CAT Financial Statement Analysis 3 — Questions and Answers
Question 1: A company has total debt of $500,000 and total equity of $250,000. What is its debt-to-equity ratio?
- 0.5
- 1.0
- 2.0 (Correct answer)
- 3.0
Correct answer: 2.0
Debt-to-equity ratio = Total Debt / Total Equity = $500,000 / $250,000 = 2.0, indicating $2 of debt for every $1 of equity.
Question 2: Which section of the statement of cash flows reflects the purchase of equipment?
- Operating activities
- Investing activities (Correct answer)
- Financing activities
- Non-cash supplemental disclosures
Correct answer: Investing activities
Purchasing equipment is a capital expenditure recorded under investing activities, as it involves acquiring long-term assets.
Question 3: What does a price-to-earnings (P/E) ratio measure?
- How many times a company's earnings cover its interest expense
- The market price investors are willing to pay per dollar of earnings (Correct answer)
- The ratio of dividends paid to net income
- The relationship between stock price and book value
Correct answer: The market price investors are willing to pay per dollar of earnings
The P/E ratio = Market Price per Share / Earnings per Share, indicating how much investors pay for each dollar of the company's earnings.
Question 4: When FIFO inventory method is used during a period of rising prices, compared to LIFO, the income statement will show:
- Lower gross profit
- Higher cost of goods sold
- Higher gross profit (Correct answer)
- The same net income
Correct answer: Higher gross profit
Under FIFO during rising prices, older (cheaper) costs are matched against revenue, leaving higher gross profit compared to LIFO which uses newer, costlier units first.
Question 5: Earnings before interest, taxes, depreciation, and amortization (EBITDA) is used primarily to assess:
- A company's net worth
- Operating cash-generating ability independent of financing and accounting decisions (Correct answer)
- The company's tax burden
- Working capital efficiency
Correct answer: Operating cash-generating ability independent of financing and accounting decisions
EBITDA strips out interest, taxes, and non-cash charges to provide a measure of core operating performance and approximate operating cash flow.
Question 6: A company's acid-test (quick) ratio is calculated using:
- Cash + Marketable Securities + Inventory divided by Current Liabilities
- Cash + Marketable Securities + Net Receivables divided by Current Liabilities (Correct answer)
- Total Current Assets divided by Total Current Liabilities
- Net Income divided by Total Equity
Correct answer: Cash + Marketable Securities + Net Receivables divided by Current Liabilities
The quick ratio uses only the most liquid current assets (cash, short-term investments, and net receivables) divided by current liabilities, excluding inventory and prepaid expenses.
Question 7: What does a declining gross profit margin over multiple periods most likely signal?
- Improved operational efficiency
- Rising revenues outpacing cost growth
- Increasing cost of production relative to sales prices (Correct answer)
- Reduced selling and administrative expenses
Correct answer: Increasing cost of production relative to sales prices
A falling gross profit margin indicates that cost of goods sold is rising faster than revenue, reflecting pricing pressure, higher input costs, or both.
CAT Financial Statement Analysis 3
A company has total debt of $500,000 and total equity of $250,000.
What is its debt-to-equity ratio?