Ratio analysis often is employed to gain insight into the financial risks associated with an audit client. The calculation of ratios can lead to a better understanding of a firm’s financial position and performance.

A specific ratio or a number of selected ratios can be calculated and used to measure or evaluate a specific financial or operating characteristic of an audit client.

Required:

For the five financial ratios and four operating ratios listed below 

1. Describe how the ratio is calculated.

2. Identify a financial characteristic of a firm that would be measured by the ratio.

3. Identify how the auditor would use the information to identify risk areas.

4. Identify a trend in the ratio that would indicate an increase in risk, and then indicate the specific effect that such a trend would have on the conduct of the audit.
For example, indicate additional audit evidence that should be acquired during the audit, whether planning materiality ought to be changed, or whether any risk factors ought to be changed.

Financial Position Ratios:

a. Current ratio

b. Quick ratio

c. Number of days’ sales in receivables

d. Number of days’ sales in inventory

e. Debt/Equity ratio Operating Ratios:

f. Gross margin g. Net operating margin h. Earnings before interest and taxes i. Number of times interest earned