a company’s current assets minus the amount of its current liabilities. For example, if a company’s balance sheet dated June 30 reports total current assets of $323,000 and total current liabilities of $310,000 the company’s working capital on June 30 was $13,000. If another company has total current assets of $210,000 and total current liabilities of $60,000 its working capital is $150,000.
The adequacy of a company’s working capital depends on the industry in which it competes, its relationship with its customers and suppliers, and more. Here are some additional factors to consider:
- The types of current assets and how quickly they can be converted to cash. If the majority of the company’s current assets are cash and cash equivalents and marketable investments, a smaller amount of working capital may be sufficient. However, if the current assets include slow-moving inventory items, a greater amount of working capital will be needed.
- The nature of the company’s sales and how customers pay. If a company has very consistent sales via the Internet and its customers pay with credit cards at the time they place the order, a small amount of working capital may be sufficient. On the other hand, a company in an industry where the credit terms are net 60 days and its suppliers must be paid in 30 days, the company will need a greater amount of working capital.
- The existence of an approved credit line and no borrowing. An approved credit line and no borrowing allows a company to operate comfortably with a small amount of working capital.
- How accounting principles are applied. Some companies are conservative in their accounting policies. For instance, they might have a significant credit balance in their allowance for doubtful accounts and will dispose of slow-moving inventory items. Other companies might not provide for doubtful accounts and will keep slow-moving items in inventory at their full cost.
In short, analyzing working capital should involve more than simply subtracting current liabilities from current assets.
Question 18. What Is The Difference Between Gross Profit Margin And Gross Margin?
The use of the terms such as gross margin and gross profit margin often varies by the person using the terms. Some people prefer to use gross margin instead of gross profit when referring to the dollars of gross profit. Often they want to avoid the use of the word profit because the selling and administrative expenses must also be covered. Recall that gross profit is defined as Net Sales minus Cost of Goods Sold.
Others use the term gross margin to mean the gross profit as a percentage of net sales. Perhaps the term gross profit margin means the gross profit percentage or the gross margin ratio.
Question 19. What Is The Average Collection Period?
The average collection period is the average number of days between 1) the date that a credit sale is made, and 2) the date that the money is received from the customer. The average collection period is also referred to as the days’ sales in accounts receivable.
The average collection period can be calculated as follows: 365 days in a year divided by the accounts receivable turnover ratio. Assuming that a company has an accounts receivable turnover ratio of 10 times per year, the average collection period is 36.5 days (365 divided by 10).
An alternate way to calculate the average collection period is: the average accounts receivable balance divided by average credit sales per day.
If a company offers credit terms of net 30 days, the company may find that its average collection period is actually 45 days or more. Monitoring the average collection period is important for a company’s cash flow and its ability to meet its obligations when they come due.
Question 20. What Are The Typical Items Reported As Current Liabilities?
Here are the typical items that are reported as current liabilities on a corporation’s balance sheet:
- Accounts payable. These are the amounts that are due to vendors who have supplied goods or services. The accounts payable are supported by the vendor invoices that have been approved and processed, but have not yet been paid.
- Deferred revenues. This reports the amounts that a customer has prepaid and will be earned by the company within one year of the balance sheet date. An example is a retailer’s unredeemed gift cards.
- Accrued compensation. Included in this are payroll related items such as the amounts due to employees and the amounts to be remitted for payroll taxes.
- Other accrued expenses or liabilities. This reports the amounts that the company owes for items not recorded in accounts payable or accrued compensation. Examples include the interest expense that the company has incurred (but has not yet paid) and repairs that took place but the vendor’s invoice has not been fully processed.
- Accrued income taxes and perhaps some deferred income taxes.
- Short-term notes. These include the loans from banks that will become due within one year of the balance sheet date.
- The current portion of long-term debt. The principal payments of a mortgage loan or an equipment loan that must be paid within one year of the date of the balance sheet are reported in this item.
To be reported as a current liability the item must be due within one year of the balance sheet date (unless the company’s operating cycle is longer). However, there is no requirement that the current liabilities be presented in the order in which they will be paid. Hence, the current portion of long-term debt might be listed last, but the principal payment might be due within several days of the balance sheet date.
Question 21. What Is The Meaning Of Debtor?
A debtor is a person or entity that owes money. In other words, the debtor has a debt or legal obligation to pay an amount to another person or entity.
Question 22. What Is The Acid Test Ratio?
The acid test ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses are excluded. In other words, the acid test ratio compares the total of the cash, temporary marketable securities, and accounts receivable to the amount of current liabilities.
Let’s illustrate the acid test ratio by assuming that a company has cash of $7,000 + temporary marketable securities of $20,000 + accounts receivables of $93,000. This adds up to $120,000 of quick assets. If its current liabilities amount to $100,000 its acid test ratio is 1.2:1.
The larger the acid test ratio, the more easily will the company be able to meet its current obligations.
Question 23. What Are Pro Forma Financial Statements?
A pro forma financial statement is one based on certain assumptions and projections.
For example, a corporation might want to see the effects of three different financing options. Therefore, it prepares projected balance sheets, income statements, and statements of cash flows. These projected financial statements are referred to as pro forma financial statements.
Question 24. How Does An Expense Affect The Balance Sheet?
An expense will decrease the amount of assets or increase the amount of liabilities, and will reduce the amount of owner’s or stockholders’ equity.
For example an expense might
- reduce a company’s assets such as Cash, Prepaid Expenses, or Inventory,
- increase the credit balance in a contra-asset account such as Allowance for Doubtful Accounts or Accumulated Depreciation,
- increase the balance in the liability account Accounts Payable, or increase the amount of accrued expenses payable such as Wages Payable, Interest Payable, and so on.
In addition to the change in the assets or liabilities, an expense will reduce the credit balance in the Owner Capital account of a sole proprietorship, or will reduce the credit balance in the Retained Earnings account of a corporation.
Question 25. What Are Accounting Ratios?
Accounting ratios (also known as financial ratios) are considered to be part of financial statement analysis. Accounting ratios usually relate one financial statement amount to another. For example, the inventory turnover ratio divides a company’s cost of goods sold for a recent year by the cost of its inventory on hand during that year.
For a company with current assets of $300,000 and current liabilities of $150,000 its current ratio is $300,000 to $150,000, or 2 to 1, or 2:1. This ratio of 2:1 can then be compared to other companies in its industry regardless of size or it can be compared to the company’s ratio from an earlier year.
Other examples of accounting ratios include:
- Quick ratio
- Current ratio
- Debt to equity ratio
- Acid-test ratio
- Contribution margin ratio
- Interest coverage ratio
- Debt to total assets ratio
- Gross margin ratio
- Return on assets ratio
- Profit margin (after tax) ratio
- Total assets turnover ratio
- Fixed asset turnover ratio
- Times interest earned ratio
- Liquidity ratio
- Working capital ratio
- Dividend payout ratio
- Free cash flow ratio
To assist you in computing and understanding accounting ratios, we developed 24 forms that are available as part of AccountingCoach PRO.
Question 26. What Is The Advantage Of Issuing Bonds Instead Of Stock?
There are several advantages of issuing bonds or other debt instead of stock when acquiring assets. One advantage is that the interest on bonds and other debt is deductible on the corporation’s income tax return. Dividends on stock are not deductible on the income tax return.
A second advantage of financing assets with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest. This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people’s money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners’ financial position.
Question 27. What Is The Times Interest Earned Ratio?
The times interest earned ratio is an indicator of a company’s ability to meet the interest payments on its debt. The times interest earned calculation is a corporation’s income before interest and income tax expense, divided by interest expense.
To illustrate the times interest earned ratio, let’s assume that a corporation’s net income after tax was $500,000; its interest expense was $200,000; and its income tax expense was $300,000. Given these assumptions, the corporation’s income before interest and income tax expense is $1,000,000 (net income of $500,000 + interest expense of $200,000 + income tax expense of $300,000). Since the interest expense was $200,000, the corporation’s times interest earned is 5 ($1,000,000 divided by $200,000).
The higher the times interest earned ratio, the more likely it is that the corporation will be able to meet its interest payments.
Question 28. What Is Trend Analysis?
In the analysis of financial information, trend analysis is the presentation of amounts as a percentage of a base year.
If I want to see the trend of a company’s revenues, net income, and number of clients during the years 2006 through 2012, trend analysis will present 2006 as the base year and the 2006 amounts will be restated to be 100. The amounts for the years 2007 through 2012 will be presented as the percentages of the 2006 amounts. In other words, each year’s amounts will be divided by the 2006 amounts and the resulting percentage will be presented. For example, revenues for the years 2006 through 2012 might have been $31,691,000; $40,930,000; $50,704,00; $63,891,000; $79,341,000; $101,154,000; $120,200,000. These revenue amounts will be restated to be 100, 129, 160, 202, 250, 319, and 379.
Let’s assume that the net income amounts divided by the 2006 amount ended up as 100, 147, 206, 253, 343, 467, and 423. The number of clients when divided by the base year amount are 100, 122, 149, 184, 229, 277, and 317.
From this trend analysis we can see that revenues in 2012 were 379% of the 2006 revenues, net income in 2012 was 467% of the 2006 net income, and the number of clients in 2012 was 317% of the number in 2006. Using the restated amounts from trend analysis makes it much easier to see how effective and efficient the company has been during the recent years.
Trend analysis can also include the monitoring of a company’s financial ratios over a period of many years.
Question 29. What Is Window Dressing?
Window dressing refers to actions taken or not taken prior to issuing financial statements in order to improve the appearance of the financial statements.
Here is an example of window dressing. A company operates throughout the year with a negative balance in its general ledger Cash account. (Its balance at the bank is positive due to the time it takes for its checks to clear its bank account.) Since the financial statements report the Cash amount appearing in its general ledger account, the financial statements would report a negative amount of Cash. However, the company does not want its December 31 balance sheet to report a negative cash balance, since it will be reviewed by many outsiders. To avoid reporting a negative cash balance the company does not make the payments for amounts that should be paid between December 26 and December 31. This postponement of payments allows its book amount of Cash to temporarily be a positive amount. Then on January 2, the company issues checks for all of the amounts that normally would have been paid at the end of December.
Question 30. What Is The Operating Cycle?
The operating cycle is also known as the cash conversion cycle. In the context of a manufacturer the operating cycle has been described as the amount of time that it takes for a manufacturer’s cash to be converted into products plus the time it takes for those products to be sold and turned back into cash. In other words, the manufacturer’s operating cycle involves:
- paying for the raw materials needed in its products
- paying for the labor and overhead costs needed to convert the raw materials into products
- holding the finished products in inventory until they are sold
- waiting for the customers’ cash payments for the products that have been sold Some calculate the operating cycle to be the sum of:
- the days’ sales in inventory (365 days/inventory turnover ratio), plus
- the average collection period (365 days/accounts receivable turnover ratio)
The above sum is sometimes reduced by the number of days in the credit terms of the accounts payable.
The operating cycle has importance in classifying current assets and current liabilities. While most manufacturers have operating cycles of several months, a few industries require very long processing times. This could result in an operating cycle that is longer than one year. To accommodate those industries, the accountants’ definitions of current assets and current liabilities include the following phrase: …within one year or within the operating cycle, whichever is longer.
Question 31. What Is The Days’ Sales In Inventory Ratio?
The days’ sales in inventory tells you the average number of days that it took to sell the average inventory held during the specified one-year period. You can also think of it as the number of days of sales that was held in inventory during the specified year. The calculation of the days’ sales in inventory is: the number of days in a year (365 or 360 days) divided by the inventory turnover ratio.
For example, if a company had an inventory turnover ratio of 9, the company’s inventory turned over 9 times during the year. If we use 360 as the number of days in the year, the company had (on average) 40 days of inventory on hand during the year (360 days divided by the inventory turnover ratio of 9).
Since the inventory turnover ratio reflects the average amount of inventory during the year, and since sales usually fluctuate during the year, the days’ sales in inventory is an approximation.
Question 32. What Is A Customer Deposit?
A customer deposit could be an amount paid by a customer to a company prior to the company providing it with goods or services. In other words, the company receives the money prior to earning it. The company receiving the money has an obligation to provide the goods or services to the customer or to return the money.
For example, Ace Manufacturing Co. might agree to produce an expensive, custom-made machine for one of its customers. Ace requires that the customer pay $50,000 before Ace begins to design and construct the machine. The $50,000 payment is made in December 2012 and the machine must be finished by June 30, 2013. The $50,000 is a down payment toward the machine’s price of $400,000.
In December 2012, Ace will debit Cash for $50,000 and will credit Customer Deposits, a current liability account. (The customer will record the $50,000 payment with a debit to a long-term asset account such as Construction Work in Progress or Downpayment on New Equipment, and will credit Cash.)
Question 33. What Is The Inventory Turnover Ratio?
The calculation for the inventory turnover ratio is: Cost of Goods Sold for a Year divided by Average Inventory during the same 12 months.
To illustrate the inventory turnover ratio, let’s assume 1) that during the most recent year a company’s Cost of Goods Sold was $3,600,000, and 2) the company’s average cost in its Inventory account during the same 12 months was calculated to be $400,000. The company’s inventory turnover ratio is 9 ($3,600,000 divided by $400,000) or 9 times.
The higher the inventory turnover ratio, the better, provided you are able to fill customers’ orders on time. It would be foolish to lose customers because you didn’t carry sufficient inventory quantities.
A company’s inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.
Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.
Question 34. What Is The Book Value Per Share Of Stock?
If a corporation does not have preferred stock outstanding, the book value per share of stock is a corporation’s total amount of stockholders’ equity divided by the number of common shares of stock outstanding on that date.
For example, if a corporation without preferred stock has stockholders’ equity on December 31 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42.
Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation’s stockholders’ equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Noncurrent assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.
Question 35. What Is The Difference Between Income And Profit?
Some people intend for the terms income and profit to have the same meaning. For example, the income statement was commonly referred to as the profit and loss (P&L) statement. When a company is profitable, we mean that the company has a positive net income.
To aid in understanding these terms, the word “net” is often added. Hence, we often see the terms net income and net profit. This communicates that the amounts are the remainder after expenses have been deducted. For example, a company’s profit margin is often listed as the net profit margin (which is defined as the company’s net income divided by its net sales). The word “net” also helps to distinguish a company’s net profit from its gross profit, and its net profit margin from its gross profit margin.
Some people use the term income to mean revenues. For example, a bank or an individual will often refer to the interest they earn on bond investments as interest income or investment income. A retailer will refer to the sales of merchandise as revenues, but the revenues from secondary activities will be reported as other income or nonoperating income.
It is wise to keep in mind that different meanings are not unusual among people, businesses and countries.
Question 36. What Is The Working Capital Turnover Ratio?
The working capital turnover ratio is also referred to as net sales to working capital. It indicates a company’s effectiveness in using its working capital.
The working capital turnover ratio is calculated as follows: net annual sales divided by the average amount of working capital during the same 12 month period.
For example, if a company’s net sales for a recent year were $2,400,000 and its average amount of working capital during the year was $400,000, its working capital turnover ratio was 6 ($2,400,000 divided by $400,000).
Working capital is defined as the total amount of current assets minus the total amount of current liabilities. As indicated above, you should use the average amount of working capital for the year of the net sales.
As with most financial ratios, you should compare the working capital turnover ratio to other companies in the same industry and to the same company’s past and planned working capital turnover ratio.
Question 37. How Is Working Capital Defined And Measured?
Working capital is the amount of current assets minus the amount of current liabilities as of specific date. These amounts are obtained from your company’s balance sheet. For example, if your company’s balance sheet reports current assets of $450,000 and current liabilities of $320,000 then your company’s working capital is $130,000.
Even with a significant amount of working capital, a company can experience a cash shortage if its current assets are not turning to cash. For example, if a company has most of its current assets in the form of inventory, that inventory needs to be sold. Similarly, if a company has a large amount of receivables that are not being collected, the working capital amount isn’t much consolation when you can’t meet Friday’s payroll.
There are several financial ratios that pertain to working capital. They include the current ratio, quick ratio, accounts receivable turnover ratio, days sales in accounts receivable, inventory turnover ratio, and days sales in inventory.
Monitor your current assets daily to keep the cash coming into your checking account. If you do the right things each day, your financial ratios have a better chance of being respectable at the end of the month.
Question 38. What Is Trading On Equity?
Trading on equity is sometimes referred to as financial leverage or the leverage factor.
Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.
If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.
Question 39. Is The Installation Labor For A New Asset Expensed Or Included In The Cost Of The Asset?
The cost of installation is part of the cost of the asset. An asset’s cost is considered to be all of the costs of getting an asset in place and ready for use. Therefore, the labor cost of installing a new machine is considered to be part of the asset’s cost and not an immediate expense of the period.
The cost of the installation labor will include the workers’ wages and the fringe benefits applicable to those wages.
The total cost of the asset, including installation costs, will be depreciated over the useful life of the asset.
The concept of materiality does allow you to expense the installation cost immediately if the amount is insignificant.
Question 40. What Is The Difference Between The Current Ratio And The Acid Test Ratio?
The difference between the current ratio and the acid test ratio (or quick ratio) generally involves the current assets inventory, prepaid expenses, and some deferred income taxes.
The current ratio uses the total amount of all of the current assets.
The acid test ratio uses only the following current assets, which are considered to be quick assets: cash and cash equivalents, short-term marketable securities, and accounts receivable (net of the allowance for uncollectible accounts). In other words, the acid test ratio excludes inventory (which is a significant current asset for retailers and manufacturers) and some other amounts such as prepaid expenses and deferred income taxes (that are classified as current assets).
To illustrate the difference between the current ratio and the acid test ratio, let’s assume that a company has current liabilities of $50,000 and has the following current assets:
- Cash and cash equivalents $5,000
- Short-term marketable securities $10,000
- Accounts receivable, net $25,000
- Inventory $56,000
- Prepaid expenses $4,000
The current ratio is 2 to 1 (or 2:1) calculated as: total current assets of $100,000 divided by the total current liabilities of $50,000.
The acid test ratio or quick ratio is 0.8 to 1 (or 0.8:1) calculated as: quick assets of $40,000 ($5,000 + $10,000 + $25,000) divided by the total current liabilities of $50,000.
Question 41. What Is The Working Capital Ratio?
Some use the term working capital ratio to mean working capital or net working capital. Working capital is defined as current assets minus current liabilities. When used in this manner, working capital ratio is not really a ratio. Rather, it is simply a dollar amount.
For example, if a company has $900,000 of current assets and has $400,000 of current liabilities, its working capital is $500,000. If a company has $900,000 of current assets and has $900,000 of current liabilities, it has no working capital.
Other people use the term working capital ratio to mean the current ratio, which is defined as the amount of current assets divided by the amount of current liabilities.
Question 42. What Is Solvency?
I use the term solvency to mean 1) that a company is able to pay its obligations when they come due and 2) that a company is able to continue in business.
Some people look to a company’s working capital in deciding whether a company is solvent. They conclude that a company with a positive amount of working capital is solvent. In other words, a company that is solvent has more current assets than it has current liabilities. Stated another way a company that is solvent will have a current ratio that is greater than 1:1.
Others look at a company’s total assets and total liabilities in deciding whether a company is solvent. They might conclude that if a company’s total assets are greater than its total liabilities, the company is solvent.
I suspect that the definition of solvency varies among people in the same country and from country to country. You should check the legal system in your country to find the appropriate meaning.
Question 43. What Is Separation Of Duties?
The separation of duties is one of several steps to improve the internal control of an organization’s assets. For example, the internal control of cash is improved if the money handling duties are separated from the record keeping duties. By separating these duties the likelihood of theft is reduced because it will now require two dishonest people working together to admit to each other that they are dishonest, plan the theft, and to then carry out the theft. One person will have to remove the cash and the other person will have to falsify the records.
Without the separation of duties, the theft of cash is easier. One dishonest person can steal the money and enter a fictitious amount into the records—thereby concealing the theft.
Another step in improving internal control over cash is to use a cash register, issue receipts, and have two people present when cash is handled.
Question 44. What Is The Debt To Equity Ratio?
The debt to equity ratio or debt-equity ratio is calculated by dividing a corporation’s total liabilities by the total amount of stockholders’ equity: (Liabilities/Stockholders’ Equity):1.
A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders’ equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of $1,200,000 and stockholders’ equity of $400,000 will have a debt to equity ratio of 3:1.
Generally, the higher the ratio of debt to equity, the greater is the risk for the corporation’s creditors and its prospective creditors.
Question 45. What Is A Liquidity Ratio?
A liquidity ratio is an indicator of whether a company’s current assets will be sufficient to meet the company’s obligations when they become due.
The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.
Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios.
Question 46. What Are The Reasons For High Inventory Days?
The days sales in inventory is high when the inventory turnover is low.
Since inventory turnover is associated with sales and average inventory, changes in either sales or inventory can cause a high amount of inventory days.
For example, if a company has maintained its inventory quantities, but economic factors cause a significant drop in its sales, the company’s inventory days will increase dramatically.
If a retailer increases its inventory in order to generate additional sales, but sales do not increase, there will also be an increase in the number of inventory days.
Question 47. What Is The Accounts Receivable Collection Period?
The accounts receivable collection period is similar to the days sales outstanding or the days sales in accounts receivable.
To illustrate the accounts receivable collection period, let’s assume a corporation had net credit sales of $360,000 during the past year and its accounts receivable balance was on average $40,000. The average credit sales per day were approximately $1,000 per day ($360,000 of annual credit sales divided by 360 or 365 days per year). The average accounts receivable balance of $40,000 divided by $1,000 of credit sales per day equals 40 days.
An alternative calculation is to use the accounts receivable turnover ratio. In our example, the accounts receivable ratio is 9 times per year ($360,000 of net credit sales divided by $40,000—the average accounts receivable balance). 360 days per year divided by the accounts receivable turnover of 9 equals 40 days.
Question 48. What Is An Example Of An Unrealized Gain?
A common example of an unrealized gain is the gain in the market value of an investment in the stock of another corporation that is held as an available-for-sale security.
The unrealized holding gain is reported on the balance sheet by 1) increasing the asset available-for-sale securities, and 2) increasing the stockholders’ equity component accumulated other comprehensive income. Note that the holding gains on available-for-sale securities are not reported on the income statement.
Question 49. How Can Working Capital Be Improved?
Working capital can be improved by 1) earning profits, 2) issuing common stock or preferred stock for cash, 3) replacing short-term debt with long-term debt, 4) selling long-term assets for cash, 5) settling short-term debts for less than the stated amounts, and 6) collecting more of the accounts receivables than was anticipated and then reducing the balance required in the current asset account Allowance for Doubtful Accounts.
I am sure there are additional ways to increase working capital. The concept is to increase the amount of current assets and/or to decrease the amount of current liabilities.
Question 50. What Is The Interest Coverage Ratio?
The interest coverage ratio is a financial ratio used to measure a company’s ability to pay the interest on its debt. (The required principal payments are not included in the calculation.) The interest coverage ratio is also known as the times interest earned ratio.
The interest coverage ratio is computed by dividing 1) a corporation’s annual income before interest and income tax expenses, by 2) its annual interest expense.
To illustrate the interest coverage ratio, let’s assume that a corporation’s most recent annual income statement reported net income after tax of $650,000; interest expense of $150,000; and income tax expense of $100,000. Given these assumptions, the corporation’s annual income before interest and income tax expenses is $900,000 (net income of $650,000 + interest expense of $150,000 + income tax expense of $100,000). Since the interest expense was $150,000 the corporation’s interest coverage ratio is 6 ($900,000 divided by $150,000 of annual interest expense).
A large interest coverage ratio indicates that a corporation will be able to pay the interest on its debt even if its earnings were to decrease. A small interest coverage ratio sends a caution signal.
Since the interest coverage ratio is based on the net income under the accrual method of accounting, we recommend that you also review the cash provided by operating activities (which is found on the corporation’s statement of cash flows) for the same time period.
Question 51. What Is Liquidity?
Liquidity refers to a company’s ability to pay its bills from cash or from assets that can be turned into cash very quickly.
The quick ratio, also known as the acid-test ratio, is an indicator of a company’s liquidity.
Question 52. What Is Gross Margin?
Gross margin is the difference between 1) the cost to produce or purchase an item, and 2) its selling price. For example, if a company’s manufacturing cost of a product is $28 and the product is sold for $40, the product’s gross margin is $12 ($40 minus $28), or 30% of the selling price ($12/$40). Similarly, if a retailer has net sales of $40,000 and its cost of goods sold was $24,000, the gross margin is $16,000 or 40% of net sales ($16,000/$40,000).
It is important to realize that the gross margin (also known as gross profit) is the amount before deducting expenses such as selling, general and administrative (SG&A) and interest. In other words, there is a big difference between gross margin and profit margin (or net profit margin).
Question 53. What Is The Difference Between Cash Flow And Free Cash Flow?
A corporation’s cash flow from operations is available from the first section of the statement of cash flows. Usually the calculation begins with the accrual accounting net income followed by adding back depreciation expense and then adjusting for the changes in the balances of current assets and current liabilities.
Free cash flow is often defined as the cash flow from operations (or net cash flows from operating activities) minus the cash necessary for capital expenditures. Occasionally, dividends to stockholders are also deducted.
Question 54. What Are Turnover Ratios?
In accounting, turnover ratios are the financial ratios in which an annual income statement amount is divided by the average balance of an asset (or group of assets) throughout the year. Turnover ratios include:
- accounts receivable turnover ratio
- inventory turnover ratio
- total assets turnover ratio
- fixed assets turnover ratio
- working capital turnover ratio
Some of the turnover ratios are also categorized as liquidity ratios, operating ratios, activity ratios, efficiency ratios, and asset utilization ratios.
The larger the turnover ratio, the better. For instance, a large amount of credit sales in relationship to a small amount of accounts receivable indicates that the company was efficient and effective in collecting its accounts receivable. (Remember that ratios are averages. Hence, some of the accounts receivable could be very old, but they are “hidden” because other customers paid quickly.)
Turnover ratios are more accurate when they use the asset’s average balances for the year (as opposed to one balance at the final instant of the accounting year). The reason is that an income statement amount reflects the total activity during the entire year.
To assist you in computing and understanding accounting ratios, we developed 24 forms that are available as part of AccountingCoach PRO.
Question 55. What Is The Difference Between The Current Ratio And Working Capital?
The current ratio is the proportion (or quotient or fraction) of the amount of current assets divided by the amount of current liabilities.
Working capital is not a ratio, proportion or quotient, but rather it is an amount. Working capital is the amount remaining after current liabilities are subtracted from current assets.
To illustrate the difference between the current ratio and working capital, let’s assume that a company’s balance sheet reports current assets of $60,000 and current liabilities of $40,000. The company’s current ratio is 1.5 to 1 (or 1.5:1, or simply 1.5) resulting from dividing $60,000 by $40,000. The company’s working capital is $20,000 which is the remainder after subtracting $40,000 from $60,000.
AccountingCoach PRO contains 24 blank forms to guide you in computing and understanding often-used financial ratios. In addition, there are 24 filled-in forms based on the amounts from two financial statements which are also included.
Question 56. What Is The Fixed Asset Turnover Ratio?
The fixed asset turnover ratio shows the relationship between the annual net sales and the net amount of fixed assets.
The net amount of fixed assets is the amount of property, plant and equipment reported on the balance sheet after deducting the accumulated depreciation. Ideally, you should use the average amount of net fixed assets during the year of the net sales.
A corporation having property, plant and equipment with an average gross amount of $10 million and an average accumulated depreciation of $4 million would have average net fixed assets of $6 million. If its net sales were $18 million, its fixed asset turnover would be 3 ($18 million of net sales divided by $6 million of average net fixed assets).
Question 57. What Is Leverage?
In accounting and finance, leverage refers to the use of a significant amount of debt and/or credit to purchase an asset, operate a company, acquire another company, etc.
Generally the cost of borrowed money is much less than the cost of obtaining additional stockholders’ equity. As a result, it is usually wise for a corporation to use some debt and leverage. Perhaps this is one of the reasons that leverage is also known as trading on equity.
Financial ratios such as debt to equity and debt to total assets are indicators of a corporation’s use of leverage. In these ratios debt is the total amount of all liabilities (current and noncurrent). This means that a corporation’s debt includes bonds payable, loans from banks, loans from others, accounts payable, and all other amounts owed.
Question 58. What Is The Debt Ratio?
The debt ratio is also known as the debt to asset ratio or the total debt to total assets ratio.
The calculation of the debt ratio is: Total Liabilities divided by Total Assets.
The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors.
A high debt ratio indicates that a corporation has a high level of financial leverage.
Question 59. What Is The Profit Margin (after Tax) Ratio?
The after tax profit margin ratio tells you the profit per sales dollar after all expenses are deducted from sales. In other words, the after tax profit margin ratio shows you the percentage of net sales that remains after deducting the cost of goods sold and all other expenses including income tax expense. The calculation is: Net Income after Tax divided by Net Sales.
The before tax profit margin ratio expresses the corporation’s income before income tax expense as a percentage of net sales.
The profit margin ratio is most useful when it is compared to 1) the same company’s profit margin ratios from earlier accounting periods, 2) the same company’s targeted or planned profit margin ratio for the current accounting period, and 3) the profit margin ratios of other companies in the same industry during the same accounting period.
Question 60. What Is Turnover?
Turnover is used in some countries to mean sales.
Turnover is also used in certain financial ratios. For example, the inventory turnover ratio is calculated by dividing the cost of goods sold during a year by the average inventory during the same year. The accounts receivable turnover ratio is computed by dividing the credit sales during a year by the average balance in Accounts Receivable during the same year.
Financial Planning Interview Questions
Financial Reporting and Analysis Tutorial
Financial Reporting and Analysis Interview Questions
Financial Management Tutorial
Financial Management Interview Questions
Sales Interview Questions
Accounting Basics Tutorial
Financial Analyst Interview Questions
Financial Planning Interview Questions
Marketing Interview Questions
Financial Services Interview Questions
Financial Reporting and Analysis Interview Questions
Financial Management Interview Questions
Sales Interview Questions
Financial Analyst Interview Questions
Marketing Interview Questions
Financial Services Interview Questions