Chapter 5 exercises

Multiple Choice Questions (MCQs)

1. The current ratio can be numerically expressed in the form of the following equation:-
a. Current ratio = Current assets – current liabilities
b. Current ratio = Current assets + current liabilities
c. Current ratio = Current assets / current liabilities
d. Current ratio = Current assets * current liabilities
2. From the following data, calculate the liquid ratio:

Current Assets = 50,000 ; Current Liabilities = 20,000 ; Inventory = 13,000 ; Prepaid Expenses = 1,000.

a. 1 : 1

b. 1.8 : 1

c. 1 : 1.8

d. 1.5 : 1

3. Operating Margin can be numerically expressed in the form of following equation:-

a. [(Net profits – operating expenses) / Revenue]

b. [(Gross profits – operating expenses) / Revenue]

c. [(Net profits – operating revenue) / Revenue]

d. [(Gross profits – non-operating expenses) / Revenue]

4. Which of the following is not a part of liquidity ratios?

a. Current ratio

b. Solvency ratio

c. Liquid ratio

d. Quick ratio

Ans. B) Solvency ratio

Explanation: Liquidity ratios has been sub-classified into two ratios as stated below:-

Current Ratio

Liquid Ratio (or Quick Ratio)

Interest coverage ratio can be numerically expressed in the form of the following equation:-

(Gross profit / interest on total debts)

(Interest on long-term debts / Net profit before interest and tax)

(Net profit after interest / interest on long-term debts)

(Net profit before interest and tax/interest on long-term debts)

Ans. D) (Net profit before interest and tax/interest on long-term debts)

Explanation: The interest coverage ratio tells whether the PBIT (Profit Before Interest and Tax) is
sufficient enough to pay off the interest expenses on long-term debts (like debentures) of the
concerned entity.

What is the ideal liquid ratio of any entity?

1: 1

2: 1

1: 2

None

Ans. A) 1 : 1

Explanation: Ideally, the liquid assets should be equal to the current liabilities of an entity. Hence the
ideal liquid ratio is 1: 1.

Accounting Ratios provide a _________ measure of a company’s performance and condition.

Definitive

Gross

Relative

Qualitative

Ans. C) Relative

Explanation: Accounting ratios are a relative measure of a company’s performance and condition as
they are calculated by determining the relationship between two or more financial variables or
values taken from the financial data or financial statements of an entity.

_________ analysis involves the comparison of different firm’s financial ratios at the same point in
time.

Time-series

Cross-sectional

Marginal

Quantitative

Ans. B) Cross-sectional

Explanation: Cross-sectional analysis involves the comparison of a firm’s ratios with that of some
other selected firms in the same industry or the industry average at the same point of time. Such a
comparison is very helpful in assessing the relative financial position and performance of the firm.
__________ analysis involves the comparison between the current and historical financial
performance and the evaluation of developing trends.

Time-series

Cross-sectional

Marginal

Quantitative

Ans. A) Time series

Explanation: When the ratios of the same firm over a period of time are compared, it is known as the
time series analysis (or trend analysis). Such an analysis gives an indication of the direction of change
or developing trends and reflects whether a firm’s financial performance has improved, deteriorated,
or remained constant over a period of time.

Time-series analysis is often used to

Assess developing trends

Correct errors of judgement

Reflect performance relative to some norms

Standardize

Ans. A) Assess developing trends

Explanation: In order to derive meaningful conclusions from time-series analysis, we require quality
data over a period of time so that it gives an indication of the direction of variation or developing
trends and depicts whether a firm’s financial performance has improved, deteriorated, or remained
constant over a period of time.

Which of the following ratios are basically the measures of yield or return.

Liquidity

Activity

Debt

Profitability

Ans. D) Profitability

Explanation: Profitability ratios are used to measure the various aspects of profitability of a company,
such as what is the rate of profit on revenue from operations and whether the profits are decreasing
or increasing and if declining, the cause of such decline.
An analysis in which the firm’s ratio values are compared to those of a key competitor or group of
competitors, primarily to identify areas for improvement is called:-

Time-series analysis

Combined analysis

Benchmarking

None of the above

Ans. C) Benchmarking

Explanation: Benchmarking refers to the process of evaluating the firm’s accounting ratios and its
financial performance with that of the competitor or a group of competitors in order to know where
the entity needs to improve.

The _________ of a business firm is measured by its ability to satisfy its short-term obligations as
they become due.

Activity

Liquidity

Debt

Profitability

Ans. B) Liquidity

Explanation: Liquidity refers to the ability of the firm to pay off its current liabilities (or short term
obligations) as and when they fall due.

____________ ratios are a measure of the speed with which various accounts are converted into
sales or cash.

Activity

Liquidity

Debt

Profitability

Ans. A) Activity

Explanation: Activity ratios (or Turnover ratios) are calculated on the basis of either cost of revenue
from operations or revenue from operations. It indicates the speed or the number of times the
capital employed has been rotated in the process of doing business.

The __________ is useful in evaluating credit and collection policies.

Average payment period

Current ratio

Average collection period

Inventory turnover ratio

Ans. C) Average collection period

Explanation: The average collection period is used as an accounting measure to symbolize the avg.
No. of days among a credit score sale date and the date whilst the customer remits payment. An
entity’s average collection period indicates the effectiveness of its Accounts Receivable (or Trade
Receivables) Management.

Net working capital is defined as

Total assets less current assets

The excess of current assets over current liabilities

Current liabilities less current assets

Marketable securities and cash

Ans. B) The excess of current assets over current liabilities

Explanation: Net working capital of a firm depicts the difference between its current assets and
current liabilities.

Net working capital = Current assets – current liabilities

The two basic measures of liquidity are

Inventory turnover and current ratio

Current ratio and liquid ratio

Gross profit margin and operating ratios

Current ratio and average collection period

Ans. B) Current ratio and liquid ratio

Explanation: Liquidity ratios has been sub-classified into two ratios as stated below:-

Current Ratio

Liquid Ratio (or Quick Ratio)

ABC Company extends credit terms of 45 days to its customers. Its credit collection would be
considered poor if its average collection period was

30 days
36 days

40 days

57 days

Ans. D) 57 days

Explanation: Avg.collection period =365Avg.receivables turnover ratios

Higher the avg. Collection period, the poorer is its credit collection and lower the avg. Collection
period, the stronger is its credit collection.

The __________ indicates the percentage of each sales rupee remaining after the firm has paid for
its goods.

Net profit margin

Operating profit margin

Gross profit margin

Earnings available to equity shareholders

Ans. C) Gross profit margin

Explanation: Gross profit margin establishes the relationship between the gross profit and revenue
from operation of the concerned entity.

If the inventory turnover is divided by 365, it becomes a measure of

Revenue from operations efficiency

The average age of the inventory

Revenue from operations turnover

The average collection period

Ans. B) The average age of the inventory

Explanation: The average age of the inventory is the average number of days it takes for an entity to
completely sell off its stock or inventory. It is a measure that is used to determine the performance of
the revenue from operations or sales. The average age of inventory can also be termed as DSI (Day’s
Sale in Inventory).
Answer:

1. C) Current ratio = Current assets / current liabilities

Explanation: Current ratio tells (a number of times) whether a current asset is sufficient
enough to be used to pay off the current liabilities of the entity concerned.
2. Ans. B) 1.8 : 1
Explanation: Liquid assets = Current assets – inventory – prepaid expenses
Liquid assets = 50,000 – 13,000 – 1,000 = 36,000
Liquid Ratio = Liquid AssetsCurrent Liabilities = 36,00020,000
Liquid Ratio = 1.8 : 1
3. Ans. B) [(Gross profits – operating expenses) / Revenue from operations]
Explanation: Operating Margin determines the relationship between the profit of a company
after paying its variable cost except interest and tax and the sales of an entity.
4.