Finance for Non-Finance Managers Financial Ratios 2 — Questions and Answers
Question 1: A company has a debt-to-equity ratio of 2.5. What does this indicate?
- The company has $2.50 in equity for every $1 of debt
- The company has $2.50 in debt for every $1 of equity (Correct answer)
- The company's assets are worth 2.5 times its liabilities
- The company earns $2.50 profit per dollar of equity
Correct answer: The company has $2.50 in debt for every $1 of equity
A debt-to-equity ratio of 2.5 means the company carries $2.50 of debt for every $1 of shareholder equity, indicating relatively high financial leverage.
Question 2: Which ratio best measures how efficiently a company collects payments from its customers?
- Inventory turnover ratio
- Accounts receivable turnover ratio (Correct answer)
- Asset turnover ratio
- Current ratio
Correct answer: Accounts receivable turnover ratio
The accounts receivable turnover ratio measures how many times a company collects its average receivables balance during a period, reflecting collection efficiency.
Question 3: If a firm's gross profit margin is 40% and its net profit margin is 8%, what can you conclude?
- Operating and other expenses consume 32% of revenue (Correct answer)
- The company is losing money after taxes
- The company's COGS equals 60% of gross profit
- The company has very low revenue
Correct answer: Operating and other expenses consume 32% of revenue
The 32-percentage-point gap between gross margin (40%) and net margin (8%) represents operating expenses, interest, and taxes consuming that portion of revenue.
Question 4: What does a price-to-earnings (P/E) ratio of 20 mean for a stock priced at $40?
- Investors pay $20 for every $1 of book value
- The company earns $20 per share annually
- Investors pay $40 for $2 of annual earnings per share (Correct answer)
- The stock will double in 20 years
Correct answer: Investors pay $40 for $2 of annual earnings per share
A P/E of 20 with a $40 stock price implies earnings per share of $2, meaning investors pay $40 for $2 of annual earnings.
Question 5: A company's days payable outstanding (DPO) increases from 30 to 45 days. This generally means the company is:
- Paying suppliers faster than before
- Taking longer to pay its suppliers, improving short-term cash flow (Correct answer)
- Collecting receivables more slowly
- Increasing its inventory levels
Correct answer: Taking longer to pay its suppliers, improving short-term cash flow
A higher DPO means the company is delaying supplier payments longer, which keeps cash on hand longer and improves short-term liquidity.
Question 6: Which of the following would DECREASE a company's current ratio?
- Collecting an outstanding receivable
- Purchasing inventory with a long-term loan
- Paying off a short-term loan with cash
- Using short-term debt to pay a long-term obligation (Correct answer)
Correct answer: Using short-term debt to pay a long-term obligation
Converting a long-term liability into a short-term one increases current liabilities without changing current assets, which lowers the current ratio.
Question 7: Return on equity (ROE) is best described as:
- Net income divided by total assets
- Net income divided by shareholders' equity (Correct answer)
- Operating income divided by total revenue
- Total revenue divided by number of shares outstanding
Correct answer: Net income divided by shareholders' equity
ROE measures how much profit a company generates for each dollar of shareholder equity by dividing net income by shareholders' equity.
Finance for Non-Finance Managers Financial Ratios 2
A company has a debt-to-equity ratio of 2.5.
What does this indicate?