Question 1

2.A.2.a
tb.liquid.ratios.024_1711
LOS: 2.A.2.a
Lesson Reference: Liquidity Ratios
Difficulty: medium
Bloom Code: 3

Ottoman Manufacturing Company reported net sales (all credit) of $120,000 and $140,000 for 20x3 and 20x4,
respectively, and net income of $24,000 and $32,000 for 20x3 and 20x4, respectively. Ottoman's 20x3 and
20x4 balance sheets appear here:

Calculate the company's current ratio for 20x4, rounding to two decimal places.

1.13

1.46
Correct

2.07

3.30

Rationale
 1.13
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. Higher current ratios indicate greater liquidity, as there are more current
assets available to satisfy current liabilities. If inventory is left out of current assets, the result for 20x4 is
1.13 ($34,000 ÷ $30,000). This is the quick ratio. However, the question asks for the current ratio.
Therefore, this is an incorrect answer.

Rationale
 1.46
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. Higher current ratios indicate greater liquidity, as there are more current
assets available to satisfy current liabilities. If total assets and total liabilities are used, the result is 1.46
($102,000 ÷ 720,000). However, this is not the current ratio. Therefore, this is an incorrect answer.

Rationale
 2.07
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. Higher current ratios indicate greater liquidity, as there are more current
assets available to satisfy current liabilities. Ottoman's current ratio for 20x4 is 2.07 ($62,000 ÷ $30,000).
Therefore, this is the correct answer.

Rationale
 3.30
One of the most common ratios used to assess liquidity is the current ratio. It is defined as Current
Assets ÷ Current Liabilities. Higher current ratios indicate greater liquidity, as there are more current
assets available to satisfy current liabilities. Ottoman's current ratio for 20x3 is 3.30 ($66,000 ÷ $20,000).
However, the question asks for the 20x4 current ratio. Therefore, this is an incorrect answer.
Question 2
2.A.2.m
tb.eff.ratios.020_1711
LOS: 2.A.2.m
Lesson Reference: Efficiency Ratios
Difficulty: hard
Bloom Code: 4
A(n) ________ will cause accounts receivable turnover to increase.
longer collection period
Correct

shorter collection period

increase in sales discounts

decrease in sales discounts

Rationale
 longer collection period
A longer collection period means that a company will give customers more time to pay. This will in turn
decrease accounts receivable turnover. Therefore, this is an incorrect answer.

Rationale
 shorter collection period
If a company shortens their collection period, they will collect accounts receivable from their customers
more quickly. This will in turn increase accounts receivable turnover. Therefore, this is the correct
answer.

Rationale
 increase in sales discounts
Sales discounts are price reductions offered to customers. An increase in sales discounts could increase
sales; however, this action is not directly related to accounts receivable turnover. Therefore, this is an
incorrect answer.

Rationale
 decrease in sales discounts
Sales discounts are price reductions offered to customers. A decrease in sales discounts could decrease
sales; however, this action is not directly related to accounts receivable turnover. Therefore, this is an
incorrect answer.
Question 3
2.A.2.w
limit.ratio.tb.014_2210
LOS: 2.A.2.w
Lesson Reference: Limitations of Ratio Analysis
Difficulty: medium
Bloom Code: 4
Which of the following best illustrates the correct use of ratio analysis?
Your Answer

Analyzing the solvency of a company by comparing its debt-to-asset and interest coverage ratios to the
ratios of a company of comparable size but in a different industry

Assessing the solvency of a company by comparing its fixed charge coverage ratio to its main competitor’s
fixed charge coverage ratio

Assessing the liquidity of a company by calculating the cash ratio, quick ratio, and cash flow ratio
Correct

Assessing the profitability of a company by comparing its gross profit ratio and return on sales ratio to the
figures of its main competitor

Rationale
 Analyzing the solvency of a company by comparing its debt-to-asset and interest coverage
ratios to the ratios of a company of comparable size but in a different industry
This answer is incorrect. It is important to compare a company’s ratios to ratios of a company in the
same industry as “good” values for ratios differ between industries.

Rationale
 Assessing the solvency of a company by comparing its fixed charge coverage ratio to its main
competitor’s fixed charge coverage ratio
This answer is incorrect. Assessing solvency with only one ratio is not a good idea as looking at only one
ratio provides a limited view of solvency.

Rationale
 Assessing the liquidity of a company by calculating the cash ratio, quick ratio, and cash flow
ratio
This answer is incorrect. It is important to compare a company’s ratios to a competitor’s ratios when
performing an analysis.

Rationale
 Assessing the profitability of a company by comparing its gross profit ratio and return on sales
ratio to the figures of its main competitor
Correct. Ratio analysis is a powerful tool for assessing company performance. However, there are some
potential problems with ratio analysis. For example, it is important to use more than one ratio to
analyze a particular area (for example, profitability) as one ratio may provide a misleading view of
performance. It is also important to compare a company’s ratios to a competitor’s ratios to provide
perspective to the figures. The comparison company should be in the same industry as different
industries have different “expected” values for ratios. Finally, it is important that the two companies
use similar accounting methods (for example, they both use FIFO for inventory) as different methods
can result in different accounting numbers.
Question 4
2.A.2.h
oplev.tb.009_2104
LOS: 2.A.2.h
Lesson Reference: Operating Leverage and Financial Leverage
Difficulty: medium
Bloom Code: 3

Ingram Industries has the following financial results. What is its financial leverage for 20X2?

20X2 20X1
Net Sales $13,047 $12,135
Gross Profit 6,123 5,747
Income from Operations 1,944 1,856
EBIT 1,933 1,859
Net Income 1,197 1,122
Total Assets 20,349 19,074
Total Liabilities 16,076 15,450
Total Equity 4,273 3,624

0.53

1.68
Correct

4.76

5.26

Rationale
 0.53
This answer is incorrect. This incorrect solution is Ingram Industries’ degree of operating leverage.

Rationale
 1.68
This answer is incorrect. This incorrect solution is Ingram Industries’ degree of financial leverage.

Rationale
 4.76

This answer is correct. The calculation for financial leverage is Total Assets ÷ Equity.

$20,349 ÷ $4,273 = 4.76

Rationale
 5.26
This answer is incorrect. This incorrect solution is financial leverage for 20X1.
Question 5
2.A.2.a
liquid.ratios.tb.046_0220
LOS: 2.A.2.a
Lesson Reference: Liquidity Ratios
Difficulty: medium
Bloom Code: 4

A company has current liabilities of $2,000,000 and net working capital of $300,000. If the company has a
quick ratio of 0.8, the company has inventory of:

*Source: Retired ICMA CMA Exam Questions.

$100,000.
Correct

$700,000.

$460,000.
Your Answer

$1,600,000.

Rationale
 $100,000.
This answer is incorrect. Inventory would be $100,000 if net working capital was ($300,000).

Rationale
 $700,000.
The quick ratio is calculated as “Quick assets ÷ Current liabilities.” Quick assets are only the most liquid
current assets and consist of cash, marketable securities, and accounts receivable. Another way to
define quick assets is as all current assets except inventory. If the quick ratio is 0.8, quick assets must be
$1,600,000 ($2,000,000 × 0.8). Net working capital is the difference between current assets and current
liabilities. If current liabilities are $2,000,000 and net working capital is $300,000, current assets must be
$2,300,000. If current assets are $2,300,000 and quick assets are $1,600,000, inventory is the $700,000
difference between the two.

Rationale
 $460,000.
This answer is incorrect. Inventory is not calculated as (1 − Quick ratio) × Current assets.

Rationale
 $1,600,000.
This answer is incorrect. The total quick assets are $1,600,000.
Question 6
2.A.2.w
limit.ratio.tb.003_2104
LOS: 2.A.2.w
Lesson Reference: Limitations of Ratio Analysis
Difficulty: medium
Bloom Code: 4

Dorsey Lumber and Green & Sons are both in the lumber industry. Over the past three years, lumber prices
have been steadily increasing. During this time, the company’s respective ratios are shown:

20X3 20X2 20X1

Current Ratio
Dorsey Lumber 2.29 2.25 2.27
Green & Sons 2.01 2.14 2.26
Quick Ratio
Dorsey Lumber 0.85 0.89 0.93
Green & Sons 0.87 0.88 0.94

Knowing the limitations of ratio analysis, which of the following is the best explanation of why the current
ratio for Dorsey Lumber is increasing as Green & Sons’ is decreasing?

Correct

Dorsey Lumber uses FIFO to value its inventory while Green & Sons values its inventory using LIFO.

Dorsey Lumber uses LIFO to value its inventory while Green & Sons values its inventory using FIFO.

Dorsey Lumber has been decreasing its inventory levels so as not to purchase at higher prices.
Your Answer

Green & Sons has been increasing its inventory levels because it expects prices to continue rising.

Rationale
 Dorsey Lumber uses FIFO to value its inventory while Green & Sons values its inventory using
LIFO.
This answer is correct. One of the limitations of ratio analysis is that it has limited usefulness in
comparing firms using different inventory valuation methods. If Dorsey is using FIFO to measure
inventory, during rising prices its inventory value will increase, which will increase its current ratio.

Rationale
 Dorsey Lumber uses LIFO to value its inventory while Green & Sons values its inventory using
FIFO.
This answer is incorrect. One of the limitations of ratio analysis is that it has limited usefulness in
comparing firms using different inventory valuation methods. If Dorsey is using LIFO to measure
inventory, during rising prices its inventory value will not increase as quickly as if it used FIFO.
Therefore, this does not adequately explain the difference.

Rationale
 Dorsey Lumber has been decreasing its inventory levels so as not to purchase at higher prices.
This answer is incorrect. Decreasing inventory levels would decrease Dorsey’s current ratio, not
increase it.

Rationale
 Green & Sons has been increasing its inventory levels because it expects prices to continue
rising.
This answer is incorrect. Increasing inventory levels would increase Green & Sons’ current ratio, not
decrease it.
Question 7
2.A.2.q
profit.vertical.tb.045_0820
LOS: 2.A.2.q
Lesson Reference: Profitability – Vertical Analysis Revisited and Return Ratios
Difficulty: hard
Bloom Code: 6

A financial analyst who works for Company Z has collected the following information on Company Z and its
three main competitors.

Company Z Company A Company B Company C

Net income $1,000,000 $ 5,000,000 $ 850,000 $2,545,000
Interest expense 200,000 750,000 100,000 565,000
Average total assets 2,500,000 10,000,000 1,250,000 7,750,000
Income tax rate 40% 45% 30% 50%

Based on the collected information, the financial analyst calculated each company’s return on assets. Which
one of the following statements is most correct?

*Source: Retired ICMA CMA Exam Questions.

Company C’s management is making the best use of the assets.

Correct

Company B’s management is operating more efficiently than Company A’s management.

Company A’s management is making the least use of the assets.

Company Z’s management is operating more efficiently than Company B’s management.

Rationale
 Company C’s management is making the best use of the assets.
This answer is incorrect. Company C has the lowest return on assets of the four companies. ($2,545,000
÷ $7,750,000 = 32.8%)

Rationale
 Company B’s management is operating more efficiently than Company A’s management.
Return on assets is a simple way to measure how efficiently a company is using its assets to generate
net income. It is calculated as “Net income ÷ Average total assets.” Since Company B’s return on assets
is higher than Company A’s, it is reasonable to conclude that Company B’s management is operating
more efficiently than Company A’s management. ($850,000 ÷ $1,250,000 = 68%)

Rationale
 Company A’s management is making the least use of the assets.
This answer is incorrect. Company A does not have the lowest return on assets of the four companies.
($5,000,000 ÷ $10,000,000 = 50%)

Rationale
 Company Z’s management is operating more efficiently than Company B’s management.
This answer is incorrect. Company Z’s return on assets is lower than Company B’s return on assets.
($1,000,000 ÷ $2,500,000 = 40%)
Question 8
2.A.2.f
oplev.tb.006_2104
LOS: 2.A.2.f
Lesson Reference: Operating Leverage and Financial Leverage
Difficulty: hard
Bloom Code: 5

Eduardo at Moody Manufacturing was asked by his supervisor to calculate the company’s degree of
operating leverage. Based on the following information, what does Eduardo report?

Degree of Financial Leverage 1.89

Percent Change in Net Income 7.5%
Percent Change in Sales 11.2%
Total Assets $20,400
Equity $4,284

Correct

0.36
Your Answer

0.68

0.21

4.76

Rationale
 0.36

This answer is correct. The degree of operating leverage (DOL) is calculated as: Percent Change in
Earnings Before Interest and Taxes (EBIT) ÷ Percent Change in Sales. To calculate Percent Change in
EBIT, first calculate the degree of financial leverage.

The degree of financial leverage is calculated as Percent Change in Net Income ÷ Percent Change in
EBIT.

1.89 = 7.5% ÷ Percent Change in EBIT

Percent Change in EBIT = 7.5% ÷ 1.89

Percent Change in EBIT = 4.0%

DOL = 4.0% ÷ 11.2%

DOL = 0.36

Rationale
 0.68
This answer is incorrect. This incorrect solution is the degree of total leverage.

Rationale
 0.21
This answer is incorrect. This incorrect solution is DFL × Percent Change in Sales.

Rationale
 4.76
This answer is incorrect. This incorrect solution is Moody Manufacturing’s financial leverage.
Question 9
2.A.2.a
tb.liquid.ratios.011_1711
LOS: 2.A.2.a
Lesson Reference: Liquidity Ratios
Difficulty: medium
Bloom Code: 4
Which ratio is calculated using amounts obtained exclusively from the balance sheet?
Profit margin
Correct

Current ratio

Inventory turnover

Earnings per share

Rationale
 Profit margin
Profit margin is defined as Net Income ÷ Net Sales. Neither of these items are from the balance sheet.
Therefore, this is an incorrect answer.

Rationale
 Current ratio
The current ratio is defined as Current Assets ÷ Current Liabilities. Both of these items are from the
balance sheet. Therefore, this is the correct answer.

Rationale
 Inventory turnover
Inventory turnover is defined as Cost of Goods Sold ÷ Average Inventory. Only average inventory is from
the balance sheet. Therefore, this is an incorrect answer.

Rationale
 Earnings per share
Earnings per share is defined as (Net Income − Preferred Stock Dividends) ÷ Weighted Average Common
Shares. None of these items are from the balance sheet. Therefore, this is an incorrect answer.
Question 10
2.A.2.r
tb.profit.market.001_1711
LOS: 2.A.2.r
Lesson Reference: Profitability – Market Value Ratios
Difficulty: medium
Bloom Code: 3

The Treehouse Company's income statement for December 31, 20x4 reported the following:

The company had 50,000 shares of common stock outstanding during 20x4 with a market price of $18 per
share at the end of the year. Cash dividends of $45,000 were paid, including $8,000 paid to preferred
stockholders. Compute the company's price-earnings ratio for 20x4, rounding to two decimal places.

Correct

9.78

9.00

14.29

16.36

Rationale
 9.78
Price-earnings ratio (P/E) is a measure of expected growth in a company's earnings and stock price.
Higher P/E ratios indicate higher expected growth. It is defined as Market Price ÷ Earnings per Share.
Earnings per share is defined as Net Income Available to Common Shareholders ÷ Average Number of
Common Shares Outstanding. Treehouse's EPS is $1.84 [($100,000 − $8,000) ÷ 50,000]. From this,
Treehouse's P/E ratio is 9.78 ($18 ÷ $1.84). Therefore, this is the correct answer.

Rationale
 9.00
Price-earnings ratio (P/E) is a measure of expected growth in a company's earnings and stock price.
Higher P/E ratios indicate higher expected growth. It is defined as Market Price ÷ Earnings per Share.
Earnings per share is defined as Net Income Available to Common Shareholders ÷ Average Number of
Common Shares Outstanding. Treehouse's EPS would be $2.00 if preferred dividends is not subtracted
($100,000 ÷ 50,000]. From this, Treehouse's P/E ratio would be 9.00 ($18 ÷ $2.00). Therefore, this is an
incorrect answer.

Rationale
 14.29
Price-earnings ratio (P/E) is a measure of expected growth in a company's earnings and stock price.
Higher P/E ratios indicate higher expected growth. It is defined as Market Price ÷ Earnings per Share.
Earnings per share is defined as Net Income Available to Common Shareholders ÷ Average Number of
Common Shares Outstanding. Treehouse's EPS would be $1.26 if common dividends is subtracted
instead of preferred dividends [($100,000 − $37,000) ÷ 50,000]. From this, Treehouse's P/E ratio would
be 14.29 ($18 ÷ $1.26). Therefore, this is an incorrect answer.

Rationale
 16.36
Price-earnings ratio (P/E) is a measure of expected growth in a company's earnings and stock price.
Higher P/E ratios indicate higher expected growth. It is defined as Market Price ÷ Earnings per Share.
Earnings per share is defined as Net Income Available to Common Shareholders ÷ Average Number of
Common Shares Outstanding. Treehouse's EPS would be $1.10 if total dividends is subtracted to get
the numerator [($100,000 − $45,000) ÷ 50,000]. From this, Treehouse's P/E ratio would be 16.36 ($18 ÷
$1.10). Therefore, this is an incorrect answer.