FA Financial Reporting & Analysis 2 — Questions and Answers
Question 1: What does the current ratio measure?
- A company's ability to pay long-term debt obligations
- A company's ability to meet short-term obligations using current assets (Correct answer)
- A company's profitability relative to total assets
- A company's efficiency in collecting receivables
Correct answer: A company's ability to meet short-term obligations using current assets
The current ratio (current assets ÷ current liabilities) measures a company's short-term liquidity and ability to pay near-term obligations.
Question 2: If a company's accounts receivable turnover is 8, what is the approximate average collection period (days sales outstanding)?
- 8 days
- 45.6 days (Correct answer)
- 32 days
- 73 days
Correct answer: 45.6 days
Days Sales Outstanding = 365 ÷ Accounts Receivable Turnover = 365 ÷ 8 ≈ 45.6 days.
Question 3: Which profitability ratio measures how effectively a company uses its total assets to generate net income?
- Return on Equity (ROE)
- Net Profit Margin
- Return on Assets (ROA) (Correct answer)
- Gross Profit Margin
Correct answer: Return on Assets (ROA)
Return on Assets (ROA) = Net Income ÷ Total Assets, directly measuring asset efficiency in generating profit.
Question 4: The quick ratio differs from the current ratio primarily by excluding which asset?
- Cash and cash equivalents
- Accounts receivable
- Inventory (Correct answer)
- Short-term marketable securities
Correct answer: Inventory
The quick ratio excludes inventory because it is the least liquid current asset and may not be quickly converted to cash.
Question 5: Under DuPont analysis, Return on Equity (ROE) is decomposed into which three components?
- Profit margin × Asset turnover × Equity multiplier (Correct answer)
- Gross margin × Asset turnover × Debt ratio
- Net income × Total assets × Equity
- Operating margin × Revenue growth × Leverage ratio
Correct answer: Profit margin × Asset turnover × Equity multiplier
The DuPont formula breaks ROE into Net Profit Margin × Asset Turnover × Equity Multiplier, revealing the drivers of shareholder returns.
Question 6: Which of the following best describes the debt-to-equity ratio?
- Total assets divided by total equity
- Total liabilities divided by total equity (Correct answer)
- Long-term debt divided by total assets
- Interest expense divided by total debt
Correct answer: Total liabilities divided by total equity
The debt-to-equity ratio compares total liabilities to shareholders' equity, indicating how much the company is financed by creditors versus owners.
Question 7: A price-to-earnings (P/E) ratio of 20 most accurately means that:
- Investors are paying $20 for every $1 of annual earnings (Correct answer)
- The company earns $20 for every dollar of equity invested
- The stock price is 20% above its book value
- Earnings are growing at 20% per year
Correct answer: Investors are paying $20 for every $1 of annual earnings
A P/E of 20 means the market price is 20 times the earnings per share, so investors pay $20 for each $1 of current earnings.
FA Financial Reporting & Analysis 2
What does the current ratio measure?