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Which of the following ratios would least likely measure liquidity?
A)
Quick ratio.
B)
Return on assets (ROA).
C)
Current ratio.



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.

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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.

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

Balance Sheet

AssetsYear 2003Year 2004
Cash500450
Accounts Receivable600660
Inventory500550
Total CA13001660
Plant, prop. equip10001250
Total Assets26002910
Liabilities
Accounts Payable500550
Long term debt7001102
Total liabilities12001652
Equity
Common Stock400538
Retained Earnings1000720
Total Liabilities & Equity26002,910

Income Statement

Sales3000
Cost of Goods Sold(1000)
Gross Profit2000
SG&A500
Interest Expense151
EBT1349
Taxes (30%)405
Net Income944

What is the gross profit margin?
A)
0.666.
B)
0.333.
C)
0.472.



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

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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 MarginOperating Profit Margin
A)
40%20%
B)
40%10%
C)
20%15%



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

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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.



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).

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An analyst has gathered the following information about a company:

Balance Sheet

Assets
Cash100
Accounts Receivable750
Marketable Securities300
Inventory850
Property, Plant & Equip900
Accumulated Depreciation(150)
Total Assets2750
Liabilities and Equity
Accounts Payable300
Short-Term Debt130
Long-Term Debt700
Common Stock1000
Retained Earnings620
Total Liab. and Stockholder's equity2750

Income Statement

Sales1500
COGS1100
Gross Profit400
SG&A150
Operating Profit250
Interest Expense25
Taxes75
Net Income150

What is the current ratio?
A)
4.65.
B)
2.67.
C)
0.22.



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

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Wells Incorporated reported the following common size data for the year ended December 31, 20X7:
Income Statement%
Sales100.0
Cost of goods sold58.2
Operating expenses30.2
Interest expense0.7
Income tax5.7
Net income5.2
Balance sheet%%
Cash4.8Accounts payable15.0
Accounts receivable14.9Accrued liabilities13.8
Inventory49.4Long-term debt23.2
Net fixed assets30.9Common equity48.0
Total assets100.00Total liabilities & equity100.0

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%


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).

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To calculate the cash ratio, the total of cash and marketable securities is divided by:
A)
total liabilities.
B)
current liabilities.
C)
total assets.



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

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Earnings before interest and taxes (EBIT) is also known as:
A)
gross profit.
B)
operating profit.
C)
earnings before income taxes.



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

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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.



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.

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