Finance for Non-Finance Managers Financial Ratios 4 — Questions and Answers
Question 1: Which of these scenarios would improve a company's debt-to-assets ratio?
- Taking on additional long-term debt to buy equipment
- Repaying a bank loan using retained earnings (Correct answer)
- Issuing new shares but also borrowing an equal amount
- Writing off obsolete inventory
Correct answer: Repaying a bank loan using retained earnings
Repaying debt with retained earnings reduces total liabilities while total assets may decrease proportionally less, lowering the debt-to-assets ratio.
Question 2: A company's receivables days outstanding (DSO) increases from 30 to 55 days. A manager should be concerned because:
- Customers are paying faster than expected
- Cash is being collected more slowly, tying up working capital (Correct answer)
- The company's revenue has decreased significantly
- The company's inventory is increasing
Correct answer: Cash is being collected more slowly, tying up working capital
Rising DSO means customers are taking longer to pay, which delays cash inflows and can create working capital pressure.
Question 3: The DuPont analysis decomposes ROE into three components. Which set correctly represents these components?
- Gross margin, asset turnover, equity multiplier
- Net profit margin, asset turnover, equity multiplier (Correct answer)
- Operating margin, current ratio, debt-to-equity
- Net income, total assets, total equity
Correct answer: Net profit margin, asset turnover, equity multiplier
DuPont analysis breaks ROE into net profit margin (profitability) × asset turnover (efficiency) × equity multiplier (leverage), revealing the drivers of shareholder returns.
Question 4: A company has an interest coverage ratio of 1.2. This is a warning sign because:
- The company is earning too much compared to its interest expense
- The company barely earns enough to cover its interest payments, leaving little buffer (Correct answer)
- The ratio indicates the company has no debt
- The company's equity is undervalued
Correct answer: The company barely earns enough to cover its interest payments, leaving little buffer
An interest coverage ratio just above 1.0 means operating earnings barely exceed interest obligations, signaling financial stress and limited capacity to absorb downturns.
Question 5: Which ratio would a bank most likely focus on when deciding whether to extend additional credit to a business?
- Price-to-earnings ratio
- Debt service coverage ratio (Correct answer)
- Dividend payout ratio
- Price-to-book ratio
Correct answer: Debt service coverage ratio
The debt service coverage ratio (DSCR) measures whether operating income is sufficient to cover all debt payments, which is the key question lenders ask.
Question 6: If a company's gross profit margin is declining while its revenue is growing, the most likely explanation is:
- Operating expenses are growing faster than revenue
- The cost of goods sold is rising faster than revenue (Correct answer)
- The company is paying more taxes
- Interest expense has increased
Correct answer: The cost of goods sold is rising faster than revenue
Gross profit margin only reflects revenue minus COGS, so a declining margin with growing revenue means COGS is rising at a faster rate than sales.
Question 7: Working capital is defined as:
- Total assets minus total liabilities
- Current assets minus current liabilities (Correct answer)
- Cash plus accounts receivable
- Long-term assets minus long-term debt
Correct answer: Current assets minus current liabilities
Working capital = Current Assets − Current Liabilities, representing the net short-term financial resources available to fund day-to-day operations.
Finance for Non-Finance Managers Financial Ratios 4
Which of these scenarios would improve a company's debt-to-assets ratio?