Page 146 - Fundamentals of Management Myths Debunked (2017)_Flat

Exhibit QM–5 Popular Financial Controls Quantitative Module 145

ObjECTIVE RATIO CAlCulATION MEANING

Liquidity test Current ratio Current assets Tests the organization’s ability to
meet short-term obligations
Current liabilities
Acid test Current assets less Tests liquidity more accurately
inventories when inventories turn over slowly
or are difficult to sell
Current liabilities
Leverage test Debt to assets Total debt The higher the ratio, the more
leveraged the organization
Total assets
Times interest earned Profits before interest Measures how far profits can
and taxes decline before the organization
is unable to meet its interest
Total interest charges
expenses
Operations test Inventory turnover Cost of sales The higher the ratio, the more
efficiently inventory assets are
Inventory
being used
Total assets turnover Revenues The fewer assets used to achieve
a given level of sales, the more
Total assets
efficiently management is using
the organization’s total assets
Profitability Profit margin on Net profit after taxes Identifies the profits that various
revenues products are generating
Total revenues
Return on investment Net profit after taxes Measures the efficiency of assets
to generate profits
Total assets

current financial performance with that of previous periods and other organizations in the
same industry. Some of the more useful ratios evaluate liquidity, leverage, operations, and
profitability. These ratios are summarized in Exhibit QM–5.
What are liquidity ratios? Liquidity is a measure of the organization’s ability to convert
assets into cash in order to meet its debt obligations. The most popular liquidity ratios are the
current ratio and the acid test ratio.
The current ratio is defined as the organization’s current assets divided by its current
liabilities. Although there is no magic number that is considered safe, the accountant’s rule
of thumb for the current ratio is 2:1. A significantly higher ratio usually suggests that man-
agement is not getting the best return on its assets. A ratio at or below 1:1 indicates potential
difficulty in meeting short-term obligations (accounts payable, interest payments, salaries,
taxes, etc.).
The acid test ratio is the same as the current ratio except that current assets are reduced
by the dollar value of inventory held. When inventories turn slowly or are difficult to sell, the
acid test ratio may more accurately represent the organization’s true liquidity. That is, a high
current ratio heavily based on an inventory that is difficult to sell overstates the organiza-
tion’s true liquidity. Accordingly, accountants typically consider an acid test ratio of 1:1 to
be reasonable.
Leverage ratios refer to the use of borrowed funds to operate and expand an organi-
zation. The advantage of leverage occurs when funds can be used to earn a rate of return
well above the cost of those funds. For instance, if management can borrow money at