FAR · Financial reporting · 6 practice questions
Financial Ratio Analysis: Liquidity, Leverage, and ROE
A higher current ratio may reflect inventory buildup, and higher ROE may reflect leverage rather than stronger operations. Compare one company's ratios and judge which interpretation the evidence supports.
Try one first
Hint
Compare what the current ratio includes with what the quick ratio excludes, then look at which turnover ratio changed the most.
Answer D. This is the best conclusion because the current ratio improved while the quick ratio fell sharply, which suggests that less-liquid current assets, most likely inventory, increased relative to cash and receivables. The drop in inventory turnover also shows that inventory is being sold more slowly. Together, those two metrics point to an inventory buildup rather than stronger liquidity.
Why not A: This is tempting because weakening liquidity can make candidates think of collection problems. However, accounts receivable turnover was essentially unchanged from 8.4x to 8.3x, so the data do not support a significant deterioration in collections.
Why not B: This choice is tempting because a 30% gross profit margin may still look healthy in isolation. But the question asks for the primary issue indicated by the full set of metrics, and the gross profit margin actually slipped slightly while the stronger signal is the deterioration in inventory quality and liquidity mix.
Why not C: This is a common shortcut mistake because it focuses on only one ratio. The quick ratio declined substantially, and inventory turnover also worsened, so the higher current ratio appears to be driven by more inventory, not by stronger liquid resources.
What should you do?
The situation
Orion reports these Year 1 to Year 2 ratios: current, 1.50 to 1.75; quick, 0.67 to 0.50; debt-to-equity, 0.73 to 0.93; interest coverage, 6.0x to 3.3x. Inventory rose from $100 million to $150 million. EBIT rose from $90 million to $100 million. Which assessment is best supported?
The current ratio improved, but quick liquidity and solvency weakened.
Best Inventory buildup supports the higher current ratio. Falling quick liquidity, higher leverage, and lower interest coverage indicate greater risk.
Review inventory quality before treating the higher current ratio as stronger liquidity.
Acceptable This questions current asset quality but leaves out the deterioration in leverage and interest coverage.
Liquidity clearly improved because the current ratio increased.
Wrong The quick ratio fell. More inventory does not establish greater ability to meet near-term obligations.
Higher EBIT shows that Orion's ability to cover interest improved.
Wrong Interest coverage fell from 6.0x to 3.3x, so EBIT covered interest expense fewer times despite its increase.
Key points
- Remember: Better-looking headline ratios do not prove stronger financial health; check what drives the change.
- Falling inventory turnover indicates slower inventory movement, not improved profitability.
- Compare operating cash flow with reported profit to assess whether earnings are converting to cash.
- Debt-to-equity can rise because liabilities increase or equity falls.
How the exam traps you
- Calling liquidity stronger because the current ratio increased. Check the quick ratio and inventory turnover for less-liquid assets behind the increase.
- Treating higher EBIT as proof of better interest coverage. Divide EBIT by interest expense. Coverage falls when interest expense grows proportionally faster.
- Calling higher ROE an operating improvement without checking its drivers. Separate net profit margin, asset turnover, and the equity multiplier.
Question 2
| Financial Item | Amount |
|---|---|
| cash | $25,000 |
| accounts receivable, net | $55,000 |
| inventory | $140,000 |
| prepaid insurance | $20,000 |
| current liabilities | $120,000 |
Hint
Compute both current assets and quick assets before deciding what the balance sheet says about liquidity.
Answer A. Current assets total $240,000 (25,000 + 55,000 + 140,000 + 20,000), so working capital is $120,000 and the current ratio is 2.0 ($240,000 ÷ $120,000). Quick assets (cash + receivables) are $80,000, so the quick ratio is 0.67 ($80,000 ÷ $120,000). The current ratio appears healthy only because a large portion of current assets is inventory, so liquidity depends on converting that inventory to cash.
Why not B: This is tempting if a student computes only the current ratio and stops there. The quick ratio excludes inventory and prepaids; here quick assets are $80,000 and the quick ratio is 0.67, which does not exceed 1.0, so River does not show strong liquidity on both measures.
Why not C: This distractor confuses current assets with quick assets. Prepaid insurance is a current asset (included in working capital and the current ratio) even though it is excluded from the quick ratio. With prepaid included, River's working capital is positive, not negative.
Why not D: While income statement information can provide context, short-term liquidity can be assessed directly from the balance sheet using working capital, the current ratio, and the quick ratio. Net income is not required to classify short-term liquidity here.
Question 3
Hint
Focus on the main limitation of the current ratio: it measures quantity of current assets, not necessarily their quality or speed of conversion to cash.
Answer D. The current ratio treats all current assets as if they are equally available to meet short-term obligations, but liquidity depends on how quickly those assets can be converted to cash. Slow-moving inventory with declining demand may be difficult to sell or may require discounts, so it may not be readily available to pay current liabilities. Thus a high current ratio can be misleading if it is supported mainly by such inventory.
Why not A: Year-end AR increases can sometimes signal weaker liquidity, but if receivables remain within normal terms and collection history is strong, they still represent reasonably liquid current assets. This fact does not weaken the liquidity conclusion as much as stale inventory would.
Why not B: This confuses profitability with liquidity. An improved gross margin indicates better profit per sale but does not show whether current assets are liquid enough to meet near-term obligations.
Why not C: This is tempting because liability mix affects financing risk, but trade payables are ordinary current obligations already included in the current ratio. That classification does not undermine the ratio the way illiquid current assets do.
Question 4
Hint
Track the combined effect of the borrowing and the simultaneous buyback on assets, liabilities, and equity; decide which ratio numerators and denominators change and in which direction.
Answer C. The $1,000,000 loan increases long-term liabilities and temporarily raises cash, but the proceeds are simultaneously used to repurchase stock, so current assets (cash) are unchanged and the current ratio is unchanged. Total liabilities increase while total assets remain the same, so debt-to-assets increases. The repurchase reduces stockholders' equity, so debt-to-equity increases. With net income unchanged for the immediate effect, ROE increases because the equity denominator is smaller.
Why not A: This is tempting if a student incorrectly thinks the liability increase is offset proportionally by the equity reduction in a way that lowers debt/equity. It's wrong because increasing total liabilities while simultaneously reducing equity raises the total-liabilities/equity ratio, not lowers it.
Why not B: This reflects the mistake of focusing only on the borrowing (which momentarily raises cash) and assuming immediate interest expense lowers net income. It's wrong because the proceeds were immediately used to repurchase stock (leaving current assets unchanged) and the question directs you to ignore any immediate change in net income, so the current ratio doesn't increase and ROE does not decrease.
Why not D: This reflects the error of thinking the repurchase simply reduces cash (lowering current assets) while overlooking that the borrowing restored cash first. It's wrong because the net effect on current assets is zero (borrow then repurchase), total liabilities increase (so debt-to-assets increases), and ROE rises when equity falls with net income unchanged.
Question 5
Hint
Think about which current assets count in the current ratio but may not actually help satisfy near-term cash needs.
Answer B. The current ratio includes all current assets, even those that may not be readily available to satisfy near-term obligations. Inventory may take time to sell, and prepaid insurance is not a source of cash. The much lower quick ratio reinforces that Lane's apparent liquidity is weaker once less liquid current assets are excluded.
Why not A: This distractor confuses the classification of liabilities. Accrued expenses are current liabilities and are included in the denominator; the fact pattern points to the quality of current assets, not omitted liabilities.
Why not C: This is incorrect because the quick ratio intentionally excludes inventory and prepaids. A difference between the ratios is normal and informative, it doesn't make the current ratio meaningless.
Why not D: A high current ratio is only an indicator of liquidity, not proof. It doesn't guarantee cash is available exactly when obligations come due, especially if current assets are illiquid.
Question 6
Hint
Evaluate liquidity (current/quick), efficiency (turnover), leverage/coverage separately, and adjust ROA for one-time items before concluding about recurring profitability.
Answer A. Inventory turnover rose (4.0 → 6.0), indicating improved operating efficiency; ROA excluding the one-time gain rose from 5% to 6%, so recurring profitability improved modestly. However, the current and quick ratios fell, showing weaker short-term liquidity, while debt-to-equity increased and times interest earned fell (6x → 3x), indicating higher financial risk. The reported 8% ROA overstates recurring performance because of the $200,000 one-time gain.
Why not B: Tempting because turnover and reported ROA rose, but incorrect: both current and quick ratios declined (weaker liquidity) and leverage/interest coverage worsened; the reported ROA is inflated by a one-time gain.
Why not C: Attractive to candidates focused on liquidity and coverage, but incorrect because recurring profitability did not deteriorate, ROA excluding the one-time gain actually rose (5% → 6%) and inventory turnover improved, indicating modestly better core profitability.
Why not D: Plausible if one assumes the debt funded productive assets, but the stem only states debt financed expansion and shows materially higher leverage (D/E 0.5 → 1.2) and lower interest coverage (6x → 3x); these indicate increased financial risk that cannot be judged 'acceptable' solely from higher turnover.
Common questions
What does a rising current ratio but falling quick ratio mean?
Less-liquid assets, such as inventory and prepaids, represent a larger share of current assets. If inventory turnover also falls, the pattern points to slower-moving inventory rather than stronger immediate liquidity.
What do rising debt-to-equity and falling interest coverage indicate?
Financial risk increased: liabilities are higher relative to equity, and EBIT provides less coverage of interest expense. Higher profit does not cancel those warning signs.
Can ROE increase while operating performance gets worse?
Yes. ROE equals net profit margin × asset turnover × equity multiplier; with consistent measurement bases, rising ROE despite falling margin and asset turnover means increased leverage is driving the gain.
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