Accounting Ratios Respond to all three questions thoroughly

Accounting Ratios Respond to all three questions thoroughly 1 The current year\'s amount of net income (after income tax) is 20% larger than that of the preceding year. Does this indicate an improved operating performance? Discuss. 2. What could a low accounts receivable turnover rate indicate? Use at least one internet resource to support your response. 3. What does possible liquidation have to do with the ratio of debt to total assets?

Solution

1.      Net income is the net earnings of company after taking into account its revenues and after adjusting depreciation, cost of goods sold, interest, tax and other expenses. The financial performance of a company can be analysed using net income. However, a growth of 20% in net income for the current year as compared to previous financial year cannot be treated as improved operating performance of a company. To analyse if a company has improved its operating performance, net profit ratio of current year can be compared with the net profit ratio of previous year. Net profit ratio is given by

Net profit ratio= Net income after tax/ Net sales

The increment in net income might indicate increase in net sales or revenues however, if net profit ratio does not increase then despite increase in net income, the operating performance of a company would deteriorate. Hence, company’s operating performance cannot be judged on the basis of growth in net income, rather it should be analysed using profitability ratios.

2.      Account receivable turnover ratio is an indicator of the efficiency of a company in using its assets to generate cash flows. It is given by

Account receivable turnover ratio= Annual Credit sales/Average Account receivable

A high account receivable ratio indicates that company has a very strict credit policy and it is prompt in collection of receivables from its debtors. However, a low account receivable ratio is a sign that company is inefficient in generating cash flows from its credit sales. It may also indicate that company is very lenient regarding its credit policies and its clients are failing to clear their dues in time (Filbeck and Krueger, 2005).

                                              

3.      Debt to total assets ratio is an indicator of company’s solvency position. It is measured as the value of assets required to clear all the obligations of the company. It is given by

Debt ratio= Total liabilites/ Total assets

If debt ratio is more than one, then company’s solvency position is critical. This ratio indicated whether company is financially sound in paying off its debt liabilities in future. The worst case scenario that can be interpreted may be that company might liquidate in near future as its assets are not enough to pay off its debt obligations. A higher ratio is unfavourable to the company and a lower ratio indicates favourable situations with respect to financial solvency of the company.

Works Cited

Filbeck, G. and Krueger, T.M. (2005) \'An analysis of working capital management results across industries\', American Journal of Business, vol. 20, no. 2, pp. 11-20.