Financial Ratios

Question 1

What liquidity ratio interprets?

Answer 1

Liquidity ratios are a group of financial metrics that measure a company’s ability to pay off its short-term debts as they come due.

Question 2

What does a high liquidity ratio indicates?

Answer 2

High liquidity ratio indicates that a company has a strong ability to pay its debts, while a low ratio suggests the opposite.

Question 3

What is the working capital?

Answer 3

Working capital is a financial metric that measures a company’s short-term liquidity and efficiency.

Question 4

What is the formula for working capital?

Answer 4

calculated as the difference between a company’s current assets and its current liabilities.

Question 5

What does negative working capital indicates?

Answer 5

.A negative working capital suggests that a company may have difficulty paying its short-term debts.

Question 6

What are the Key Liquidity Measures?

Answer 6

Commonly used to assess a company’s short-term financial health and its ability to meet its obligations:

> Current Ratio
Quick Ratio
Cash Ratio
Days Sales Outstanding (DSO)
Inventory Turnover
Days Payable Outstanding (DPO

Question 7

What does current ratio interprets?

Answer 7

measures a company’s ability to pay its short-term debts as they come due

Question 8

What does high current ratio implies?

Answer 8

A high current ratio generally implies that a company has a strong ability to pay its short-term debts as they come due. A current ratio that is higher than 1 means that a company has more current assets than current liabilities, indicating that it has sufficient resources to meet its short-term financial obligations.

Question 9

What are the marketable securities?

Answer 9

Marketable securities are financial instruments that can be easily converted into cash and have a readily determinable value. They are typically used by companies and investors to manage risk and liquidity.

Question 10

Give example of marketable securities

Answer 10

> Stocks
Bonds
Money market instruments
Mutual Funds
Exchange- traded funds

Question 11

What is operating cycle?

Answer 11

Time it takes to go from the receipt of inventory to the sale of inventory on account to the receipt of cash from the customer.

Question 12

What happens to current and quick ratio when cash and account receivable increase?

Answer 12

There will be increases in the current ratio and the quick ratio.

Question 13

What happens when inventory and prepaid expenses increases?

Answer 13

Improve the current ratio, but not the quick ratio and cash ratio.

Question 14

What happens when liability increases?

Answer 14

This will decrease all three of the ratios.

Question 15

Why are financial ratios an effective method for analyzing company performance?

Answer 15

Ratios measure relationships between components in financial statements and can show changes over time. They are easy to understand and can be visualized for performance comparison to other companies and industry averages.

Question 16

What is solvency?

Answer 16

Solvency is a company’s ability to meet its short-term and long-term financial obligations for survival over time

Question 17

Two primary factors that contribute to business risk are:

Answer 17

Sales volatility and the degree of operating leverage are primary contributors to business risk.

Question 18

All else being equal, a firm’s sensitivity to swings in the business cycle is higher when:

Answer 18

The higher the percentage of a firm’s costs that are fixed, the higher the operating leverage, and the greater the firm’s business risk and the more susceptible it is to business cycle fluctuations.

Question 19

The uncertainty in return on assets due to the nature of a firm’s operations is known as:

Answer 19

Business risk is a function of the firm’s revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage.

Question 20

Successful use of financial leverage is evidenced by a:

Question 21

Successful use of financial leverage is evidenced by a:

Answer 21

Financial leverage results from the use of fixed-cost debt securities in the capital structure of an entity. Successful use of leverage (favorable leverage) results when invested funds earn more than the cost of borrowing the funds.

Question 22

Which of the following is a key determinant of operating leverage?

Answer 22

Operating leverage can be defined as the tradeoff between variable and fixed costs. It determines the contribution margin that can be used to pay fixed costs. (Contribution margin = sales – variable costs. So, contribution ÷ sales = contribution margin ratio.)

Question 23

The company that is most likely to have lost sales due to an inventory shortage is:

Answer 23

Companies with high inventory turnover or low days in inventory are more likely to lose sales due to a lack of inventory because they carry relatively little inventory.

Question 24

Which of the following will occur if a company shortens its collection period?

Answer 24

as collection period decreases, accounts receivable turnover increases

Question 25

The cash conversion cycle is the:

Answer 25

sum of the time it takes to sell inventory and collect on accounts receivable, less the time it takes to pay for credit purchases.

Question 26

What are Market Value Ratios?

Answer 26

Market Value Ratios show how much investors value a publicly traded company using both accounting and stock market data. There are two types: Market-to-Book Ratio and Price/Earnings Ratio (P/E).

Question 27

What is the interpretation of Market-to-Book Ratio?

Answer 27

Market-to-Book Ratio shows how much a company is worth compared to the investment made by stockholders. A high ratio indicates high expectations for the company’s growth potential.

Question 28

What is the interpretation of Book Value?

Answer 28

Book Value is the net assets owned by common stockholders, but it may not reflect the actual market value of the company due to accounting methods and management assumptions. Book Value is useful for financial and manufacturing companies with high cash or fixed assets.

Question 29

What is the interpretation of Price/Earnings Ratio?

Answer 29

The P/E Ratio is a way for investors to evaluate a company’s future earnings potential. A high P/E Ratio suggests that the company has growth potential or stable earnings, making it more valuable. Comparing a company’s P/E Ratio to the industry average or similar firms is appropriate.

Question 30

The price-earnings ratio is a ___________________ ratio that will ___________________ when the market price per share of stock increases.

Answer 30

profitability; increase

Question 31

When the market price per share of a firm’s stock decreases but the firm’s earnings remain constant, the firm’s price-earnings ratio will _______, which suggests that investors expect the firm’s profitability to _______.

Answer 31

decrease; decrease

Question 32

Which ratio must be calculated using an amount external to a company’s financial statements?

Answer 32

Price-earnings ratio

Question 33

Grid Corp. acquired some of its own common shares at a price greater than both their par value and original issue price but less than their book value. Grid uses the cost method of accounting for Treasury stock. What is the impact of this acquisition on total stockholders’ equity and the book value per common share, respectively?

Answer 33

When a company buys its own stock (Treasury stock), its total stockholders’ equity decreases by the cost of the stock. The cost method records Treasury stock at cost and lists it as a contra-account in stockholders’ equity. Treasury stock is issued but not considered outstanding. Book value per common share is calculated based on outstanding shares only (excluding Treasury stock). If Treasury stock is acquired at a price lower than its book value, the book value per common share increases as the remaining outstanding shares receive the benefit of the excess book value.

Question 34

What is earnings per share, and how is it calculated?

Answer 34

Earnings per share (EPS) is a financial metric that represents the net income earned on each outstanding share of common stock.

Question 35

Why is diluted earnings per share lower than basic earnings per share?

Answer 35

Diluted earnings per share is lower than basic earnings per share because it includes potentially dilutive securities, such as convertible bonds, warrants, preferred stock, and stock options, that could increase the number of outstanding shares.

Question 36

What are the four sources of dilution for diluted earnings per share?

Answer 36

The four sources of dilution for diluted earnings per share are stock options, stock warrants, convertible bonds, and convertible preferred stock.

Question 37

What adjustments are made when calculating diluted earnings per share?

Answer 37

Adjustments made when calculating diluted earnings per share include using the “if-converted” method to account for potentially dilutive securities, such as increasing the weighted average common shares outstanding amount and increasing the net income numerator by the amount of after-tax interest saved.

Question 38

When are stock options antidilutive?

Answer 38

Stock options are antidilutive when the exercise price is greater than the average stock price, as the holder would be able to purchase the stock at a lower price on the open market.

Question 39

How is Diluted EPS calculated?

Answer 39

Diluted EPS is calculated by dividing the adjusted net income, which includes the impact of all potentially dilutive securities, by the weighted average number of shares outstanding, including all potential dilutive securities.

Question 40

What is the impact of converted bonds on net income?

Answer 40

The conversion of bonds into shares has an impact on net income, as the interest expense on the bonds needs to be adjusted to an after-tax amount that is added back to net income.

Question 41

What is earnings yield?

Answer 41

Earnings yield is the percentage of a dollar invested that was earned by the company and is calculated by dividing EPS by the market price per share.

Question 42

How is dividend yield calculated?

Answer 42

Dividend yield is calculated by dividing the annual dividend per share by the market price per share and represents the yield from the dividend payment.

Question 43

What is dividend payout ratio?

Answer 43

Dividend payout ratio represents the percentage of earnings that was paid out in dividends to common stockholders and is calculated by dividing common dividends by earnings available to common shareholders.

Question 44

How is shareholder return calculated?

Answer 44

Shareholder return is calculated as the percentage increase in stock price plus the annual dividend per share divided by the beginning stock price.

Question 45

What should be considered when assessing dividend payout and yield?

Answer 45

When assessing dividend payout and yield, it is important to consider that most companies are reluctant to cut dividends, even if there is an earnings shortfall, and that the amount of dividends, and whether they are paid or not, are at the discretion of the board of directors.