 Hello and welcome to the session this is Professor Farhad in which we would look at a CPA exam simulation that you could see on the BEC exam that deals with ratios. Now when it comes to ratios you can see ratios on the BEC exam, you can see ratios on the FAR exam financial accounting and reporting and you need to know the ratios about the auditing exam. Now in the future the BEC exam is going away but the material in the BEC exam will be tested in various specializations. So financial ratios is something that you need to be familiar with and that's the first thing we look at when we are looking at a simulation. So the first thing you ask yourself is you look at the simulation and immediately you don't have to think about it a lot this ratio is about financial ratios and this topic is important. Now what should you do if you are giving a simulation like this one on the exam? For one thing you should be very happy because the financial ratios are easy to understand easy to apply especially if you are using Farhad lectures. Before we proceed any further I have a public announcement about my company farhadlectures.com. Farhad accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead start your free trial today. So let's go ahead and get started to see how we will solve a simulation like this one. Well the first thing is let's look at the exhibit you are giving the definitions the analytics definition for various ratios. So you are giving the account receivable, the formula asset turnover, the formula so you don't have to memorize it that's good news and you are also giving the valuation matrices for certain items like the cap amp capital asset pricing model. Just take a minute and look at those don't look don't take more than a don't take a look more than a minute because we already figure out that the that the simulation is a drop down menu just you have to select something from the menu and the topic is ratio. So we answer two questions about the simulation is what type drop down menu and the topic is simulation and also if you look at it all what they all what they want us to do this is even easier than a multiple choice question it's basically they're asking you they're giving you a financial ratio and they're asking you to select what type of a ratio is this. So we already know what they're asking and where to find the answer the last thing we want to answer to answer is easy because if you know ratios you know where to find the answers okay. So task one the controllers of kettles corporation provided you with a list of financial ratio and ask you to determine the correct category for each ratio and believe it or not in the real world as I mentioned ratios are covered in auditing they're covering they're covered in FAR and they're covered in BEC in the real world you would use ratios in financial statement analysis you would you would use ratio in auditing if you are performing an audit before you start the audit during the audit and after the audit and you would use ratios when you are preparing a financial reviews. So ratios are important and far hat lectures does a great job I take pride in helping you understand ratios inside out. So let's go ahead and see how we will answer these questions I mean you're gonna see a simulation like this it should take you five minutes to complete I'm gonna show you how that's gonna take me more minutes to explain but if you already it should take you five minutes to complete so you would read the instruction for each of the following ratios in column A right here select the option list in column B the category of each ratio should be happy if you get something like this if the ratio does not belong to any category select not applicable each item in the each item included in the option list may be used once more than once or not at all so these you know it could be once more than once or not at all starting with days sales and account receivable well I hope you know what is days sales and account receivable okay it measures what I mean you can see the ratio if you like if you would like to but basically it measures how long it takes a company to collect its account receivable so how long does it take the company to collect its account receivable what type of a ratio is this is it asset utilization is it liquidity well when you heard the word liquidity it has to do with debt and specifically short-term debt it cannot be liquidity is it long-term solvency well liquidity and solvency they're kind of the same the only difference is long-term solvency is is long-term debt rather than short-term debt is it market value well asset account receivable doesn't tell us much about the market value of the company profitability the ratio profitabilities are are they would involve either net income or return on something return on asset return on equity so I would say they they sales and account receivable is a form of asset utilization how well you are utilizing your asset in other words how well you are collecting your receivable utilizing your asset but on the exam you want to memorize which ratio in each category first understand them memorize and this is how I can help you equity multiplier well well it cannot be asset utilization liquidity it's short-term debt long-term solvency let's hold on this market value market value deals with your stock how well your stock is doing equity this is like could be misleading equity well it could be it may not be but let's see how you can find out profitability is something to do with your return now if you are not sure if you suspect it's market it's market value it's not market value but if you suspect this what should you do look at the analytics definition so look at the equity multiplier look at that look at that ratio and you would see that the equity multiplier is total asset divided by total equity it has nothing to do it has nothing to do with the market value so just in case you are not sure this is how you kind of say it's not market it's not market so if it's not market what's left really is long-term solvency let's see if it makes sense just from the ratio since you don't have to memorize the ratio you are giving the ratio but you should know the ratio total assets divided by total equity what is it telling you it's telling you total assets total assets is how much assets you have in total remember assets assets remember assets equal liabilities plus equity so let's assume for the sake of illustration for the sake of illustration total assets divided by total liability let's assume for the sake of illustration you have $100 in assets and you have $20 in equity. Total assets divided by total equity equal to five. Okay, 100 divided by 20 of equity equal to five. Now what should you tell yourself? What else do you know? What would you know about this? What you know about this if $20 of my assets of my $100 of assets are coming from equity, $80 are coming from debt. So what it's telling me in a sense it's telling me how much in a sense it's complimenting my ability my ability to know how much do I have in debt. Okay, so this ratio measures the company financial leverage although you don't see the word debt in there but I know if 100 assets 20 is equity I know $80 is debt. Therefore this ratio deals with long-term solvency. Again on the exam you don't do this on the exam it should take you a minute less than a minute. Inventory turnover what is inventory turnover? How well you are selling your inventory not how well how fast the faster your inventory turnover the better off you are. Well inventory turnover deals with your deals with your asset utilization how well you are utilizing your asset because if you really think about it first you have inventory you sell it how fast you sell it is how well you are using your asset then this inventory is sold on account how fast you convert your account receivable into cash has to do with your asset utilization. So account receivable turnover also it's there's another ratio called the account receivable turnover which is another form of day sales and account receivable how long it's taking you to collect your money an account inventory turnover or there's a ratio called day sales and inventory they're all form of asset utilization price earning ratio let's assume you don't know anything about this ratio if you go to the formulas that you are giving which is price earnings it's easy PE which is price PE price of the asset divided by the earning price of the share price of the asset price per share divided by the basic earning well if you don't know anything about this ratio once I see the price per share I'm dealing with the market value with the market value ratio why because the price of the stock is a market value otherwise make sure you know it I mean this is my favorite ratio I spent 15 to 20 minutes explaining this ratio PE is my favorite ratio and it's the most quoted financial ratio in the real world so it's a market value quick ratio maybe this is the second ratio you would learn about after the current ratio again if you don't know what the quick ratio is it is quick assets divided by current liabilities so it's your as it should be here we have current ratio current assets divided by current liabilities do we have quick ratio and a quick ratio which is quick asset cash and cash equivalent short-term marketable securities and receivable divided by current liabilities even if you don't if you don't know it once you see they are divided by current liabilities they're measuring your ability of short-term assets specifically liquid asset in comparison to your current liabilities well that's liquidity liquidity means liquidity ratios measures your short-term ability to pay that therefore the category is liquidity liquidity return on equity every time you see the word return return on equity return on asset return on I don't care about something else once you hear the word return it has to do with profitability profitability ratios how much common stockholders are earning from net income return on equity how much are the earning a percentage times interest earned well we're dealing with interest times interest earned times interest earned is how well how many times you are you are using your interest how much how much income do you have to cover your interest so times interest earned let's assume you have just for the sake of illustration let me use some numbers here just to show you how you would look at this if you have ten dollars in earnings before interest and taxes ten dollars and you have two dollars in interest again the answer is five so ten dollars in earning before interest two dollars in interest the answer is five this is your cold times interest earned it means how many times you can cover your interest if you have four ten dollars in income in two dollars in interest you can cover your interest five times so when it comes to interest immediately it's not asset it could be liquidity but not really not market value not profitability if you're if you're confused between liquidity and long-term solvency interest deals with long-term debt so long-term solvency can you pay your debt in the long term therefore the answer is long-term solvency again it took me a little bit of time to select these questions if you are really prepared and i'm saying if you are really prepared if you're using far hat lectures it will take you less than five minutes less than five minutes to insert this part of the simulation less than five let's take a look at part two cattle's controller want to understand the effect of certain business scenario on specific financial ratios and this is very common thing you want to know whether it's for the auditing exam the financial accounting or reporting or for the ec order for the future specialization the table below present two different scenarios and financial ratios documented in column a and column b respectively indicate the effect of each scenario on the associated ratio using the option list so basically they're giving you the financial ratio is asset turnover now if you don't know what asset turnover is the good thing is here they're telling you what the asset they're giving you the definition or the ratio for each one asset turnover is sales divided by the average asset so if the sales are 100 or 1000 and your average assets are 10000 1000 divided by 10000 is 10 percent it means from your asset you're generating 10 percent in sales how well you are utilizing your asset okay that's fine now we know what the ratio is now the the the question is so let's assume net income increases from 700 000 to 800 000 so we have more profit due to a decrease in a cruel employee compensation why did that why did we have more profit because we lowered our employee expenses okay that's fine what's the effect on the asset turnover well let's take a look at this asset turnover is sales which is reducing employee expenses does not affect my sales what's the effect on average total asset it has nothing to do with assets it's expenses and maybe current liabilities so the answer is no effect no effect no effect be careful net income is not the same thing as sales okay because if it affects sales then it would affect this ratio whether it's up or down well depending if it's we have more sales it's going to increase it we have less sales it's going to decrease it but sales is not involved let's take a look at this ratio interest expense increased from 80000 to 90000 due to additional debt taken by carol so we have more interest expense how would that affect times interest expense that's all what we are told if that's all what you are told you have more interest expense let's go back to the calculator and if you have more interest expense so if you go from 10 divided by 2 equal to 5 let's assume we have more interest expense 10 divided by 4 now we have more interest expense it's gonna lower our times interest i'm sorry 10 divided by 4 is 2.5 it's gonna lower we went from 5 we were able to cover our interest expense five times now we can cover it 2.5 it's gonna lower i mean this is even using common sense you would know it's gonna decrease our interest expense now once again i'm what i'm gonna tell you is this you should be lucky you should be lucky if you are using farhat and you get a ratio simulation because if you if you work with farhat on the ratios you will maximize it it means if you use my material um once again stay calm when you have a simulation and uh have confidence in yourself prepared well and you will be fine you will be fine don't let simulation overwhelm you good luck study hard and i'm always here to help you