Financial Statements and Ratios Questions and Answers

Answer: C

Correct answer: current liabilities

The current ratio compares what will turn into cash within the year against what must be paid within the year, so a ratio of two means twice the cover. It is the first liquidity measure looked at, and the conventional benchmark of about two is a starting point rather than a rule, since the right level depends on the industry.

Answer: D

Correct answer: inventory from the numerator

Inventory is the least liquid of the current assets: it must be sold before it becomes a receivable and collected before it becomes cash, and in a difficulty it may not sell at all. Removing it gives a stricter test, which is why the quick ratio matters most for a business carrying slow-moving stock.

Answer: A

Resources sitting in cash or stock earn little, so an unusually high ratio can be a sign of poor asset management rather than of strength. Ratios have to be read against a norm and in both directions, not simply maximised.

Answer: B

Correct answer: how far the firm is financed by borrowing

Debt to equity is the gearing measure, comparing what has been borrowed with what the owners have put in. High gearing magnifies the return to the owners when things go well and magnifies the loss when they do not, and it is the fixed interest obligation that makes the difference dangerous.

Answer: C

Correct answer: operating profit divided by interest charge

Interest cover asks how many times over the profit would pay the interest, so a cover of six means profit could fall by more than four fifths before the interest became unaffordable. It is the flow counterpart of the debt to equity ratio, which measures the stock of debt rather than the burden of servicing it.

Answer: D

Whatever the assets earn above the interest rate accrues entirely to the owners, and whatever they earn below it is borne entirely by them. The effect works in both directions, which is exactly what makes leverage risky.

Answer: A

Correct answer: average inventory

Turnover is the number of times the stock is sold and replaced in the year, and it is computed on cost because inventory is carried at cost - using sales revenue would mix a figure including margin with one excluding it. The average is used rather than the closing figure because stock varies through the year.

Answer: B

Correct answer: receivables divided by daily credit sales

Dividing the amount owed by the sales made per day gives the number of days of sales that remain uncollected, which is the collection period. Only credit sales belong in the denominator, since cash sales never become receivables, and the result is compared with the terms actually offered.

Answer: C

It shows how intensively the asset base is being used, and it differs enormously between a retailer and a steelworks. Multiplying it by the profit margin gives the return on assets, which is the beginning of the DuPont decomposition.

Answer: D

Correct answer: net profit divided by total assets

Return on assets asks what the whole capital employed earned, irrespective of who supplied it, so it measures operating performance without regard to financing. Return on equity is the corresponding figure for the owners alone, and the gap between the two is what gearing produces.