Mechanic

Which of the following ratios would least likely measure liquidity?

A) Quick ratio.

B) Return on assets (ROA).

C) Current ratio.

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ROA = (EBIT / average total assets) which measures management's ability and efficiency in using the firm's assets to generate operating profits. Other ratios that measure liquidity (if a company can pay its current bills) besides the quick, cash, and current ratios are the: receivables turnover, inventory turnover, and payables turnover ratios.

Mechanic

Are the following ratios best classified as profitability ratios?Ratio #1 – Cash plus short-term marketable investments plus receivables divided by average daily cash expenditures.

Ratio #2 – Earnings before interest and taxes divided by average total assets.

A) Both of the ratios are profitability ratios.

B) Only one of the ratios is a profitability ratio.

C) Neither of the ratios is a profitability ratio.

(Cash + short-term marketable investments + receivables) divided by average daily cash expenditures is known as the defensive interval ratio. The defensive interval ratio is a liquidity ratio that measures the firm’s ability to pay cash expenditures in the absence of external cash flows, but does not directly measure profitability. EBIT / average total assets is one variation of the return on assets ratio. Return on assets is a profitability ratio that measures the efficiency of managing assets and generating profits.

Mechanic

Given the following income statement and balance sheet for a company:

Balance Sheet
Assets	Year 2003	Year 2004
Cash	500	450
Accounts Receivable	600	660
Inventory	500	550
Total CA	1300	1660
Plant, prop. equip	1000	1250
Total Assets	2600	2910
Liabilities
Accounts Payable	500	550
Long term debt	700	1102
Total liabilities	1200	1652
Equity
Common Stock	400	538
Retained Earnings	1000	720
Total Liabilities & Equity	2600	2,910
Income Statement
Sales		3000
Cost of Goods Sold		(1000)
Gross Profit		2000
SG&A		500
Interest Expense		151
EBT		1349
Taxes (30%)		405
Net Income		944

What is the gross profit margin?

A) 0.666.

B) 0.333.

C) 0.472.

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Gross profit margin = (gross profit / net sales) = (2,000 / 3,000) = 0.666

Mechanic

Given the following information about a firm:

• Net Sales = $1,000.
• Cost of Goods Sold = $600.
• Operating Expenses = $200.
• Interest Expenses = $50.
• Tax Rate = 34%.

What are the gross and operating profit margins?

Gross Operating Margin

Operating Profit Margin

A) 40% 20%

B) 40% 10%

C) 20% 15%

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Gross profit margin = ($1,000 net sales − $600 COGS) / $1,000 net sales = 400 / 1,000 = 0.4
Operating profit margin = ($1,000 net sales − $600 COGS − $200 operating expenses) / $1,000 net sales = $200 / $1000 = 0.2

Mechanic

An analyst gathered the following data about a company:

• Current liabilities are $300.
• Total debt is $900.
• Working capital is $200.
• Capital expenditures are $250.
• Total assets are $2,000.
• Cash flow from operations is $400.

If the company would like a current ratio of 2, they could:

A) increase current assets by 100 or decrease current liabilities by 50.

B) decrease current assets by 100 or increase current liabilities by 50.

C) increase current assets by 100 or increase current liabilities by 50.

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For the current ratio to equal 2.0, current assets would need to move to $600 (or up by $100) or current liabilities would need to decrease to $250 (or down by $50). Remember that CA − CL = working capital (500 − 300 = 200).

Mechanic

An analyst has gathered the following information about a company:

Balance Sheet
Assets
	Cash	100
	Accounts Receivable	750
	Marketable Securities	300
	Inventory	850
	Property, Plant & Equip	900
	Accumulated Depreciation	(150)
Total Assets		2750
Liabilities and Equity
	Accounts Payable	300
	Short-Term Debt	130
	Long-Term Debt	700
	Common Stock	1000
	Retained Earnings	620
Total Liab. and Stockholder's equity		2750
Income Statement
Sales		1500
COGS		1100
Gross Profit		400
SG&A		150
Operating Profit		250
Interest Expense		25
Taxes		75
Net Income		150

What is the current ratio?

A) 4.65.

B) 2.67.

C) 0.22.

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Current ratio = [100(cash) + 750(AR) + 300(marketable securities) + 850(inventory)] / [300(AP) + 130(short-term debt)] = (2,000 / 430) = 4.65

Mechanic

Wells Incorporated reported the following common size data for the year ended December 31, 20X7:

Income Statement	%
Sales	100.0
Cost of goods sold	58.2
Operating expenses	30.2
Interest expense	0.7
Income tax	5.7
Net income	5.2

Balance sheet	%			%
Cash	4.8		Accounts payable	15.0
Accounts receivable	14.9		Accrued liabilities	13.8
Inventory	49.4		Long-term debt	23.2
Net fixed assets	30.9		Common equity	48.0
Total assets	100.00		Total liabilities & equity	100.0

For 20X6, Wells reported sales of $183,100,000 and for 20X7, sales of $215,600,000. At the end of 20X6, Wells’ total assets were $75,900,000 and common equity was $37,800,000. At the end of 20X7, total assets were $95,300,000. Calculate Wells’ current ratio and return on equity ratio for 20X7.

Current ratio

Return on equity

A) 2.4 26.4%

B) 4.6 25.2%

C) 2.4 26.8%

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The current ratio is equal to 2.4 [(4.8% cash + 14.9% accounts receivable + 49.4% inventory) / (15.0% accounts payable + 13.8% accrued liabilities)]. This ratio can be calculated from the common size balance sheet because the percentages are all on the same base amount (total).
Return on equity is equal to net income divided by average total equity. Since this ratio mixes an income statement item and a balance sheet item, it is necessary to convert the common-size inputs to dollars. Net income is $11,211,200 ($215,600,000 × 5.2%) and average equity is $41,772,000 [($95,300,000 × 48.0%) + $37,800,000] / 2. Thus, 2007 ROE is 26.8% ($11,211,200 net income / $41,772,000 average equity).

Mechanic

To calculate the cash ratio, the total of cash and marketable securities is divided by:

A) total liabilities.

B) current liabilities.

C) total assets.

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Current liabilities are used in the denominator for the: current, quick, and cash ratios.

Mechanic

Earnings before interest and taxes (EBIT) is also known as:

A) gross profit.

B) operating profit.

C) earnings before income taxes.

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Operating profit = earnings before interest and taxes (EBIT)
Gross profit = net sales – COGS
Net income = earnings after taxes = EAT

Mechanic

A company has a receivables turnover of 10, an inventory turnover of 5, and a payables turnover of 12. The company’s cash conversion cycle is closest to:

A) 79 days.

B) 30 days.

C) 37 days.

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Cash conversion cycle = receivables days + inventory processing days – payables payment period.
Receivables days = 365 / receivables turnover = 365 / 10 = 36.5 days.
Inventory processing days = 365 / inventory turnover = 365 / 5 = 73.0 days.
Payables payment period = 365 / payables turnover = 365 / 12 = 30.4 days.
Cash collection cycle = 36.5 + 73.0 – 30.4 = 79.1 days.