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Questions and Answers
The current ratio measures a company's ability to pay its debts over the next 5 years.
False
A higher current ratio indicates a company is less liquid.
False
The quick ratio is also known as the acid-test ratio or quick assets ratio.
True
A commonly acceptable current ratio is 1.
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Liquidity ratios measure a company's ability to meet its long-term debt obligations.
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The cash ratio measures a company's ability to pay its debts over the next 6 months.
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A debt ratio of 1 means that total liabilities are half of total assets.
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The debt ratio is a type of profitability ratio.
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A higher debt ratio is generally more favorable than a lower debt ratio.
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The debt ratio is calculated by dividing total assets by total liabilities.
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Financial leverage is also known as 'trading on equity'.
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The times interest earned ratio is calculated by dividing earnings before income and taxes by interest expense.
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A debt ratio of 0.5 is considered highly leveraged.
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The debt to equity ratio is the same as the debt ratio.
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A high inventory turnover indicates poor inventory management.
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A low accounts receivable turnover indicates that a company is efficient in collecting its credit sales.
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A company with a higher total asset turnover ratio is using its assets inefficiently.
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The average collection period measures the average number of days between the date a credit sale is made and the date payment is received from the credit sale.
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Financial leverage ratios measure the ability of a company to settle its maturing liabilities including the interest.
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Financial leverage refers to the use of equity to acquire additional assets.
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A debt ratio of 1.5 implies a company has more assets than liabilities.
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A company with a debt ratio of 0.5 has more liabilities than assets.
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In a company with a debt ratio of 1, investors and creditors have an equal stake in the business assets.
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A debt to equity ratio of 0.25 implies a more risky business to creditors and investors.
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A company with a debt ratio of 0.5 is considered highly leveraged.
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A company with a debt to equity ratio of 0.5 has $2 of equity for every $1 of liabilities.
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A higher debt ratio implies a company with lower overall debt.
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A company with a debt to equity ratio of 1 has $1 of equity for every $1 of liabilities.
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The Times Interest Earned ratio is calculated by dividing the total liabilities by the interest expense.
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A higher Times Interest Earned ratio indicates a higher credit risk.
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Market ratios are based solely on information contained in the firm's financial statements.
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A ratio of 4 in the Times Interest Earned means the company's income is 4 times lower than its interest expense.
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The Debt to Equity Ratio is a type of market ratio.
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Creditors would prefer a company with a lower Times Interest Earned ratio.
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The Times Interest Earned ratio is expressed as a percentage.
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Market ratios are not closely watched by those considering security purchases.
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Study Notes
Financial Leverage/Solvency Ratios
- Financial leverage is also known as "trading on equity."
- Debt ratio = Total Liabilities / Total Assets
- A lower debt ratio implies a more stable business with lower overall debt.
- A debt ratio of 1 means total liabilities equal total assets, making the company highly leveraged.
- Debt to equity ratio = Total Liabilities / Common Shareholder's Equity
- A lower debt to equity ratio implies a more financially stable business.
- Times interest earned = Earnings Before Income and Taxes / Interest Expense
- A higher times interest earned ratio indicates a company can afford to pay its interest payments.
Liquidity Ratios
- Liquidity ratios measure a company's ability to meet its short-term debt obligations.
- Current ratio = Current Assets / Current Liabilities
- A higher current ratio indicates a company is more liquid.
- Quick ratio (acid-test ratio) = (Current Assets + Marketable Securities + Accounts Receivable) / Current Liabilities
- Cash ratio = Cash / Current Liabilities
- Accounts receivable turnover = Total Sales / Average Accounts Receivable
- A higher accounts receivable turnover indicates efficient collections.
- Average collection period = Average Accounts Receivable / (Total Sales / 365)
- Total asset turnover = Total Sales / Total Assets
- A higher total asset turnover indicates efficient use of assets.
Market Ratios
- Market ratios are based on information not contained in a firm's financial statements.
- Market ratios are used to evaluate securities for potential purchases.
- These ratios are closely watched by those considering security purchases.
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Description
This quiz covers financial leverage, also known as 'trading on equity', and solvency ratios, including debt ratio and debt to equity ratio. Test your understanding of these financial concepts!
