CCP Ratio Analysis & Cash Flow 3 — Questions and Answers
Question 1: The acid-test (quick) ratio differs from the current ratio primarily because it:
- Excludes long-term liabilities from the denominator
- Excludes inventory and prepaid expenses from current assets (Correct answer)
- Includes all non-current assets in the numerator
- Replaces current liabilities with total debt
Correct answer: Excludes inventory and prepaid expenses from current assets
The quick ratio excludes inventory and prepaid expenses from current assets because these are less liquid and may not be quickly convertible to cash.
Question 2: When analyzing a manufacturer's cash conversion cycle (CCC), which formula is correct?
- DIO + DSO − DPO (Correct answer)
- DSO + DPO − DIO
- DIO − DSO + DPO
- DPO + DIO + DSO
Correct answer: DIO + DSO − DPO
The cash conversion cycle equals Days Inventory Outstanding plus Days Sales Outstanding minus Days Payable Outstanding, measuring the net days to convert investments into cash.
Question 3: A company's gross profit margin declined from 42% to 31% over two years while revenue grew. A credit analyst should first investigate:
- Whether the company is under-investing in capital expenditures
- Rising cost of goods sold relative to revenue, possibly from input cost pressure or pricing erosion (Correct answer)
- Whether accounts payable days have shortened
- The company's dividend payout policy
Correct answer: Rising cost of goods sold relative to revenue, possibly from input cost pressure or pricing erosion
A declining gross margin despite revenue growth typically signals rising input costs, commoditization, or competitive pricing pressure on the core business.
Question 4: Under IFRS, interest paid may be classified in the cash flow statement as:
- Only operating activities
- Only financing activities
- Either operating or financing activities (Correct answer)
- Either investing or financing activities
Correct answer: Either operating or financing activities
IFRS allows interest paid to be classified as either operating or financing activities, providing more flexibility than US GAAP which requires operating classification.
Question 5: A company with a return on equity (ROE) of 22% and a return on assets (ROA) of 8% is most likely:
- Minimally leveraged with strong asset efficiency
- Using significant financial leverage to amplify equity returns (Correct answer)
- Carrying no long-term debt on its balance sheet
- Experiencing declining profitability trends
Correct answer: Using significant financial leverage to amplify equity returns
When ROE substantially exceeds ROA, it indicates the company is using debt (financial leverage) to boost returns to equity holders beyond what assets alone generate.
Question 6: Days payable outstanding (DPO) of 90 days compared to an industry average of 35 days most likely suggests a company is:
- Efficiently managing its working capital by paying suppliers quickly
- Stretching supplier payments, which may strain vendor relationships (Correct answer)
- Experiencing rapid inventory turnover
- Aggressively collecting from customers
Correct answer: Stretching supplier payments, which may strain vendor relationships
A DPO far above the industry average indicates the company is delaying supplier payments significantly, which may improve short-term liquidity but risks supply chain disruption.
Question 7: Which of the following would INCREASE a company's operating cash flow without affecting net income?
- A decrease in accounts payable
- An increase in depreciation expense (Correct answer)
- An increase in accounts receivable
- A decrease in accrued liabilities
Correct answer: An increase in depreciation expense
Depreciation is a non-cash expense that reduces net income but is added back in the indirect method, so an increase in depreciation raises operating cash flow without changing cash net income.
CCP Ratio Analysis & Cash Flow 3
The acid-test (quick) ratio differs from the current ratio primarily because it: