Finance for Non-Finance Managers Financial Ratios 3 — Questions and Answers
Question 1: The interest coverage ratio is calculated as:
- Net income divided by interest expense
- EBIT divided by interest expense (Correct answer)
- Total debt divided by annual interest payments
- Operating cash flow divided by total liabilities
Correct answer: EBIT divided by interest expense
The interest coverage ratio equals Earnings Before Interest and Taxes (EBIT) divided by interest expense, showing how many times the company can cover its interest payments.
Question 2: A retailer's inventory turnover ratio drops from 12 to 6 over one year. The most likely concern is:
- The company is selling goods too quickly
- Inventory is moving slower, possibly due to weak sales or overstocking (Correct answer)
- The company's gross margin is improving
- Accounts receivable are increasing
Correct answer: Inventory is moving slower, possibly due to weak sales or overstocking
A falling inventory turnover ratio suggests goods are sitting longer before being sold, which may indicate weakening demand or excess inventory buildup.
Question 3: Which financial ratio is most useful for comparing companies across different industries?
- Debt-to-equity ratio
- EV/EBITDA ratio (Correct answer)
- Accounts payable days
- Working capital ratio
Correct answer: EV/EBITDA ratio
EV/EBITDA removes the effects of capital structure, taxes, and depreciation policies, making it more comparable across industries than most other ratios.
Question 4: If net income is $500,000 and average shareholders' equity is $2,000,000, what is the ROE?
- 4%
- 25% (Correct answer)
- 40%
- 0.25%
Correct answer: 25%
ROE = Net Income / Shareholders' Equity = $500,000 / $2,000,000 = 25%, indicating a 25-cent profit per dollar of equity invested.
Question 5: A company reports operating cash flow of $800,000 and capital expenditures of $300,000. Its free cash flow is:
- $1,100,000
- $800,000
- $500,000 (Correct answer)
- $300,000
Correct answer: $500,000
Free cash flow = Operating cash flow − Capital expenditures = $800,000 − $300,000 = $500,000, representing cash available after maintaining or expanding assets.
Question 6: The quick ratio differs from the current ratio primarily because the quick ratio:
- Uses total assets instead of current assets
- Excludes inventory from current assets (Correct answer)
- Includes long-term investments
- Divides by total liabilities instead of current liabilities
Correct answer: Excludes inventory from current assets
The quick ratio excludes inventory (and sometimes prepaid expenses) from current assets because inventory cannot always be quickly converted to cash.
Question 7: A firm's asset turnover ratio is 1.8. This means:
- The firm earns $1.80 profit for every $1 of assets
- The firm generates $1.80 in revenue for every $1 of total assets (Correct answer)
- The firm's assets depreciate at $1.80 per year
- The firm replaces its assets 1.8 times per year
Correct answer: The firm generates $1.80 in revenue for every $1 of total assets
Asset turnover = Revenue / Total Assets, so a ratio of 1.8 means the company generates $1.80 in sales for each dollar of assets it holds.
Finance for Non-Finance Managers Financial Ratios 3
The interest coverage ratio is calculated as: