Financial Statement Analysis

Chapter 2Ratio Analysis: The Effect Ratios

Learning objectives

• Identify which ratios are effect ratios.
• Distinguish what each of these ratios measures.
• Calculate each ratio.

Introduction

The effect ratios are used to determine the extent of a company’s problems. Liquidity, leverage, and profitability measures are included.

The purpose of this chapter is to introduce you to the effect ratios. These ratios do not show the reason for a change; they only show that a change has occurred. The ratios show the magnitude of a change but do not record the reason for that change. The chapter does show how a change in any of the causal ratios can change each of the effect ratios. The nine effect ratios are the current ratio, inventory to working capital, receivables to working capital, net sales to working capital, debt to net worth, debt to assets, short-term debt to net worth, times interest earned, and return on equity.

Effect ratios

Liquidity measures

• Current ratio
• Quick ratio
• Defensive interval
• Cash conversion cycle
• Inventory/working capital
• Receivables/working capital
• Net sales/working capital
• Operating cash flow to current liabilities

Leverage measures

• Debt to net worth
• Debt to assets
• Tangible debt ratios
• Short-term debt to net worth
• Times interest earned
• Cash times interest earned
• Fixed charge coverage

Knowledge check

1. Which ratio is not a liquidity measure?
   1. Current ratio.
   2. Defensive interval.
   3. Times interest earned.
   4. All of the above are liquidity measures.

Profitability ...