Business Ratios Interview Preparation Guide

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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.

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).

To illustrate the difference between the current ratio and the quick ratio, let's assume that a company's balance sheet reports current assets of $60,000 and current liabilities of $40,000. Its current assets include $35,000 of inventory and $1,000 of supplies and prepaid expenses. The company's current ratio is 1.5 to 1 [$60,000 divided by $40,000]. Its quick ratio is 0.6 to 1 [($60,000 minus $36,000) divided by $40,000].

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.

This means that a net incremental cash inflow of $50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a $50,000 cash outflow that was part of the initial investment made four years earlier.

Let's illustrate what this means by using two hypothetical projects which are being considered as an investment:
Project #187 has a payback period of 4 years. However, the amounts of the net incremental cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7.
Project #188 has a payback period of 6 years. However, the amounts of its net incremental cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15.
While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.

Net incremental cash flows are the combination of the cash inflows and the cash outflows occurring in the same time period, and between two alternatives. For example, a company could use the net incremental cash flows to decide whether to invest in new, more efficient equipment or to retain its existing equipment.

Net incremental cash flows are necessary for calculating an investment's:
★ Net present value
★ Internal rate of return
★ Payback period

To illustrate net incremental cash flows let's assume that Your Corporation has the opportunity to purchase a product line from Divesting Company for a single cash payment of $800,000. Your Corporation expects that the product line will result in the following cash flows occurring in each year for 10 years:
★ Additional cash receipts or cash inflows of $900,000 (from the collection of accounts receivable related to product sales)
★ Additional cash payments or cash outflows of $750,000 (for payments related to the product line's costs and expenses)
These cash flows indicate that the net incremental cash flows are expected to be a positive $150,000 per year for 10 years, or that there will be net incremental cash inflows of $150,000 per year for 10 years.

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

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 quick ratio (or the acid test ratio) is the proportion of only the most liquid current assets to the amount of current liabilities.

The current ratio is the proportion (or quotient or fraction) of the amount of current assets divided by the amount of current liabilities.

A drawback of ROI is that the accounting amounts (revenues, expenses, asset book values, etc.) ignore the time value of money. As a result, companies began using discounted cash flows to better assess the profitability of its investments. Calculations such as net present value and internal rate of return became common and ROI was referred to as the accounting rate of return.

ROI is the acronym for return on investment. Originally the objective of ROI was to relate a return (the income statement benefit) to the amount invested (such as the asset information from the balance sheet).

Inventory turnover is important because a company often has a significant amount of money tied up in its inventory. If the items in inventory do not get sold, the company's money will not become available to pay its employees, suppliers, lenders, etc.

It is also possible that a company's inventory will become less in demand, perhaps become obsolete, or even deteriorate. If that occurs some of the company's money will be lost. Having slow-moving items in inventory also uses valuable space and makes the warehouse less efficient.

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.

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.

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.

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.

In accounting, base year may refer to the year in which a business had adopted the LIFO cost flow assumption for valuing its inventory and its cost of goods sold. Under the dollar-value LIFO technique a company's current inventory is restated to base-year prices in order to determine whether the quantity of inventory has increased or decreased.

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.