Business Ratios Interview Preparation Guide

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In accounting and finance, leverage refers to the use of a significant amount of debt and/or credit to purchase an asset, operate a company, acquire another company, etc.

Gross margin is the difference between:
1) the cost to produce or purchase an item, and
2) its selling price.
For example, if a company's manufacturing cost of a product is $28 and the product is sold for $40, the product's gross margin is $12 ($40 minus $28), or 30% of the selling price ($12/$40). Similarly, if a retailer has net sales of $40,000 and its cost of goods sold was $24,000, the gross margin is $16,000 or 40% of net sales ($16,000/$40,000).

To illustrate the difference between the current ratio and the quick ratio, let's assume that a company's balance sheet reports current assets of $60,000 and current liabilities of $40,000. Its current assets include $35,000 of inventory and $1,000 of supplies and prepaid expenses. The company's current ratio is 1.5 to 1 [$60,000 divided by $40,000]. Its quick ratio is 0.6 to 1 [($60,000 minus $36,000) divided by $40,000].

To illustrate the difference between the current ratio and working capital, let's assume that a company's balance sheet reports current assets of $60,000 and current liabilities of $40,000. The company's current ratio is 1.5 to 1 (or 1.5:1, or simply 1.5) resulting from dividing $60,000 by $40,000. The company's working capital is $20,000 which is the remainder after subtracting $40,000 from $60,000.

This means that a net incremental cash inflow of $50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a $50,000 cash outflow that was part of the initial investment made four years earlier.

Let's illustrate what this means by using two hypothetical projects which are being considered as an investment:
Project #187 has a payback period of 4 years. However, the amounts of the net incremental cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7.
Project #188 has a payback period of 6 years. However, the amounts of its net incremental cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15.
While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.

Net incremental cash flows are the combination of the cash inflows and the cash outflows occurring in the same time period, and between two alternatives. For example, a company could use the net incremental cash flows to decide whether to invest in new, more efficient equipment or to retain its existing equipment.

Net incremental cash flows are necessary for calculating an investment's:
★ Net present value
★ Internal rate of return
★ Payback period

To illustrate net incremental cash flows let's assume that Your Corporation has the opportunity to purchase a product line from Divesting Company for a single cash payment of $800,000. Your Corporation expects that the product line will result in the following cash flows occurring in each year for 10 years:
★ Additional cash receipts or cash inflows of $900,000 (from the collection of accounts receivable related to product sales)
★ Additional cash payments or cash outflows of $750,000 (for payments related to the product line's costs and expenses)
These cash flows indicate that the net incremental cash flows are expected to be a positive $150,000 per year for 10 years, or that there will be net incremental cash inflows of $150,000 per year for 10 years.

The difference between the current ratio and the acid test ratio (or quick ratio) generally involves the current assets inventory, prepaid expenses, and some deferred income taxes.
The current ratio uses the total amount of all of the current assets.

The acid test ratio uses only the following current assets, which are considered to be quick assets: cash and cash equivalents, short-term marketable securities, and accounts receivable (net of the allowance for uncollectible accounts). In other words, the acid test ratio excludes inventory (which is a significant current asset for retailers and manufacturers) and some other amounts such as prepaid expenses and deferred income taxes (that are classified as current assets).