Profitability and liquidity ratio analysis practice questions.

A firm has current assets of 60 000, inventory of 24 000 and current liabilities of 30 000. Calculate the acid-test (quick) ratio.

• 2.0
• 1.2
• 0.8
• 2.8

Answer: 1.2

Acid-test ratio = (current assets − inventory) ÷ current liabilities = (60 000 − 24 000) ÷ 30 000 = 36 000 ÷ 30 000 = 1.2.

Gross profit is 84 000 and sales revenue is 210 000. Calculate the gross profit margin.

• 40%
• 25%
• 60%
• 84%

Answer: 40%

Gross profit margin = (gross profit ÷ sales revenue) × 100 = (84 000 ÷ 210 000) × 100 = 40%.

A firm's profit before interest and tax is 36 000 and capital employed is 240 000. Calculate the return on capital employed (ROCE).

• 6.7%
• 15%
• 18%
• 12%

Answer: 15%

ROCE = (profit before interest and tax ÷ capital employed) × 100 = (36 000 ÷ 240 000) × 100 = 15%.

A retailer reports a current ratio of 3.5:1, well above the industry average of 1.6:1. This most likely suggests that the firm:

• is close to running out of cash
• is holding idle cash or slow inventory
• has borrowed heavily over the long term
• is more profitable than its competitors

Answer: is holding idle cash or slow inventory

A very high current ratio ties up funds in cash, receivables or stock that could earn a better return elsewhere, so liquidity can be excessive. Liquidity ratios say nothing about profitability or about long-term borrowing.

A manufacturer has a current ratio of 1.9:1 but an acid-test ratio of 0.6:1. The most likely explanation is that the firm:

• holds a large amount of inventory (stock)
• has written off most of its receivables
• carries almost no short-term liabilities at all
• has raised extra long-term loan capital

Answer: holds a large amount of inventory (stock)

The gap between the two ratios is inventory, which the acid-test strips out, so a wide gap means stock dominates current assets. Reading the low acid-test as immediate insolvency ignores that the stock may still sell.

A firm's return on capital employed has fallen from 18 % to 12 %, while its profit before interest and tax is unchanged. The most likely explanation is that:

• its capital employed has grown during the year
• its sales revenue has fallen during the year
• it has repaid part of its non-current liabilities
• its cost of sales has risen during the year

Answer: its capital employed has grown during the year

ROCE relates profit to the long-term finance invested, so with the numerator fixed only a larger denominator can pull the ratio down - typically new investment that has not yet started to earn. Repaying long-term debt shrinks capital employed and would raise ROCE.