FAC Financial Statement Analysis 2 — Questions and Answers
Question 1: A company's current ratio is 2.5 and its quick ratio is 0.8. What does this disparity most likely indicate?
- The company has high inventory levels relative to current liabilities (Correct answer)
- The company is highly profitable
- The company has excessive cash balances
- The company's accounts receivable turnover is very high
Correct answer: The company has high inventory levels relative to current liabilities
A large gap between the current ratio and quick ratio indicates significant inventory in current assets, since inventory is excluded from the quick ratio.
Question 2: Which financial statement best reveals a company's ability to generate cash from its core operations?
- Balance sheet
- Income statement
- Statement of cash flows — operating section (Correct answer)
- Statement of stockholders' equity
Correct answer: Statement of cash flows — operating section
The operating section of the cash flow statement shows cash generated or used by core business activities, independent of accrual adjustments.
Question 3: When a company uses LIFO instead of FIFO during a period of rising prices, what is the effect on its reported net income?
- Net income is higher under LIFO
- Net income is lower under LIFO (Correct answer)
- Net income is unaffected by inventory method
- Net income is only affected if inventory is sold
Correct answer: Net income is lower under LIFO
Under LIFO during rising prices, cost of goods sold is higher (most recent, costlier units sold first), reducing gross profit and net income.
Question 4: The DuPont analysis decomposes return on equity (ROE) into which three components?
- Gross margin, asset turnover, and financial leverage
- Net profit margin, asset turnover, and equity multiplier (Correct answer)
- Operating margin, inventory turnover, and debt ratio
- Revenue growth, operating leverage, and tax rate
Correct answer: Net profit margin, asset turnover, and equity multiplier
DuPont analysis breaks ROE into net profit margin × asset turnover × equity multiplier (financial leverage).
Question 5: A negative operating cash flow combined with positive net income most likely suggests:
- The company is collecting receivables faster than expected
- Significant non-cash revenues or working capital build-up consuming cash (Correct answer)
- The company has repaid long-term debt during the period
- Depreciation expense exceeds capital expenditures
Correct answer: Significant non-cash revenues or working capital build-up consuming cash
Positive net income with negative operating cash flow often signals non-cash revenue recognition or a growing investment in working capital that drains cash.
Question 6: Which ratio measures how efficiently a company collects its credit sales?
- Inventory turnover
- Accounts receivable turnover (Correct answer)
- Payables turnover
- Asset turnover
Correct answer: Accounts receivable turnover
Accounts receivable turnover (net credit sales ÷ average accounts receivable) measures how quickly a company collects amounts owed by customers.
Question 7: Under common-size income statement analysis, each line item is expressed as a percentage of:
- Total assets
- Net income
- Net revenues (sales) (Correct answer)
- Gross profit
Correct answer: Net revenues (sales)
In a common-size income statement, every line item is stated as a percentage of net revenues, enabling comparisons across periods or companies of different sizes.
FAC Financial Statement Analysis 2
A company's current ratio is 2.5 and its quick ratio is 0.8.
What does this disparity most likely indicate?