D366 Financial Statement Analysis - Set 3 - Part 1

Correct Answer: Current assets divided by current liabilities

The current ratio equals current assets divided by current liabilities. It measures a company's ability to cover short-term obligations with short-term assets; a ratio above 1.0 indicates current assets exceed current liabilities.

Correct Answer: 2.0

The current ratio equals $300,000 divided by $150,000, which is 2.0. This means the company has $2 of current assets for every $1 of current liabilities.

Correct Answer: Inventory and prepaid expenses

The quick ratio excludes inventory and prepaid expenses from current assets because they are less liquid and cannot always be converted to cash quickly. It provides a stricter measure of short-term liquidity.

Correct Answer: Potentially unable to cover current liabilities without selling inventory

A quick ratio below 1.0 means the company's most liquid assets do not fully cover its current liabilities, suggesting it may need to sell inventory or raise funds to meet short-term obligations.

Correct Answer: The proportion of financing from creditors relative to owners

The debt-to-equity ratio compares total liabilities to shareholders' equity, showing how much of the company is financed by creditors versus owners. A higher ratio indicates greater financial leverage and risk.

Correct Answer: Times interest earned ratio

The times interest earned ratio (EBIT divided by interest expense) shows how many times a company can cover its interest obligations with operating earnings. A higher ratio indicates a greater ability to service debt.

Correct Answer: Meet short-term obligations

Liquidity ratios, such as the current and quick ratios, measure a company's ability to meet short-term obligations as they come due using its most readily available assets.

Correct Answer: Meet its long-term debt obligations

Solvency ratios evaluate a company's ability to meet long-term obligations and remain financially viable over time. They focus on capital structure and the relationship between debt and equity or assets.

Correct Answer: Cash and cash equivalents relative to current liabilities

The cash ratio divides cash and cash equivalents (plus sometimes marketable securities) by current liabilities. It is the strictest liquidity test because it ignores receivables and inventory.

Correct Answer: 60% of the company's assets are financed by debt

The debt ratio equals total liabilities divided by total assets. A ratio of 0.60 means 60% of the company's assets are financed with debt, with the remaining 40% financed by equity.

Correct Answer: 2.0

The debt-to-equity ratio equals total liabilities divided by total equity: $400,000 divided by $200,000 equals 2.0. The company uses $2 of debt for every $1 of equity.

Correct Answer: Current assets minus current liabilities

Net working capital equals current assets minus current liabilities. Positive working capital indicates the company has enough short-term assets to cover its short-term obligations.

Correct Answer: Using long-term financing to increase current assets

Using long-term financing to increase current assets raises current assets without increasing current liabilities, improving the current ratio. Paying a current liability with cash reduces both equally, and buying inventory on short-term credit raises both.

Correct Answer: Total assets divided by total equity

The equity multiplier equals total assets divided by total equity. It measures financial leverage: a higher multiplier means the company relies more heavily on debt to finance its assets.

Correct Answer: 4 times

Times interest earned equals $600,000 divided by $150,000, which is 4 times. The company earns four times its interest expense, indicating a comfortable ability to cover interest payments.

Correct Answer: Depreciation and amortization

The cash coverage ratio adds non-cash expenses like depreciation and amortization back to EBIT, then divides by interest expense. This better reflects the cash actually available to cover interest payments.

Correct Answer: Deteriorating short-term liquidity

A steadily declining current ratio suggests the company's ability to cover short-term obligations with current assets is weakening, which may signal growing liquidity risk that warrants further investigation.

Correct Answer: Debt-to-total-assets ratio

The debt-to-total-assets ratio is a solvency measure describing long-term capital structure. The quick, current, and cash ratios all measure short-term liquidity.

Correct Answer: Inefficiently using its current assets

A very high current ratio can indicate that a company holds excessive cash, receivables, or inventory that is not being deployed productively, suggesting inefficient use of current assets rather than a liquidity problem.

Correct Answer: Total debt plus total equity

The debt-to-capital ratio equals total debt divided by total capital (total debt plus total equity). It shows the proportion of a company's capital structure that comes from debt financing.