Liquidity and Solvency Ratios

Financial ratios
Profitability ratios
Liquidity ratios
Solvency ratios
Activity ratios
Profitability ratios

What are the examples of ratios that provide information about the profitability of an entity?

  • Profit margin ratio
  • Gross margin ratio
  • Return on assets
  • Return on equity
Liquidity ratios

What are the examples of ratios that provide information about the financial liquidity of an entity?

  • Current ratio
  • Quick ratio
  • Working capital ratio
Solvency ratios

What are the examples of ratios that provide information about the financial solvency of an entity?

  • Debt to equity ratio
  • Debt to assets ratio
  • Long-term debt to equity ratio
Activity ratios

What are the examples of ratios that provide information about the operational activity of an entity?

  • Assets turnover ratio
  • Inventory turnover ratio
  • Days in inventory
  • Accounts receivable turnover ratio
  • Accounts receivable collection period
  • Accounts payable turnover ratio
  • Accounts payable payment period
Review Questions
1. How is earnings per Share (EPS) calculated?
Earnings per share (EPS) = (1) / (2)
Where,
(1) = (Net income – Preferred stock dividends)
(2) = Average number of common shares outstanding
If preferred stock dividends = 0, then
Earnings per share (EPS) = Net income / Average number of common shares outstanding
2. How is working capital calculated?
Working capital = Current assets – Current liabilities
3. How is current ratio calculated?
Current ratio = Current assets / Current liabilities
4. How is debt to total assets ratio calculated?
Debt to total assets = Total liabilities / Total assets
5. How is free cash flow calculated?
Free cash flow
= Net cash provided by operating activities – Capital expenditures – Cash dividends
Exercise 1
Entity A had the following balances at December 31, 20×1.
Calculate the required amounts and/or financial ratios.
Current assets = $700,000
Total assets = $1,600,000
Current liabilities = $500,000
Total liabilities = $800,000
Cash provided by operations = $900,000
Capital expenditures = $200,000
Cash dividends = $100,000
Net income = $360,000
Preferred stock dividends = $50,000
Average common shares outstanding = 100,000 shares
1. What is the amount of working capital?
Working capital = Current assets – Current liabilities = $700,000 – $500,000 = $200,000
2. What is the current ratio?
Current ratio = Current assets / Current liabilities = $700,000 / $500,000 = 1.40
3. What is the debt to total assets ratio?
Debt to total assets = Total liabilities / Total assets = $800,000 / $1,600,000 = 0.50 or 50%
4. What is the amount of free cash flow?
Free cash flow = Cash provided by operations – Capital expenditures – Cash dividends
5. What is the amount of Earnings per share (EPS)?
Earnings per Share
= (Net income – Preferred stock dividends) / Average common shares outstanding
= ($360,000 – $50,000) / 100,000 shares =$310,000 / 100 shares = $3.10 per share
Exercise 2
Calculate the required ratios based on the following information:
Net sales = $3,000,000
Cost of Goods Sold = $2,100,000
Gross Profit = Net sales – Cost of goods sold = $3,000,000 – $2,100,000 = $900,000
Net income = $360,000
1. What is the gross profit rate?
Gross profit rate = Gross profit / Net sales
= (Net sales – Cost of goods sold) / Net sales
= ($3,000,000 – $2,100,000) / $3,000,000 = $900,000 / $3,000,000
= 0.30 or 30%
2. What is the profit margin ratio?
Profit margin ratio = Net income / Net sales = $360,000 / $3,000,000 = 0.12 or 12%

 

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