Chapter 8

Question 1

What are financial ratios?

Answer 1

Relationships between certain items on the income statement and balance sheet.

Question 2

Define Earning Power

Answer 2

The ability of a company to generate income.

Question 3

Define liquidity.

Answer 3

The ability of a company to meet its current obligations.

Question 4

Define solvency

Answer 4

The ability of a company to meet its long-term obligations.

Question 5

What are the three common financial ratios used to determine earning power?

Answer 5

Earnings per share
Return on Equity
Common Size comparative statements.

Question 6

Define earnings per share.

Answer 6

Data used to evaluate the past performance of a business, project its future earnings, and weigh investment opportunities

Question 7

How do investors use earnings per share?

Answer 7

They compare it and share price for publically traded companies.

Question 8

Define return on equity.

Answer 8

The rate of return on the common stockholder’s equity.

Question 9

What is a common size comparative statement?

Answer 9

A statement assigning net sales as 100% value and then expressing each income statement item as a percentage of net sales.

Question 10

How is liquidity measured?

Answer 10

It is measured by analyzing the strength of its working capital. (current ratio)
Working capital is the excess of its current assets over its liability’s

Question 11

What is current ratio?

Answer 11

It is the relationship of a companies current assets to its current liabilities.

Question 12

What is the acid test (or quick) ratio?

Answer 12

The ratio of quick assets to liabilities.

Question 13

What are quick assets?

Answer 13

Current assets that can be quickly turned into cash-cash, notes receivable, accounts receivable, and market securities.

Question 14

How is days sales uncollected calculated?

Answer 14

Average daily sales=Total sales/365

Days sales uncollected=accounts receivable balance/average daily sales.

Question 15

Define inventory turnover.

Answer 15

The number of times average inventory is sold during an accounting period.

Question 16

What does high inventory turnover indicate?

Answer 16

It indicates good merchandizing.

Question 17

How is merchandise inventory turnover calculated?

Answer 17

merchandise inventory turnover=cost of goods sold/average inventory

Question 18

What is debt service ratio?

Answer 18

The number of times that debt service can be paid from income.
Debt service is the principle and interest paid on a mortgage or other debt.

Question 19

Why and how is debt service ratio calculated?

Answer 19

It is calculated to measure the security of the return offered to bondholders or a mortgage holder.
Debt ratio=(income before taxes + interest expense)/debt service
Ratio should be 2:1 or greater

Question 20

What is leverage ratio and how is it calculated?

Answer 20

leverage ratio the relationship between liabilities and fixed assets.
leverage ratio=mortgage payable/book value of assets

Question 21

What is return on fixed assets and how is it calculated?

Answer 21

return on fixed assets=income before debt service/average fixed assets
Used to measure management’s performance

Question 22

What is an audit and when is it commonly required?

Answer 22

It is a formal review of an organizations financial records.
They are required for publically traded companies by the SEC, by lenders, or by large corporations with subsidiaries or branch offices.

Question 23

Define earning power, liquidity, and solvency.

Answer 23

earning power-the ability to generate income
liquidity-the ability to meet current obligations
solvency-the ability to meet long-term obligations

Question 24

Explain current ratio.

Answer 24

It is the relationship between a companies current assets and liabilities.
It is calculated by dividing current assets by current liabilities.
The higher the ratio the more liquid the company’s current position

Question 25

What is debt service ratio?

Answer 25

It is the number of times debt service can be paid from income.

Question 26

Why is return on fixed assets a measure of management’s performance?

Answer 26

Fixed assets are used to earn profit and management is responsible for how assets are used, therefore the return on fixed assets measures performance

Question 27

Which set of ratios measures the ability of a firm to meet its long-term obligations?

a) earnings power
b) liquidity
c) solvency
d) profitability

Answer 27

c) solvency

Question 28

When financial statement items are shown as a percentage of a total, the resulting comparison is known as a(n):

a) prior year comparison
b) industry comparison
c) budget comparison
d) common-size comparison

Answer 28

d)common-size comparison

Question 29

Which is considered an adequate acid test ratio (quick test)?

a) 1 to 1
b) 2 to 1
c) 3 to 1
d) 5 to 1

Answer 29

a) 1 to 1

Question 30

The ratio that indicates management’s ability to make its mortgage payment is called:

a) debt service ratio
b) leverage ratio
c) current ratio
d) return on equity

Answer 30

a) debt service ratio

Question 31

Audited financial statements are always required by which entity?

a) the Securities and Exchange Commission
b) the lending bank
c) the internal audit department
d) the owner

Answer 31

a) the Securities and Exchange Commission