Learning Module: Financial Analysis Techniques

1. Comparison of a company’s financial results to other peer companies for the same
time period is called:
A. time-series analysis.
B. common-size analysis.
C. cross-sectional analysis.

2. An analyst observes a decrease in a company’s inventory turnover. Which of the

following would most likely explain this trend?
A. The company installed a new inventory management system, allowing more
efficient inventory management.
B. Due to problems with obsolescent inventory last year, the company wrote off a
large amount of its inventory at the beginning of the period.
C. The company installed a new inventory management system but experienced some
operational difficulties resulting in duplicate orders being placed with suppliers.

3. Which of the following would best explain an increase in receivables turnover?

A. The company adopted new credit policies last year and began offering credit to
customers with weak credit histories.
B. Due to problems with an error in its old credit scoring system, the company had
accumulated a substantial amount of uncollectible accounts and wrote off a large
amount of its receivables.
C. To match the terms offered by its closest competitor, the company adopted new
payment terms now requiring net payment within 30 days rather than 15 days,
which had been its previous requirement.

4. Brown Corporation had average days of sales outstanding of 19 days in the most
recent fiscal year. Brown wants to improve its credit policies and collection practices
and decrease its collection period in the next fiscal year to match the industry
average of 15 days. Credit sales in the most recent fiscal year were $300 million, and
Brown expects credit sales to increase to $390 million in the next fiscal year. To
achieve Brown’s goal of decreasing the collection period, the change in the average
accounts receivable balance that must occur is closest to:
A. +USD0.41 million.
B. –USD0.41 million.
C. –USD1.22 million.
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The following information relates to questions 5-6

An analyst is interested in assessing both the efficiency and liquidity of Spherion PLC.
The analyst has collected the data in Exhibit 1 for Spherion:

5. Based on the data in Exhibit 1, what is the analyst least likely to conclude?
A. Inventory management has contributed to improved liquidity.
B. Management of payables has contributed to improved liquidity.
C. Management of receivables has contributed to improved liquidity.

6. To assess a company’s ability to fulfill its long-term obligations, an analyst would most
likely examine:
A. activity ratios.
B. liquidity ratios.
C. solvency ratios.

The following information relates to questions 7-8

An analyst is evaluating the solvency and liquidity of Apex Manufacturing and has
collected the data in Exhibit 1:

7. Which of the following would be the analyst’s most likely conclusion?

A. The company is becoming less liquid, as evidenced by the increase in its debt-to-
equity ratio from 0.35 to 0.50 from FY3 to FY5.
B. The company is becoming increasingly more liquid, as evidenced by the increase in
its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5.
C. The company is becoming increasingly less solvent, as evidenced by the increase
in its debt-to-equity ratio from 0.35 to 0.50 from FY3 to FY5.

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8. What would be the most reasonable explanation of the financial data?

A. The decline in the company’s equity results from a decline in the market value of
this company’s common shares.
B. The EUR250 increase in the company’s debt from FY3 to FY5 indicates that
lenders are viewing the company as increasingly creditworthy.
C. The decline in the company’s equity indicates that the company may be incurring
losses, paying dividends greater than income, or repurchasing shares.

9. An analyst observes the data in Exhibit 1 for two companies:

Which of the following choices best describes reasonable conclusions that the analyst
might make about the two companies’ ability to pay their current and long-term
obligations?
A. Company A’s current ratio of 4.0 indicates it is more liquid than Company B, whose
current ratio is only 1.2, but Company B is more solvent, as indicated by its lower
debt-to-equity ratio.
B. Company A’s current ratio of 0.25 indicates it is less liquid than Company B, whose
current ratio is 0.83, and Company A is also less solvent, as indicated by a debt-
to-equity ratio of 200 percent compared with Company B’s debt-to-equity ratio
of only 30 percent.
C. Company A’s current ratio of 4.0 indicates it is more liquid than Company B, whose
current ratio is only 1.2, and Company A is also more solvent, as indicated by a
debt-to-equity ratio of 200 percent compared with Company B’s debt-to-equity
ratio of only 30 percent.

The following information relates to questions 10-13

The following data appear in the five-year summary of a major international company. A
business combination with another major manufacturer took place in FY13.

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10. The company’s total assets at year-end FY9 were GBP3,500 million. Which of the
following choices best describes reasonable conclusions an analyst might make about
the company’s efficiency?
A. Comparing FY14 with FY10, the company’s efficiency deteriorated, as indicated
by its current ratio.
B. Comparing FY14 with FY10, the company’s efficiency deteriorated due to asset
growth faster than turnover revenue growth.
C. Comparing FY14 with FY10, the company’s efficiency improved, as indicated by a
total asset turnover ratio of 0.86 compared with 0.64.

11. Which of the following choices best describes reasonable conclusions an analyst
might make about the company’s solvency?
A. Comparing FY14 with FY10, the company’s solvency improved, as indicated by the
growth in its profits to GBP 645 million.
B. Comparing FY14 with FY10, the company’s solvency deteriorated, as indicated by
a decrease in interest coverage from 10.6 to 8.4.
C. Comparing FY14 with FY10, the company’s solvency improved, as indicated by an
increase in its debt-to-assets ratio from 0.14 to 0.27.

12. Which of the following choices best describes reasonable conclusions an analyst
might make about the company’s liquidity?
A. Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an
increase in its current ratio from 0.71 to 0.75.
B. Comparing FY14 with FY10, the company’s liquidity deteriorated, as indicated by
a decrease in interest coverage from 10.6 to 8.4.
C. Comparing FY14 with FY10, the company’s liquidity improved, as indicated by an
increase in its debt-to-assets ratio from 0.14 to 0.27.

13. Which of the following choices best describes reasonable conclusions an analyst
might make about the company’s profitability?
A. Comparing FY14 with FY10, the company’s profitability improved, as indicated by
an increase in its debt-to-assets ratio from 0.14 to 0.27.
B. Comparing FY14 with FY10, the company’s profitability improved, as indicated by
the growth in its shareholders’ equity to GBP6,165 million.
C. Comparing FY14 with FY10, the company’s profitability deteriorated, as indicated
by a decrease in its net profit margin from 11.0 percent to 5.7 percent.

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14. An analyst compiles the data in Exhibit 1 for a company:

Based only on the information above, the most appropriate conclusion is that, over
the period FY13 to FY15, the company’s:
A. net profit margin and financial leverage have decreased.
B. net profit margin and financial leverage have increased.
C. net profit margin has decreased but its financial leverage has increased.

15. A decomposition of ROE for Integra SA is as follows:

Which of the following choices best describes reasonable conclusions an analyst

might make based on this ROE decomposition?
A. Profitability and the liquidity position both improved in FY12.
B. The higher average tax rate in FY12 offset the improvement in profitability,
leaving ROE unchanged.
C. The higher average tax rate in FY12 offset the improvement in efficiency, leaving
ROE unchanged.

16. A decomposition of ROE for Company A and Company B is as follows:

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An analyst is most likely to conclude that:

A. Company A’s ROE is higher than Company B’s in FY15, and one explanation
consistent with the data is that Company A may have purchased new, more
efficient equipment.
B. the difference between the two companies’ ROE in FY15 is very small and Company
A’s ROE remains similar to Company B’s ROE mainly due to Company A increasing
its financial leverage.
C. Company A’s ROE is higher than Company B’s in FY15, and one explanation
consistent with the data is that Company A has made a strategic shift to a product
mix with higher profit margins.

17. When developing forecasts, analysts should most likely:

A. develop possibilities relying exclusively on the results of financial analysis.
B. aim to develop extremely precise forecasts using the results of financial analysis.
C. use the results of financial analysis, analysis of other information, and judgment.

18. Selected information for a company and its industry’s average return on equity (ROE)
is provided:

Which of the following is most likely a contributor to the company’s inferior ROE
compared with that of the industry? The company’s lower:
A. tax burden ratio.
B. financial leverage.
C. interest burden ratio.

19. By themselves, financial ratios are least likely to be sufficient in determining a

company’s:
A. past performance.
B. creditworthiness.
C. current financial condition.

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20. The following selected financial information is available:

The company’s cash conversion cycle (in days) is closest to:

A. 76.4.
B. 45.2.
C. 38.2.

21. Based on each company's interest coverage ratio, which company is the most solvent?

A. Company B
B. Company C
C. Company A

22. An analysis used to forecast earnings that shows a range of possible outcomes as
specific assumptions change best describes which of the following techniques?
A. Scenario analysis
B. Simulation
C. Sensitivity analysis

23. Consider the following information available for a company for last year:

The average shareholder’s equity is closest to:

A. $164,557.
B. $123,418.
C. $219,409.

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24. Other factors held constant, the reduction of a company’s average accounts payable
because of suppliers offering less trade credit will most likely:
A. not affect the operating cycle.
B. reduce the operating cycle.
C. increase the operating cycle.

25. A company’s most recent balance sheet shows the following values (NZ$ thousands):

The company’s debt-to-capital ratio is closest to:

A. 0.65.
B. 0.77.
C. 1.86.

26. A portion of a company’s balance sheet appears in the following table (euros in
millions):

The company’s quick ratio is closest to:

A. 1.40.
B. 0.06.
C. 0.73.

27. An analyst has calculated the following ratios for a company:

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The company’s return on equity (ROE) is closest to:

A. 22.7%.
B. 4.8%.
C. 15.2%.

28. Selected information for a company is provided.

The company’s cash conversion cycle (in days) is closest to:

A. 84.
B. 138.
C. 120.

29. Which of the following ratios is most likely to be used as a measure of operating
performance?
A. Cash ratio
B. Working capital turnover ratio
C. Defensive interval ratio

30. An analyst is completing her analysis of three companies in the same industry. Which
of these companies is the most solvent?

A. Company C
B. Company B
C. Company A

31. Compared to the industry average, which of the following financial ratios most likely
indicates a company has a highly efficient credit and collection process? A relatively
low:

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A. receivables turnover ratio

B. number of days sales outstanding
C. number of days of inventory on hand

32. With respect to company analysis, measures of inventory management are best
described as:
A. activity ratios.
B. solvency ratios.
C. profitability ratios.

33. Which of the following most likely indicates improved efficiency of a company's
credit and collection policy? An increase in:
A. receivables turnover ratio
B. days of sales outstanding
C. number of days of payables

34. An analyst gathers the following information about a company:

If all purchases and sales were made on credit, the cash conversion cycle (based on
a 360-day year) is:
A. 99 days.
B. 171 days.
C. 261 days.

35. Which of the following analyses can be used to compare a company’s financial ratios
with those of its major competitors?
A. Trend only
B. Cross-sectional only
C. Both trend and cross-sectional

36. An analyst gathers the following information about a company:

The total asset turnover ratio is closest to:

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A. 1.0.
B. 1.3.
C. 1.5.

37. An analyst gathers the following information (in € millions) about a company:

ROA is:
A. 11%.
B. 13%.
C. 15%.

38. An analyst gathers the following information about a company:

ROE is closest to:

A. 5.4%.
B. 6.9%.
C. 8.1%.

39. Which of the following ratios is most appropriate in measuring a company's ability to
cover its debt payments?
A. Return on equity
B. Fixed asset turnover
C. Fixed charge coverage

40. An analyst gathers the following information about a company:

Based only on this information, the company's debt-to-capital ratio is closest to:
A. 17%.
B. 21%.
C. 27%.

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41. All else being equal, the cash conversion cycle most likely shortens if:
A. payables turnover decreases.
B. inventory turnover decreases.
C. days of sales outstanding increases.

42. An analyst gathers the following information (in € thousands) about a company whose
fiscal year ends on 31 December:

The company’s trailing 12 month earnings (in € thousands) for the period ended 30
June of Year 2 is:
A. 1,700.
B. 3,700.
C. 4,200.

43. An analyst gathers the following information about three companies (in $ millions):

Based on this information, which company is most solvent?

A. Company 1
B. Company 2
C. Company 3

44. A debt-to-equity ratio of 1.0 most likely results in a debt-to-capital ratio of:
A. 0.5.
B. 1.0.
C. 2.0.

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45. All else being equal, a company with older assets has a fixed asset turnover ratio that
is:
A. lower compared to a company with newer assets.
B. the same compared to a company with newer assets.
C. higher compared to a company with newer assets.

46. An analyst gathers the following information (in € thousands) about a manufacturing
company:

Based only on this information, which of the following ratio(s) may indicate improved
solvency from Year 1 to Year 2?
A. Interest coverage ratio only
B. Financial leverage ratio only
C. Both interest coverage ratio and financial leverage ratio

47. Which of the following is most likely a measure of a company’s ability to meet its
short-term obligations?
A. Quick ratio
B. Operating profit margin
C. Days of payables outstanding

48. An analyst gathers the following information (in £ thousands) about a company's
current assets and liabilities:

The company's quick ratio is:

A. 0.13.
B. 0.33.
C. 0.40.

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49. An analyst gathers the following information (in £ millions) about a company:

The total debt ratio is:

A. 0.25.
B. 0.50.
C. 2.00.

50. The financial leverage ratio may be calculated as:

A. EBIT divided by interest payments.
B. total debt divided by total shareholders' equity.
C. average total assets divided by average shareholders' equity.

51. Which of the following is defined as how long a company can continue to pay its daily
cash expenditures from its existing liquid assets without receiving additional cash
inflow?
A. Cash conversion cycle
B. Defensive interval ratio
C. Fixed charge coverage

52. An analyst gathers the following information about a company:

The average tax rate is closest to:

A. 43%.
B. 47%.
C. 57%.

53. An analyst gathers the following information (in € thousands) about a company:

Based only on this information, the payables turnover ratio for Year 2 is:

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A. 9.
B. 10.
C. 12.

54. An analyst gathers the following information about a company:

Based only on the cash conversion cycle, the company's liquidity position from Year 1
to Year 2 has:
A. deteriorated.
B. remained the same.
C. improved.

55. An analyst gathers the following information (in £ millions) about a company:

The fixed charge coverage ratio is closest to:

A. 1.2.
B. 1.6.
C. 2.0.

Solutions
1. C is correct. Cross-sectional analysis involves the comparison of companies with each
other for the same time period. Time-series or trend analysis is the comparison of
financial data across different time periods. Common-size analysis involves
expressing financial data in relation to a single financial statement item, or base.

2. C is correct. The company’s problems with its inventory management system causing
duplicate orders would likely result in a higher amount of inventory and, therefore,
would result in a decrease in inventory turnover. A more efficient inventory
management system and a write-off of inventory at the beginning of the period would
both likely decrease the average inventory for the period (the denominator of the
inventory turnover ratio), thus increasing the ratio rather than decreasing it.

3. B is correct. A write-off of receivables would decrease the average amount of

accounts receivable (the denominator of the receivables turnover ratio), thus
increasing this ratio. Customers with weaker credit are more likely to make payments

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more slowly or to pose collection difficulties, which would likely increase the average
amount of accounts receivable and thus decrease receivables turnover. Longer
payment terms would likely increase the average amount of accounts receivable and
thus decrease receivables turnover.

4. A is correct. The average accounts receivable balances (actual and desired) must be
calculated to determine the desired change. The average accounts receivable balance
can be calculated as an average day’s credit sales times the DSO. For the most recent
fiscal year, the average accounts receivable balance is USD15.62 million [=
(USD300,000,000/365) × 19]. The desired average accounts receivable balance for
the next fiscal year is USD16.03 million (= (USD390,000,000/365) × 15). This is an
increase of USD0.41 million (= 16.03 million – 15.62 million). An alternative approach
is to calculate the turnover and divide sales by turnover to determine the average
accounts receivable balance. Turnover equals 365 divided by DSO. Turnover is 19.21
(= 365/19) for the most recent fiscal year and is targeted to be 24.33 (= 365/15)
for the next fiscal year. The average accounts receivable balances are USD15.62
million (= USD300,000,000/19.21), and USD16.03 million (= USD390,000,000/24.33).
The change is an increase in receivables of USD0.41 million

5. C is correct. The analyst is unlikely to reach the conclusion given in Statement C

because days of sales outstanding increased from 23 days in FY1 to 25 days in FY2
to 28 days in FY3, indicating that the time required to collect receivables has
increased over the period. This is a negative factor for Spherion’s liquidity. By
contrast, days of inventory on hand dropped over the period FY1 to FY3, a positive
for liquidity. The company’s increase in days payable, from 35 days to 40 days,
shortened its cash conversion cycle, thus also contributing to improved liquidity.

6. C is correct. Solvency ratios are used to evaluate the ability of a company to meet its
long-term obligations. An analyst is more likely to use activity ratios to evaluate how
efficiently a company uses its assets. An analyst is more likely to use liquidity ratios
to evaluate the ability of a company to meet its short-term obligations.

7. C is correct. The company is becoming increasingly less solvent, as evidenced by its

debt-to-equity ratio increasing from 0.35 to 0.50 from FY3 to FY5. The amount of a
company’s debt and equity do not provide direct information about the company’s
liquidity position.

Debt to equity:
FY5: 2,000/4,000 = 0.5000
FY4: 1,900/4,500 = 0.4222
FY3: 1,750/5,000 = 0.3500

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8. C is correct. The decline in the company’s equity indicates that the company may be
incurring losses, paying dividends greater than income, or repurchasing shares. Recall
that Beginning equity – Shares repurchased + Comprehensive income – Dividends =
Ending equity. The book value of a company’s equity is not affected by changes in the
market value of its common stock. An increased amount of lending does not
necessarily indicate that lenders view a company as increasingly creditworthy.
Creditworthiness is not evaluated based on how much a company has increased its
debt but rather on its willingness and ability to pay its obligations. (Its financial
strength is indicated by its solvency, liquidity, profitability, efficiency, and other
aspects of credit analysis.)

9. A is correct. Company A’s current ratio of 4.0 (= USD40,000/USD10,000) indicates

it is more liquid than Company B, whose current ratio is only 1.2
(=USD60,000/USD50,000). Company B is more solvent, as indicated by its lower
debt-to-equity ratio of 30 percent (= USD150,000/USD500,000) compared with
Company A’s debt-to-equity ratio of 200 percent (= USD60,000/USD30,000).

10. B is correct. The company’s efficiency deteriorated, as indicated by the decline in its
total asset turnover ratio from 1.11 {= 4,390/[(4,384 + 3,500)/2]} for FY10 to 0.87
{= 11,366/[(12,250 + 13,799)/2]} for FY14. The decline in the total asset turnover
ratio resulted from an increase in average total assets from GBP3,942 [= (4,384 +
3,500)/2] for FY10 to GBP13,024.5 for FY14, an increase of 230 percent, compared
with an increase in revenue from GBP4,390 in FY10 to GBP11,366 in FY14, an increase
of only 159 percent. The current ratio is not an indicator of efficiency.

11. B is correct. Comparing FY14 with FY10, the company’s solvency deteriorated, as
indicated by a decrease in interest coverage from 10.6 (= 844/80) in FY10 to 8.4 (=
1,579/188) in FY14. The debt-to-asset ratio increased from 0.14 (= 602/4,384) in
FY10 to 0.27 (= 3,707/13,799) in FY14. This is also indicative of deteriorating
solvency. In isolation, the amount of profits does not provide enough information to
assess solvency.

12. A is correct. Comparing FY14 with FY10, the company’s liquidity improved, as indicated
by an increase in its current ratio from 0.71 [= (316 + 558)/1,223] in FY10 to 0.75 [=
(682 + 1,634)/3,108] in FY14. Note, however, comparing only the cash ratio shows a
decline in liquidity from 0.26 (= 316/1,223) in FY10 to 0.22 (= 682/3,108) in FY14.
Debt-to-assets ratio and interest coverage are measures of solvency not liquidity.

13. C is correct. Comparing FY14 with FY10, the company’s profitability deteriorated, as
indicated by a decrease in its net profit margin from 11.0 percent (= 484/4,390) to
5.7 percent (= 645/11,366). Debt-to-assets ratio is a measure of solvency not an

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indicator of profitability. Growth in shareholders’ equity, in isolation, does not provide

enough information to assess profitability.

14. C is correct. The company’s net profit margin has decreased and its financial leverage
has increased. ROA = Net profit margin × Total asset turnover. ROA decreased over
the period despite the increase in total asset turnover; therefore, the net profit
margin must have decreased.

ROE = Return on assets × Financial leverage. ROE increased over the period despite
the drop in ROA; therefore, financial leverage must have increased.

15. C is correct. The increase in the average tax rate in FY12, as indicated by the
decrease in the value of the tax burden (the tax burden equals one minus the average
tax rate), offset the improvement in efficiency indicated by higher asset turnover)
leaving ROE unchanged. The EBIT margin, measuring profitability, was unchanged in
FY12 and no information is given on liquidity.

16. B is correct. The difference between the two companies’ ROE in FY15 is very small
and is mainly the result of Company A’s increase in its financial leverage, indicated by
the increase in its Assets/Equity ratio from 2 to 4. The impact of efficiency on ROE
is identical for the two companies, as indicated by both companies’ asset turnover
ratios of 1.5. Furthermore, if Company A had purchased newer equipment to replace
older, depreciated equipment, then the company’s asset turnover ratio (computed as
sales/assets) would have declined, assuming constant sales. Company A has
experienced a significant decline in its operating margin, from 10 percent to 7 percent
which, all else equal, would not suggest that it is selling more products with higher
profit margins.

17. C is correct. The results of an analyst’s financial analysis are integral to the process
of developing forecasts, along with the analysis of other information and judgment
of the analysts. Forecasts are not limited to a single point estimate but should involve
a range of possibilities.

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18. B is correct. Compare the three specified components from the five-way DuPont
analysis:

The lower financial leverage ratio relative to the industry is one of the causes of the
company’s poor relative performance.

19. B is correct. Financial ratios alone are not sufficient to determine the
creditworthiness of a company. Other factors must also be considered, such as
examining the entire operation of the company, meeting with management, touring
company facilities, and so forth.

20. C is correct. Cash conversion cycle = DOH + DSO – Days of payables

21. A is correct. Company B is the most solvent because it has the highest interest
coverage ratio.
Interest coverage ratio = EBIT/Interest Payments
= $24,636/$3,423
= 7.20

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22. C is Correct. Sensitivity analysis, also known as “what if” analysis, shows the range of
possible outcomes as specific assumptions are changed.

23. C is correct. The DuPont equation is

24. A is correct. Payables are not part of the operating cycle calculation, which includes
receivables and inventory.

25. A is correct. The debt-to-capital ratio is

where total debt includes only interest-bearing debt.

26. C is correct. The quick ratio is

27. C is correct. Using DuPont analysis, there are two ways to calculate ROE from the
information provided:

ROE = Net profit margin × Asset turnover × Financial leverage

= 11.7 × 0.89 × 1.46
= 15.2%

ROE = ROA × Financial leverage

= 10.4 × 1.46
= 15.2%

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28. C is correct. Cash conversion cycle = Days sales outstanding + Days of inventory on
hand – Days of payables

Cash conversion cycle = DSO + DOH – Days in payables

= 48 + 90 – 18
= 120 days

29. B is correct. Activity ratios are typically used to measure operating performance.
Working capital turnover is an example of an activity ratio; the defensive interval
ratio and cash ratio are liquidity ratios used to measure a company’s ability to meet
its short-term obligations.

30. A is correct.

31. B is correct because a relatively high receivables turnover ratio (and commensurately
low DSO) might indicate highly efficient credit and collection.

32. A is correct because activity ratios measure how efficiently a company performs day-
to-day tasks, such as the collection of receivables and management of inventory.

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33. A is correct because a relatively high receivables turnover ratio (and commensurately
low DSO) might indicate highly efficient credit and collection.

34. B is correct because Cash conversion cycle (CCC) = DOH + DSO – Number of days of
payables.
DOH = Number of days in period/ Inventory turnover = 360/2 =180 days.
DSO = Number of days in period/ Receivables turnover = 360/10 = 36 days.
Number of days of payables = Number of days in period/Payables turnover = 360/8 =
45 days.
Thus CCC = 180 + 36 – 45 = 171 days.

35. C is correct because both types of analyses are used to compare a company’s financial
ratios with those of its competitors. In general, the financial ratios of a company are
compared with those of its major competitors (cross-sectional and trend analysis)
and to the company’s prior periods (trend analysis).

36. B is correct because in accordance to the DuPont analysis for ROE, ROE = Net profit
margin × Total asset turnover × Leverage. Thus, Total asset turnover = ROE / (Net
profit margin × Leverage); or = 10% / (4% × 2) = 1.25 ≈ 1.3.

37. A is correct because ROA = Net income / Average total assets; or = 110 / 1,000 =
11%.

38. C is correct because ROE = net profit margin × total asset turnover × financial
leverage = 3.0% × 1.8 × 1.5 = 8.1%.

39. C is correct because solvency ratios are primarily of two types. Debt ratios, the first
type, focus on the balance sheet and measure the amount of debt capital relative to
equity capital. Coverage ratios, the second type, focus on the income statement and
measure the ability of a company to cover its debt payments. These ratios are useful
in assessing a company’s solvency and, therefore, in evaluating the quality of a
company’s bonds and other debt obligations.

Fixed charge coverage ratio = (EBIT + Lease payments) / (Interest payments + lease
payments). A higher fixed charge coverage ratio implies stronger solvency, offering
greater assurance that the company can service its debt (i.e., bank debt, bonds, notes,
and leases) from normal earnings.

40. B is correct because the Debt-to-capital ratio = Total debt/(Total debt + Total
shareholders' equity) = (700 + 500 + 800)/(700 + 500 + 800 + 7,500) = 2,000/9,500
= 0.211 ≈ 21%.

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41. A is correct because the Cash conversion cycle = Days of inventory on hand + Days of
sales outstanding – Number of days of payables. Number of days of payables = Days
in the period / Payables turnover. If payables turnover were to decrease, it would
increase the Number of days of payables, decreasing the CCC.

42. A is correct because the company’s trailing 12 months earnings for the period ended
30 June of Year 2 are calculated as (Earnings as of 31 December of Year 1 – Earnings
as of 30 June of Year 1) + Earnings as of 30 June of Year 2 = (1.500 – 2,000) + 2,200
= –500 + 2,200 = 1,700.

43. C is correct because the ability to meet long-term debt obligations is defined as
solvency, which can be measured using leverage and coverage ratios. Generally, the
higher the leverage ratio, the higher the financial risk and thus the weaker the
solvency. A higher interest coverage ratio indicates stronger solvency. Using the
information given, leverage and coverage ratios are:

Company 3 and Company 1 have the lowest leverage ratios (debt-to-assets, debt-to-
equity, debt-to-capital, and financial leverage), but Company 3 has a higher interest
coverage ratio than Company 1. Company 3 has the least debt (proportionally) along
with the highest coverage ability of the three companies.

44. A is correct because the debt-to-equity ratio measures the amount of debt financing
relative to equity financing. A debt-to-equity ratio of 1.0 indicates equal amounts of
debt and equity, which is the same as a debt-to-capital ratio of 50 percent.

Debt-to-equity ratio = Total debt / Total shareholder's equity = 1.0. Accordingly,

Total debt = Total shareholder's equity, while Debt-to-capital ratio = Total Debt /
(Total Debt + Total shareholder's equity) = Total Debt / (2 × Total Debt) = 1/2 = 0.5.

45. C is correct because the fixed asset turnover ratio would be lower for a company
whose assets are newer (and, therefore, less depreciated and so reflected in the
financial statements at a higher carrying value) than the ratio for a company with
older assets (that are thus more depreciated and so reflected at a lower carrying
value).

46. A is correct because the interest coverage ratio measures the number of times a
company’s EBIT could cover its interest payments. A higher interest coverage ratio

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indicates stronger solvency, offering greater assurance that the company can service
its debt from operating earnings. Accordingly, Interest coverage ratio =
EBIT/Interest payment. Year 1 Interest coverage ratio = 40/8 = 5 and Year 2
Interest coverage ratio = 35/5 = 7. Therefore, interest coverage ratio has increased
which indicates stronger solvency.

47. A is correct because the quick ratio is a liquidity ratio which measures a company’s
ability to meet its short-term obligations.

48. B is correct because the Quick ratio = (Cash and equivalents + Short-term marketable
securities + Receivables) / Current liabilities. The calculation is (800 + 500 + 2,000)
/ 10,000 = 3,300 / 10,000 = 0.33, or 33%.

49. A is correct because the total debt ratio = total debt / total assets = 100 / 400 =
0.25.

50. C is correct because this defines the financial leverage ratio. The financial leverage
ratio (also called the ‘leverage ratio’ or ‘equity multiplier’) measures the amount of
total assets supported by one money unit of equity. The higher the financial leverage
ratio, the more leveraged the company in the sense of using debt and other liabilities
to finance assets. This ratio often is defined in terms of average total assets and
average total equity and plays an important role in the DuPont decomposition of return
on equity.

51. B is correct because this ratio measures how long the company can continue to pay
its expenses from its existing liquid assets without receiving any additional cash
inflow.

52. C is correct because using DuPont analysis, ROE = Tax Burden × Interest Burden ×
EBIT margin × Total asset turnover × Leverage. Accordingly, Tax burden = ROE /
(Interest Burden × EBIT margin × Total asset turnover × Leverage) = 15% / (0.85 ×
30% × 1.1 × 1.25) = 42.78%. Tax burden reflects one minus the average tax rate, or
how much of a company’s pretax profits it gets to keep. Thus, average tax rate = 1 –
Tax burden = 1 – 42.78% = 57.22% ≈ 57%.

53. A is correct because Payables turnover = Purchases / Average trade payables; or =

Purchases (proxied by cost of sales) / Average trade payables; or = 1,800 / [(180 +
220) / 2] = 1,800 / 200 = 9. The number of days of payables reflects the average
number of days the company takes to pay its suppliers, and the payables turnover
ratio measures how many times per year the company theoretically pays off all its
creditors. For purposes of calculating these ratios, an implicit assumption is that the

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company makes all its purchases using credit. Cost of goods sold [or cost of sales] is
sometimes used as an approximation of purchases.

54. A is correct because, Cash conversion cycle (net operating cycle) (CCC) = DOH + DSO
– Number of days of payables and this metric indicates the amount of time that
elapses from the point when a company invests in working capital until the point at
which the company collects cash. A shorter cash conversion cycle indicates greater
liquidity. A longer cash conversion cycle indicates lower liquidity. Also, Payables
turnover = Purchases / Average trade payables and Number of days of payables =
Number of days in period / Payables turnover. Accordingly, the number of days
payable for Year 2 = Number of days in period / Payables turnover; or 365 / 36 ≈
10.1389 and the number of days payable for Year 1 = Number of days in period /
Payables turnover; or 365 / 18 ≈ 20.2778. (365 is used for the number of days in a
year, given the annual data.) The CCC for Year 2 = DOH + DSO – Number of days of
payables; or 11 + 24 – 10.1389 = 24.8611 and the CCC for Year 1 = DOH + DSO –
Number of days of payables; or 13 + 22 – 20.2778 = 14.7222. As the CCC is higher
(longer) in Year 2 than in Year 1 (24.8611 > 14.7222), the company's liquidity based on
its CCC alone has deteriorated.

55. C is correct because the fixed charge coverage ratio relates fixed financing charges,
or obligations, to the cash flow generated by the company. It measures the number
of times a company’s earnings (before interest, taxes, and lease payments) can cover
the company’s interest and lease payments. Accordingly, Fixed charge coverage ratio
= (EBIT + Lease payments) / (Interest payments + Lease payments) = (16 + 4) / (6 +
4) = 2.0.

For computing this ratio, an assumption sometimes made is that one-third of the lease
payment amount represents interest on the lease obligation and that the rest is a
repayment of principal on the obligation. For this variant of the fixed charge coverage
ratio, the numerator is EBIT plus one-third of lease payments and the denominator
is interest payments plus one-third of lease payments. Accordingly, Fixed charge
coverage ratio = [EBIT + (Lease payments / 3)] / (Interest payments + (Lease
payments / 3)) = (16 + 4/3) / (6 + 4/3) ≈ 2.36 which is also closest to 2.0.

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