Financial Ratio Analysis Flashcards

Question 1

What is a financial ratio, and why do analysts compute one?

Accepted Answer

A financial ratio is one number divided by another, usually taken from a company's financial statements. Analysts compute ratios because raw figures like total profit are hard to judge alone, while a ratio scales results so that companies of different sizes and periods can be compared fairly and quickly.

Question 2

Which three financial statements supply most of the data used in ratio analysis?

Accepted Answer

The three core sources are the balance sheet, the income statement, and the cash flow statement. The balance sheet reports assets, liabilities, and equity at one point in time. The income statement reports revenue, expenses, and profit over a period. The cash flow statement shows how cash moves through operating, investing, and financing.

Question 3

Why should a ratio be compared with a benchmark before drawing conclusions?

Accepted Answer

A single ratio has little meaning until it is set against a reference point. Useful benchmarks include the same company's results in earlier periods, the averages of competitors, and industry norms. Comparing against a benchmark shows whether performance is improving, declining, or unusual for the sector.

Question 4

What is the difference between trend analysis and cross-sectional analysis?

Accepted Answer

Trend analysis tracks one company's ratios across several periods to reveal direction and momentum. Cross-sectional analysis compares ratios of different companies at the same point in time to show relative standing. Strong analysis usually combines both views, since an improving ratio may still lag peers.

Question 5

What are the main limitations of ratio analysis?

Accepted Answer

Ratios rely on accounting figures, which can vary with the methods a company chooses, such as inventory valuation or depreciation. Ratios also reflect past results, may ignore qualitative factors like management quality, and can be distorted by seasonal swings or one-time events. They work best as signals that prompt further questions.

Question 6

What is common-size analysis and how does it relate to ratios?

Accepted Answer

Common-size analysis expresses every line of a financial statement as a percentage of a single base figure. On an income statement the base is usually revenue, and on a balance sheet it is total assets. This makes statements of different-sized companies comparable and turns many line items into ratio-like measures.

Question 7

Why must the numerator and denominator of a ratio come from the same time period?

Accepted Answer

Matching periods keeps the ratio meaningful. A flow measure such as annual net income should be divided by another flow measure or by a comparable average balance, not by a single year-end snapshot. Mixing a full year of profit with a point-in-time balance can distort results.

Question 8

How do you decide which ratios to emphasize for a particular business?

Accepted Answer

Start with the question you are trying to answer, such as whether a company can pay short-term debts. Then choose ratios that address that question for the company's industry. A bank, a retailer, and a software firm rely on different measures because their assets, costs, and funding differ.

Question 9

What does the current ratio measure, and what is its formula?

Accepted Answer

The current ratio measures whether a company can cover its short-term obligations with assets expected to convert to cash within a year. It equals current assets divided by current liabilities. A result above one generally means current assets exceed current liabilities, though the appropriate level depends heavily on the industry.

Question 10

How does the quick ratio differ from the current ratio?

Accepted Answer

The quick ratio, also called the acid-test ratio, removes inventory from current assets before dividing by current liabilities. Inventory is excluded because it may be slow to sell or may need discounting to turn into cash. The quick ratio therefore gives a stricter view of short-term liquidity than the current ratio does.

Question 11

Why might a high current ratio sometimes signal a problem rather than strength?

Accepted Answer

A very high current ratio can mean cash and receivables are sitting idle instead of being invested or returned to shareholders. Excess inventory may also be inflating current assets, perhaps because products are not selling. Analysts therefore check the composition of current assets, not just the total, before judging liquidity as healthy.

Question 12

What is working capital, and how is it calculated?

Accepted Answer

Working capital is the amount by which current assets exceed current liabilities. It is calculated by subtracting total current liabilities from total current assets. Positive working capital suggests a company has a cushion to meet short-term needs, while negative working capital signals that near-term obligations exceed near-term resources.

Question 13

What does the cash ratio measure, and when is it most useful?

Accepted Answer

The cash ratio measures how much of current liabilities could be paid using only cash and cash equivalents. It equals cash and equivalents divided by current liabilities. It is the strictest liquidity test and is most useful when a company faces doubts about collecting receivables or selling inventory quickly or during financial stress.

Question 14

How does operating cash flow relate to liquidity analysis?

Accepted Answer

Operating cash flow shows the cash a company generates from its core activities, often a more reliable guide than accounting profit. The operating cash flow ratio divides operating cash flow by current liabilities. A ratio above one suggests that a year of operations generated enough cash to cover current obligations.

Question 15

Why do analysts look at liquidity ratios in the context of the operating cycle?

Accepted Answer

Liquidity ratios must be read against the operating cycle, the time needed to buy inventory, sell it, and collect cash. Companies with short cycles, such as grocers, can safely operate with lower ratios than companies with long cycles, such as heavy equipment makers. Judging liquidity without this context can lead to unfair conclusions.

Question 16

How would you evaluate a company whose current ratio improved while its quick ratio fell?

Accepted Answer

This pattern usually means the company's added current assets are mostly inventory, since inventory is the one item removed in the quick ratio. Investigate whether stock is building up because sales are slowing or whether it reflects planned growth. Also check receivables and inventory turnover before concluding that liquidity has truly strengthened.

Question 17

What is gross profit margin, and how is it calculated?

Accepted Answer

Gross profit margin is the share of revenue remaining after subtracting the cost of goods sold. It is calculated by dividing gross profit by revenue and expressing the result as a percentage. It reveals how efficiently a company produces or buys what it sells, before overhead, marketing, and interest expenses.

Question 18

What does operating profit margin capture that gross margin does not?

Accepted Answer

Operating profit margin subtracts operating expenses such as salaries, rent, marketing, and administration from gross profit before dividing by revenue. It therefore captures the cost of running the business day to day, which gross margin ignores. It shows how well management controls costs beyond direct production costs.

Question 19

What is net profit margin, and what limitation should readers keep in mind?

Accepted Answer

Net profit margin is net income divided by revenue, showing what remains from each sales dollar after all expenses and taxes. Because it includes one-time gains, losses, and unusual tax effects, a single year can mislead. Compare it over several periods to separate recurring performance from unusual items.

Question 20

How is return on assets calculated, and what does it tell you?

Accepted Answer

Return on assets is calculated by dividing net income by total assets, often using average total assets for the period. It shows how much profit the company generates from each dollar of assets it controls. A higher figure suggests the business uses its resources productively, though capital-heavy industries naturally show lower values.

Question 21

How is return on equity calculated, and why do investors watch it closely?

Accepted Answer

Return on equity is net income divided by shareholders' equity, often using average equity over the period. It measures the profit generated for each dollar invested by owners. Investors watch it closely because it links earnings directly to shareholder capital, but a high value may reflect heavy borrowing rather than strong operations.

Question 22

How does the DuPont analysis break down return on equity?

Accepted Answer

DuPont analysis splits return on equity into three parts: net profit margin, asset turnover, and financial leverage, which is total assets divided by equity. Multiplying these three components reproduces return on equity. This shows whether returns come from profitability, efficient use of assets, or borrowing.

Question 23

Why might return on equity be higher than return on assets for the same company?

Accepted Answer

Return on equity exceeds return on assets when a company uses debt, because borrowed funds add to the assets it controls without adding to equity. If the company earns more on those assets than it pays in interest, the surplus flows to shareholders and lifts return on equity. The gap reflects financial leverage.

Question 24

How should a profitability analysis treat a company with unusually high one-time gains?

Accepted Answer

Exclude or separately label one-time gains when judging recurring profitability, because they inflate net income without reflecting ongoing operations. Adjusted figures give a clearer picture of the core business. Compare the adjusted and reported margins, and check the notes to the financial statements for the nature of the gains.

Question 25

What is the debt-to-equity ratio, and how is it interpreted?

Accepted Answer

The debt-to-equity ratio divides total debt by shareholders' equity, showing how much a company relies on borrowed money compared with owner funding. A higher ratio means greater financial risk, since fixed repayments must be made regardless of business conditions. Acceptable levels vary widely, so compare the result with industry peers.

Question 26

How does the debt ratio differ from the debt-to-equity ratio?

Accepted Answer

The debt ratio divides total liabilities by total assets, showing the share of a company's assets financed by creditors. The debt-to-equity ratio compares borrowed funding with owner funding instead. Both measure leverage, but they answer slightly different questions about how the business is financed.

Question 27

What does the interest coverage ratio measure, and why does it matter?

Accepted Answer

The interest coverage ratio measures how many times a company's operating earnings can pay its interest expense. It is calculated by dividing earnings before interest and taxes by interest expense. Lenders watch it closely because a low value signals that a small drop in earnings could make debt payments difficult.

Question 28

What is the equity multiplier, and how does it connect to leverage?

Accepted Answer

The equity multiplier is total assets divided by total shareholders' equity. It shows how many dollars of assets the company controls for each dollar of owner capital. A larger multiplier means more of the asset base is funded by debt, which magnifies both gains and losses for shareholders.

Question 29

What is the difference between solvency and liquidity?

Accepted Answer

Liquidity concerns the ability to meet obligations due in the near term, using liquid assets. Solvency concerns the ability to meet all obligations over the long run, including long-term debt. A company can be liquid but not solvent if its long-term debts overwhelm its assets, and the reverse can also occur.

Question 30

Why do analysts examine lease obligations when assessing leverage?

Accepted Answer

Analysts examine leases because they are long-term commitments that work much like debt, requiring fixed payments over many years. Including them in leverage calculations prevents a company from looking less indebted simply because it rents assets rather than buying them. Analysts also review lease notes when reported debt seems low.

Question 31

How does a company's debt maturity schedule affect its risk profile?

Accepted Answer

A maturity schedule shows when principal payments come due, and clustering many maturities in one period raises refinancing risk. If lenders are unwilling to roll over that debt, the company may need to repay under pressure. Spreading maturities across several years generally lowers that risk.

Question 32

How should leverage ratios be read alongside profitability and cash flow?

Accepted Answer

Leverage ratios are most informative when combined with earnings and cash flow measures, since debt is serviced from those sources. A company with high debt but steady operating cash flow may be safer than one with moderate debt and shrinking cash generation. Read them together to judge whether the debt load is sustainable.

Question 33

What does inventory turnover measure, and how is it calculated?

Accepted Answer

Inventory turnover measures how many times a company sells and replaces its inventory over a period. It is calculated by dividing cost of goods sold by average inventory. A higher turnover generally indicates efficient stock management, though very high turnover may also signal shortages or lost sales.

Question 34

How is days sales outstanding calculated, and what does it reveal?

Accepted Answer

Days sales outstanding estimates the average number of days needed to collect payment after a sale. It is calculated by dividing accounts receivable by revenue, then multiplying by the number of days in the period. Rising values can signal slower collections or looser credit terms, which may strain cash flow.

Question 35

What does total asset turnover show, and what makes a good level?

Accepted Answer

Total asset turnover shows how much revenue a company generates for each dollar of assets it holds. It equals revenue divided by average total assets. What counts as a good level varies by industry, since retailers typically turn assets faster than utilities or heavy manufacturers, so compare results with peers.

Question 36

How does the cash conversion cycle combine several efficiency measures?

Accepted Answer

The cash conversion cycle adds days inventory outstanding and days sales outstanding, then subtracts days payables outstanding. The result estimates how many days cash is tied up between paying suppliers and collecting from customers. A shorter cycle generally means cash returns to the business faster.

Question 37

What is the price-to-earnings ratio, and how should investors use it?

Accepted Answer

The price-to-earnings ratio divides a company's share price by its earnings per share. It shows how much investors are paying for each dollar of current earnings. A high ratio may reflect expected growth, while a low ratio may signal value or problems, so investors should compare it with peers and earnings expectations.

Question 38

What does the price-to-book ratio compare, and when is it most relevant?

Accepted Answer

The price-to-book ratio compares a company's market value of equity with its book value, which is shareholders' equity on the balance sheet. It is most relevant for asset-heavy firms, where book value reflects tangible resources. It is less useful for businesses whose main value lies in intangibles like software or brands.

Question 39

How does dividend yield help income-focused investors evaluate a stock?

Accepted Answer

Dividend yield divides annual dividends per share by the current share price, expressed as a percentage. It shows the cash income an investor receives relative to the price paid. An unusually high figure may signal a falling share price or an unsustainable dividend.

Question 40

Why should valuation ratios be combined with profitability and leverage ratios?

Accepted Answer

Valuation ratios reflect market sentiment and expectations, which can change quickly, so they gain meaning only when linked to a company's fundamentals. A low price-to-earnings ratio might look cheap, yet heavy debt or declining margins could explain the discount. Combining measures helps separate true bargains from value traps.

Financial Ratio Analysis Flashcards

1Ratio analysis fundamentals

2Liquidity ratios

3Profitability ratios

4Leverage and solvency ratios

5Efficiency and market valuation ratios

Learning Resources