Chapter 4: Fundamental Concepts in Financial Management

Liquid Asset
An asset that can be converted to cash quickly without having to reduce the asset’s price very much.
Liquidity Ratios
Ratios that show the relationship of a firm’s cash and other current assets to its current liabilities.
Current Ratio
This ratio is calculated by dividing current assets by current liabilities. It indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future.
Quick (Acid Test) Ratio
This ratio is calculated by deducting inventories from current assets and then dividing the remainder by current liabilities.
Asset Management Ratios
A set of ratios that measure how effectively a firm is managing its assets.
Inventory Turnover Ratio
This ratio is calculated by dividing sales by inventories.
Days Sales Outstanding (DSO) Ratio
This ratio is calculated by dividing accounts receivable by average sales per day; it indicates the average length of time the firm must wait after making a sale before it receives cash.
Fixed Assets Turnover Ratio
The ratio of sales to net fixed assets.
Total Assets Turnover Ratio
This ratio is calculated by dividing sales by total assets.
Debt Ratio
The ratio of total debt to total assests.
Times-Interest-Earned (TIE) Ratio
The ratio of earnings before interest and taxes (EBIT) to interest charges; a measure of the firm’s ability to meet its annual interest payments.
Profitability Ratios
A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results.
Operating Margin
This ratio measures operating income, or EBIT, per dollar of sales; it is calculated by dividing operating income by sales.
Profit Margin
This ratio measures net income per dollar of sales and is calculated by dividing net income by sales.
Return on Total Assets (ROA)
The ratio of net income to total assets.
Basic Earning Power (BEP) Ratio
This ratio indicates the ability of the firm’s assets to generate operating income; it is calculated by dividing EBIT by total assets.
Return on Common Equity (ROE)
The ratio of net income to common equity; measures the rate of return on common stockholders’ investment.
Market Value Ratios
Ratios that relate the firm’s stock price to its earnings and book value per share.
Price/Earnings (P/E) Ratio
The ratio of the price per share to earnings per share; shows the dollar amount investors will pay for $1 of current earnings.
Market/Book (M/B) Ratio
The ratio of a stock’s market price to its book value.
DuPont Equation
A formula that shows that the rate of return on equity can be found as the product of profit margin, total assets turnover, and the equity multiplier. It shows the relationships among asset management, debt management, and profitability ratios.
The process of comparing a particular company with a set of benchmark companies.
Trend Analysis
An analysis of a firm’s financial ratios over time; used to estimate the likelihood of improvement or deterioration in its financial condition.
“Window Dressing” Techniques
Techniques employed by firms to make their financial statements look better than they really are.