1. Ratio Analysis (Formula Approach) Step 1: Quick Take: Ratio Analysis Ratio analysis is an important way of evaluating financial statements. Using ratios, instead of simply raw financial data, can help to make better comparisons of the strength of companies. There are many different kinds of ratios, which can be grouped into five general categories: 1. Liquidity ratios: These ratios are used to analyze whether or not a firm is able to pay its short-term debts (typically maturing within the next year). Good liquidity ratios are needed to continue operations of the firm. 2. Asset management ratios: These ratios are used to analyze the efficiency of asset use by a firm. Reasonable asset management ratios are required to sustain acceptable levels of net income. 3. Debt management ratios: These ratios analyze how a firm has financed its assets, as well as whether or not the firm can repay its long-term debt. 4. Profitability ratios: These ratios analyze how profitable a firm is. These ratios take both asset and debt management ratios into account to analyze overall return on equity. 5. Market value ratios: These ratios analyze investor confidence in the firm, both now and into the future. Suppose one firm has acquired far too much inventory and capital equipment, leading to large excess capacity. Which of the following categories of ratios would likely be most appropriate for comparing these companies in this scenario? Asset management ratios Market value ratios Debt management ratios Liquidity ratios Suppose that you are given the following data for Niles Company : Note: The data and calculations are based on a 365-day year. Cash and equivalents $225,000 Fixed assets $650,000 Sales $2,500,000 Net income $112,500 Current liabilities $240,000 Current ratio 2.5 DSO 18.25 ROE 12.00% Current Assets = Cash and equivalents + Accounts Receivable + Inventories The quick ratio is equal to . Plugging in the relevant values for current assets, current liabilities, and inventories (calculated using the previous identity) yields a quick ratio of approximately 1.4583 Suppose that Niles could reduce its DSO from 18.25 to 12. Given the formula for DSO from the video, as well as the same annual sales of $2,500,000, the new value accounts receivable (associated with the new DSO) must be $20,547.95 , all else equal. The change (or the absolute value of the difference between the original and new values) in accounts receivable represents an amount of approximately in cash generated. As a result of the stock buy back, the ROA and ROE both increase Suppose Niles uses the cash generated by the lower DSO to buy back common stock at book value, thus reducing common equity. As a result of this new, lower, DSO, total debt debt/total capital ratio must and total capital . This means that the total