CPA Quiz: Interpret Liquidity Solvency And Profitability Measures
20 questions · exam conditions
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Interpret Liquidity Solvency And Profitability MeasuresQuestion 1 of 20

A public specialty chemicals company reports that net income fell year over year and wants to benchmark asset profitability. Selected year-end data (in millions): Net income 54; Average total assets 900. ROA is 54/900 = 6.0%; industry benchmark ROA is 6.5%. What insight does the ROA provide regarding the company's profitability?

ROA indicates slightly weaker profitability than the industry because 6.0% is below 6.5%, suggesting marginally lower profit generated per dollar of assets.
ROA indicates stronger profitability than the industry because 6.0% exceeds 6.5%, indicating better asset utilization.
ROA indicates improved liquidity because it measures quick assets divided by current liabilities.
ROA indicates improved solvency because it measures total liabilities divided by equity.
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CPA Quiz: Interpret Liquidity Solvency And Profitability Measures

Practice Interpret Liquidity Solvency And Profitability Measures in CPA with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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Question 1

A public specialty chemicals company reports that net income fell year over year and wants to benchmark asset profitability. Selected year-end data (in millions): Net income 54; Average total assets 900. ROA is 54/900 = 6.0%; industry benchmark ROA is 6.5%. What insight does the ROA provide regarding the company's profitability?

  1. ROA indicates slightly weaker profitability than the industry because 6.0% is below 6.5%, suggesting marginally lower profit generated per dollar of assets. (correct answer)
  2. ROA indicates stronger profitability than the industry because 6.0% exceeds 6.5%, indicating better asset utilization.
  3. ROA indicates improved liquidity because it measures quick assets divided by current liabilities.
  4. ROA indicates improved solvency because it measures total liabilities divided by equity.
Explanation: The financial concept being tested is return on assets (ROA), reflecting asset profitability. The key data are 6.0% ROA, $54 million income over $900 million assets, below 6.5% benchmark. This suggests slightly weaker profitability, per efficiency principles. Choice B is incorrect as 6.0% does not exceed 6.5%. Choice C confuses with liquidity, choice D with solvency. Decompose via DuPont. Analyze trends for improvements.

Question 2

A public logistics company reports declining net income and wants to understand whether assets are being used effectively. Selected year-end data (in millions): Net income 22; Average total assets 550. ROA is 22/550 = 4.0%; industry benchmark is 6.0%. What insight does the ROA provide regarding the company's profitability?

  1. ROA indicates the company is earning less profit per dollar of assets than the industry, suggesting weaker asset utilization or cost control relative to peers. (correct answer)
  2. ROA indicates strong liquidity because it compares cash and receivables to current liabilities.
  3. ROA indicates the company is outperforming peers because 4.0% is higher than the 6.0% benchmark.
  4. ROA indicates lower leverage because it equals debt-to-equity.
Explanation: The financial concept being tested is return on assets (ROA), gauging asset profitability. The key data are 4.0% ROA, $22 million income over $550 million assets, below 6.0% benchmark. This indicates weaker profitability, aligning with utilization principles. Choice C is incorrect as 4.0% is not higher. Choice B confuses with liquidity, choice D with leverage. Use DuPont and benchmarks. Trend for insights.

Question 3

A private hospitality company is evaluating a new loan covenant tied to interest coverage. Selected year-end data (in millions): Operating income (earnings before interest and taxes) 40; Interest expense 20. Interest coverage is 40/20 = 2.0; industry benchmark is 3.0. How does the interest coverage ratio reflect the company's solvency position?

  1. The company's solvency is stronger than peers because 2.0 exceeds the 3.0 benchmark, indicating more earnings available to pay interest.
  2. The company's solvency is weaker than peers because 2.0 is below 3.0, indicating a limited cushion to meet interest payments during downturns. (correct answer)
  3. The company's liquidity is strong because interest coverage measures the level of quick assets available to pay current liabilities.
  4. The company's profitability is strong because interest coverage is equivalent to net profit margin.
Explanation: The financial concept being tested is the interest coverage ratio, assessing solvency buffer. The key data are 2.0 ratio, $40 million income over $20 million interest, below 3.0 benchmark. This suggests weaker solvency, per earnings cushion principles. Choice A is incorrect as 2.0 does not exceed 3.0. Choice C confuses with liquidity, choice D with profitability. Framework: Benchmark analysis. Combine with leverage ratios.

Question 4

A public beverage company is experiencing cash flow tightness due to higher raw material costs and slower collections. Selected year-end data (in millions): Current assets 300; Current liabilities 250. The current ratio is 300/250 = 1.20; industry benchmark current ratio is 1.70. Based on the financial data, what does the current ratio indicate about the company's liquidity?

  1. Liquidity appears weaker than the industry because 1.20 is below 1.70, indicating less coverage of short-term obligations with current assets. (correct answer)
  2. Liquidity appears stronger than the industry because 1.20 exceeds 1.70, indicating superior working capital management.
  3. Solvency appears strong because the current ratio measures the ability to cover interest expense with operating income.
  4. Profitability appears strong because the current ratio is a direct measure of return on assets.
Explanation: The financial concept being tested is the current ratio, indicating liquidity strength. The key data are 1.20 ratio, $300 million assets over $250 million liabilities, below 1.70 benchmark. This reflects weaker liquidity, per coverage principles. Choice B is incorrect as 1.20 does not exceed 1.70. Choice C confuses with solvency, choice D with profitability. Benchmark and analyze components. Use with cash flows.

Question 5

A public consumer products company reports declining net profits over the last year and is reviewing returns. Selected year-end data (in millions): Net income 36; Average total assets 600; Average shareholders' equity 240. The company's return on assets (ROA) is 36/600 = 6.0% versus an industry benchmark of 8.5%. What insight does the ROA provide regarding the company's profitability?

  1. ROA indicates the company is generating less profit per dollar of assets than peers, suggesting weaker asset profitability relative to the industry. (correct answer)
  2. ROA indicates strong liquidity because it measures the ability to pay current liabilities with current assets.
  3. ROA indicates the company is outperforming peers because 6.0% exceeds the 8.5% benchmark, implying superior asset utilization.
  4. ROA indicates solvency is improving because it measures the proportion of debt in the capital structure.
Explanation: The financial concept being tested is return on assets (ROA), which measures profitability by indicating how efficiently assets generate net income. The key data are the company's ROA of 6.0%, calculated as $36 million net income divided by $600 million average total assets, compared to the 8.5% industry benchmark. This lower ROA reflects weaker asset profitability, consistent with analysis principles that emphasize effective asset utilization for higher returns. Choice C is incorrect because it states 6.0% exceeds 8.5%, which would suggest outperformance, contrary to the data. Choice B is wrong as ROA evaluates profitability, not liquidity, and choice D errs by linking it to solvency measures like leverage. To interpret profitability ratios, benchmark against peers and dissect components like margins and turnover. Use DuPont analysis to break down ROA into net profit margin and asset turnover for actionable insights.

Question 6

A public electronics retailer is experiencing cash flow issues after expanding store locations. Selected year-end data (in millions): Current assets 95 (Cash 8, Accounts receivable 12, Inventory 60, Other current assets 15); Current liabilities 85. The current ratio is 95/85 = 1.12; industry benchmark is 1.50. Based on the financial data, what does the current ratio indicate about the company's liquidity?

  1. Liquidity is weaker than the industry because 1.12 is below 1.50, indicating limited short-term coverage of obligations. (correct answer)
  2. Liquidity is stronger than the industry because 1.12 exceeds 1.50, indicating excess working capital.
  3. Solvency is strong because the current ratio measures the ability to cover interest expense with operating income.
  4. Profitability is strong because a lower current ratio indicates higher return on equity.
Explanation: The financial concept being tested is the current ratio, assessing liquidity coverage. The key data are 1.12 ratio, $95 million assets over $85 million liabilities, below 1.50 benchmark. This signals weaker liquidity, per principles of short-term obligation coverage. Choice B is incorrect as 1.12 does not exceed 1.50. Choice C confuses with solvency, choice D with profitability. Benchmark and dissect components for ratios. Combine with quick ratio for liquidity nuance.

Question 7

A private retail distributor reports increasing backorders and is concerned about near-term cash needs. Selected year-end data (in thousands): Balance sheet excerpt—Cash 40, Accounts receivable 110, Inventory 260, Prepaids 20, Total current assets 430; Accounts payable 190, Accrued liabilities 60, Current portion of long-term debt 70, Total current liabilities 320. Income statement excerpt—Net sales 1,200, Gross profit 300, Operating income 60, Interest expense 18, Net income 28. Management calculated a quick ratio of (40+110)/320=0.47(40+110)/320 = 0.47; industry benchmark quick ratio is 0.90. Based on the financial data, what does the quick ratio indicate about the company's liquidity?

  1. Liquidity is constrained because a 0.47 quick ratio is below the 0.90 benchmark, indicating limited ability to meet current liabilities without selling inventory. (correct answer)
  2. Liquidity is strong because a 0.47 quick ratio exceeds the 0.90 benchmark, indicating excess cash relative to obligations.
  3. Solvency is improving because the quick ratio primarily measures long-term debt repayment capacity and indicates low leverage risk.
  4. Profitability is the primary issue because a low quick ratio directly indicates declining return on equity rather than liquidity pressure.
Explanation: The financial concept being tested is the quick ratio, which evaluates a company's immediate liquidity by excluding inventory from current assets. The key financial data are the quick ratio of 0.47, derived from $150 thousand in quick assets (cash and accounts receivable) divided by $320 thousand in current liabilities, against an industry benchmark of 0.90. This lower ratio aligns with liquidity principles by indicating constrained ability to meet short-term obligations without relying on inventory sales, highlighting potential cash flow vulnerabilities. Choice B is incorrect because it falsely claims 0.47 exceeds 0.90, which would suggest strong liquidity, violating basic comparison principles. Choice C is wrong as the quick ratio focuses on short-term liquidity, not long-term solvency, and choice D errs by linking the ratio to profitability metrics like return on equity instead of liquidity. A transferable framework for ratios involves calculating them accurately and benchmarking against peers to identify strengths or weaknesses. Always integrate multiple ratios, such as combining quick and current ratios, for a holistic financial health assessment.

Question 8

A public software company is considering issuing additional bonds to fund an acquisition. Selected year-end data (in millions): Balance sheet excerpt—Total liabilities 540 (including long-term debt 360), Total shareholders' equity 300. Income statement excerpt—Operating income (earnings before interest and taxes) 120, Interest expense 30, Net income 60. Management calculated debt-to-equity of 540/300 = 1.80; industry benchmark is 1.10. How does the debt-to-equity ratio reflect the company's solvency position?

  1. The company is less leveraged than peers because 1.80 is below the 1.10 benchmark, suggesting greater capacity to take on debt.
  2. The company is more leveraged than peers because 1.80 exceeds the 1.10 benchmark, indicating higher reliance on debt financing and potentially higher solvency risk. (correct answer)
  3. Liquidity is strong because debt-to-equity measures the ability to cover current liabilities with current assets.
  4. Profitability is strong because a higher debt-to-equity ratio directly signals higher net profit margin.
Explanation: The financial concept being tested is the debt-to-equity ratio, which assesses solvency by measuring the proportion of debt to shareholders' equity. The key data are the company's ratio of 1.80, calculated as $540 million in total liabilities divided by $300 million in equity, compared to the industry benchmark of 1.10. This higher ratio indicates greater leverage and solvency risk, consistent with financial analysis principles that view excessive debt as increasing vulnerability to economic downturns. Choice A is incorrect because it states 1.80 is below 1.10, which would imply lower leverage, contradicting numerical facts. Choice C is wrong as debt-to-equity evaluates long-term solvency, not liquidity, and choice D errs by associating the ratio with profitability measures like net margins rather than capital structure. For interpreting ratios, use them to gauge risk by comparing to benchmarks and considering industry norms. Combine with other solvency metrics, like interest coverage, for a complete solvency profile.

Question 9

A private medical services provider has seen net income decline and is evaluating shareholder returns. Selected year-end data (in millions): Net income 12; Average shareholders' equity 60; Average total assets 150. The company's return on equity (ROE) is 12/60 = 20%; the industry benchmark ROE is 14%. What insight does the ROE provide regarding the company's profitability?

  1. ROE suggests the company is generating higher profit per dollar of equity than peers, indicating stronger returns to owners despite the recent earnings decline. (correct answer)
  2. ROE suggests weak liquidity because it measures the ability to convert inventory into cash to pay short-term obligations.
  3. ROE suggests the company underperforms peers because 20% is below the 14% benchmark, indicating reduced shareholder value creation.
  4. ROE suggests lower leverage because a higher ROE always means the company has less debt and therefore lower solvency risk.
Explanation: The financial concept being tested is return on equity (ROE), which assesses profitability by measuring net income relative to shareholders' equity. The key data include the ROE of 20%, from $12 million net income divided by $60 million average equity, exceeding the 14% industry benchmark. This higher ROE indicates stronger returns to owners, aligning with principles that value efficient equity use despite earnings declines. Choice C is incorrect because it claims 20% is below 14%, suggesting underperformance, which contradicts the figures. Choice B is wrong as ROE measures profitability, not liquidity, and choice D errs by assuming higher ROE implies lower leverage without considering financial leverage effects. A transferable framework involves comparing ROE to benchmarks to evaluate shareholder value creation. Decompose ROE using DuPont analysis to understand drivers like leverage, margins, and turnover.

Question 10

A public apparel company is facing cash flow pressure and is monitoring short-term solvency. Selected year-end data (in millions): Current assets 210 (including inventory 95 and prepaids 15); Current liabilities 150. The company reports a current ratio of 210/150 = 1.40; industry benchmark is 1.60. Based on the financial data, what does the current ratio indicate about the company's liquidity?

  1. Liquidity is stronger than the industry because 1.40 is above the 1.60 benchmark, indicating greater ability to pay current liabilities.
  2. Liquidity is weaker than the industry because 1.40 is below the 1.60 benchmark, suggesting tighter working capital coverage. (correct answer)
  3. Solvency is strong because the current ratio measures the company's ability to repay long-term debt at maturity.
  4. Profitability is improving because a lower current ratio indicates higher net income and better returns.
Explanation: The financial concept being tested is the current ratio, which evaluates liquidity through the ratio of current assets to current liabilities. The key data are the company's current ratio of 1.40, calculated as $210 million current assets divided by $150 million current liabilities, below the 1.60 industry benchmark. This indicates weaker liquidity, consistent with principles that a lower ratio signals potential difficulties in covering short-term obligations. Choice A is incorrect because it states 1.40 is above 1.60, implying stronger liquidity, against the numbers. Choice C is wrong as the current ratio measures liquidity, not solvency, and choice D errs by linking it to profitability improvements. For ratio interpretation, always contextualize with industry standards and trends. Combine with cash flow analysis for a robust liquidity assessment.

Question 11

A private packaging company is discussing covenant compliance with its bank, which focuses on interest coverage. Selected year-end data (in millions): Operating income (earnings before interest and taxes) 52; Interest expense 13. Interest coverage is 52/13 = 4.0; industry benchmark is 3.2. How does the interest coverage ratio reflect the company's solvency position?

  1. The company's solvency is stronger than peers because 4.0 exceeds 3.2, indicating greater earnings capacity to cover interest expense. (correct answer)
  2. The company's solvency is weaker than peers because 4.0 is below 3.2, indicating a higher probability of default.
  3. The company's liquidity is weaker because interest coverage measures current assets divided by current liabilities.
  4. The company's profitability is weaker because interest coverage equals return on assets and a higher value indicates lower profits.
Explanation: The financial concept being tested is the interest coverage ratio, measuring debt service capacity. The key data are 4.0 ratio, $52 million income over $13 million interest, exceeding 3.2 benchmark. This indicates stronger solvency, aligning with earnings buffer principles. Choice B is incorrect as 4.0 is not below 3.2. Choice C confuses with liquidity, choice D mislinks to profitability. Use benchmarks for evaluation. Combine with leverage analysis.

Question 12

A private pharmaceutical distributor is worried about meeting near-term obligations without relying on inventory sales. Selected year-end data (in millions): Cash 6, Accounts receivable 24, Inventory 50, Total current assets 80; Current liabilities 60. Quick ratio is (6+24)/60=0.50(6+24)/60 = 0.50; industry benchmark is 1.10. Based on the financial data, what does the quick ratio indicate about the company's liquidity?

  1. Liquidity is strong because 0.50 exceeds the 1.10 benchmark, indicating the company can pay current liabilities without selling inventory.
  2. Liquidity is constrained because 0.50 is below the 1.10 benchmark, indicating dependence on inventory liquidation or external financing to meet current liabilities. (correct answer)
  3. Solvency is improving because the quick ratio measures total liabilities divided by equity and indicates lower leverage.
  4. Profitability is improving because a low quick ratio signals higher net profit margin.
Explanation: The financial concept being tested is the quick ratio, focusing on immediate liquidity. The key data are 0.50 ratio, $30 million quick assets over $60 million liabilities, below 1.10 benchmark. This indicates constrained liquidity, aligning with principles avoiding inventory reliance. Choice A is incorrect as 0.50 does not exceed 1.10. Choice C misattributes to solvency, choice D to profitability. Use benchmarks and trends for interpretation. Integrate inventory analysis for full picture.

Question 13

A public utilities company reports stable revenue but declining net income due to higher operating costs. Selected year-end data (in millions): Net income 90; Average total assets 2,250. The company's ROA is 90/2,250 = 4.0%; industry benchmark ROA is 5.0%. What insight does the ROA provide regarding the company's profitability?

  1. ROA suggests the company is generating less profit from its asset base than the industry, indicating weaker asset profitability. (correct answer)
  2. ROA suggests the company has strong liquidity because it measures current assets divided by current liabilities.
  3. ROA suggests the company outperforms the industry because 4.0% is higher than the 5.0% benchmark.
  4. ROA suggests solvency is strong because it measures liabilities divided by equity.
Explanation: The financial concept being tested is return on assets (ROA), evaluating profitability from asset efficiency. The key data are 4.0% ROA, $90 million net income over $2,250 million assets, below 5.0% benchmark. This suggests weaker profitability, consistent with principles of asset utilization. Choice C is incorrect as 4.0% is not higher than 5.0%. Choice B confuses with liquidity, and choice D with solvency. Interpret via benchmarks and DuPont decomposition. Analyze trends for ongoing profitability insights.

Question 14

A private construction firm is negotiating a new term loan and wants to demonstrate debt service capacity. Selected year-end data (in millions): Balance sheet excerpt—Total liabilities 220, Total equity 180. Income statement excerpt—Operating income (earnings before interest and taxes) 66, Interest expense 22, Net income 28. The firm's interest coverage ratio is 66/22 = 3.0; the industry benchmark is 4.5. How does the interest coverage ratio reflect the company's solvency position?

  1. The firm has stronger solvency than peers because 3.0 exceeds the 4.5 benchmark, indicating ample earnings to cover interest.
  2. The firm's solvency is weaker than peers because 3.0 is below 4.5, indicating less cushion to cover interest expense if earnings decline. (correct answer)
  3. The firm's liquidity is strong because interest coverage measures the ability to pay current liabilities using current assets.
  4. The firm's profitability is declining because interest coverage is a direct measure of return on assets.
Explanation: The financial concept being tested is the interest coverage ratio, which measures solvency by showing how many times operating income covers interest expense. The key data include the ratio of 3.0, from $66 million in operating income divided by $22 million in interest expense, versus the industry benchmark of 4.5. This lower ratio suggests weaker solvency, aligning with principles that a smaller cushion increases default risk if earnings fluctuate. Choice A is incorrect because it claims 3.0 exceeds 4.5, which would indicate stronger solvency, against basic comparison. Choice C is wrong as interest coverage assesses solvency, not liquidity, and choice D errs by confusing it with profitability ratios like return on assets. A framework for ratios involves evaluating them against benchmarks to assess financial stability. Integrate with leverage ratios for deeper insights into debt management.

Question 15

A public manufacturing company is experiencing delayed customer collections and tighter supplier terms. Selected year-end data (in millions): Balance sheet excerpt—Cash 18, Accounts receivable 52, Inventory 80, Other current assets 10, Total current assets 160; Accounts payable 70, Accrued expenses 20, Short-term notes payable 30, Total current liabilities 120. Income statement excerpt—Net sales 520, Cost of goods sold 360, Operating income 48, Interest expense 12, Net income 24. Management calculated a current ratio of 160/120 = 1.33 and notes the industry benchmark is 1.80. Based on the financial data, what does the current ratio indicate about the company's liquidity?

  1. Liquidity appears stronger than peers because a 1.33 current ratio exceeds the 1.80 benchmark and suggests ample working capital.
  2. Liquidity appears weaker than peers because a 1.33 current ratio is below the 1.80 benchmark, indicating less short-term coverage of current obligations. (correct answer)
  3. Solvency appears strong because the current ratio measures long-term debt capacity and indicates the company can safely add leverage.
  4. Profitability is improving because the current ratio directly reflects higher net margins and better earnings quality.
Explanation: The financial concept being tested is the current ratio, which measures a company's liquidity by comparing current assets to current liabilities. The key financial data driving the correct answer are the company's current ratio of 1.33, calculated as $160 million in current assets divided by $120 million in current liabilities, compared to the industry benchmark of 1.80. This indicates weaker liquidity than peers because a ratio below the benchmark suggests insufficient short-term assets to cover current obligations, aligning with principles of liquidity analysis that emphasize the importance of maintaining adequate working capital to meet immediate financial demands. Choice A is incorrect because it misstates that 1.33 exceeds 1.80, which would imply stronger liquidity, contrary to basic arithmetic and ratio interpretation principles. Choice C is incorrect as the current ratio assesses short-term liquidity, not long-term solvency or debt capacity, while choice D is wrong because liquidity ratios do not directly reflect profitability metrics like net margins. To interpret financial ratios effectively, compare them to industry benchmarks and historical trends to assess relative performance. Additionally, consider the composition of current assets and liabilities for a comprehensive liquidity evaluation.

Question 16

A private technology consulting firm has experienced a drop in net income and is assessing owner returns. Selected year-end data (in thousands): Net income 420; Average equity 3,500. ROE is 420/3,500 = 12.0%; industry benchmark ROE is 18.0%. What insight does the ROE provide regarding the company's profitability?

  1. ROE indicates the firm is generating a lower return on owners' equity than the industry, suggesting weaker profitability for shareholders. (correct answer)
  2. ROE indicates strong liquidity because it measures quick assets divided by current liabilities.
  3. ROE indicates the firm is outperforming the industry because 12.0% exceeds the 18.0% benchmark.
  4. ROE indicates improved solvency because a lower ROE always means lower leverage and therefore better debt capacity.
Explanation: The financial concept being tested is return on equity (ROE), measuring profitability per equity dollar. The key data are 12.0% ROE, $420 thousand net income over $3,500 thousand equity, below 18.0% benchmark. This indicates weaker returns, aligning with shareholder value principles. Choice C is incorrect as 12.0% does not exceed 18.0%. Choice B confuses with liquidity, and choice D mislinks to solvency. Framework: Compare to peers, use DuPont for drivers. Monitor over time for equity performance.

Question 17

A private automotive parts supplier is concerned about meeting payroll and vendor payments without relying on inventory sales. Selected year-end data (in millions): Cash 4, Accounts receivable 16, Inventory 40, Other current assets 5; Current liabilities 35. Quick ratio is (4+16)/35=0.57(4+16)/35 = 0.57; industry benchmark is 0.80. Based on the financial data, what does the quick ratio indicate about the company's liquidity?

  1. Liquidity is constrained relative to the industry because 0.57 is below 0.80, indicating limited near-cash resources to cover current liabilities. (correct answer)
  2. Liquidity is strong relative to the industry because 0.57 exceeds 0.80, indicating excess quick assets.
  3. Solvency is strong because the quick ratio measures total liabilities divided by equity.
  4. Profitability is strong because the quick ratio indicates the company's net profit margin is increasing.
Explanation: The financial concept being tested is the quick ratio, evaluating near-term liquidity. The key data are 0.57 ratio, $20 million quick assets over $35 million liabilities, below 0.80 benchmark. This indicates constrained liquidity, aligning with cash resource principles. Choice B is incorrect as 0.57 does not exceed 0.80. Choice C confuses with solvency, choice D with profitability. Framework: Benchmark comparison. Pair with turnover ratios.

Question 18

A private professional services firm has seen net profits decline and is reviewing shareholder returns. Selected year-end data (in thousands): Net income 180; Average equity 1,800. ROE is 180/1,800 = 10.0%; industry benchmark is 12.5%. What insight does the ROE provide regarding the company's profitability?

  1. ROE indicates the firm is generating a lower return on equity than peers, suggesting weaker profitability for owners relative to the industry. (correct answer)
  2. ROE indicates strong liquidity because it measures current assets divided by current liabilities.
  3. ROE indicates the firm outperforms peers because 10.0% exceeds the 12.5% benchmark.
  4. ROE indicates better solvency because a lower ROE always means the company has more cash to pay long-term debt.
Explanation: The financial concept being tested is return on equity (ROE), measuring equity returns. The key data are 10.0% ROE, $180 thousand income over $1,800 thousand equity, below 12.5% benchmark. This suggests weaker profitability, consistent with owner return principles. Choice C is incorrect as 10.0% does not exceed 12.5%. Choice B confuses with liquidity, choice D mislinks to solvency. Decompose with DuPont. Monitor trends.

Question 19

A private manufacturing firm is planning to refinance its debt and lenders are focused on interest payment capacity. Selected year-end data (in millions): Operating income (earnings before interest and taxes) 84; Interest expense 28; Net income 32. Interest coverage is 84/28 = 3.0; industry benchmark is 3.5. How does the interest coverage ratio reflect the company's solvency position?

  1. Solvency is stronger than peers because 3.0 exceeds 3.5, indicating excess earnings to cover interest.
  2. Solvency is weaker than peers because 3.0 is below 3.5, indicating a smaller buffer to cover interest expense. (correct answer)
  3. Liquidity is strong because interest coverage measures how quickly accounts receivable are collected.
  4. Profitability is strong because interest coverage is the same as return on equity.
Explanation: The financial concept being tested is the interest coverage ratio, measuring solvency through earnings coverage of interest. The key data are the ratio of 3.0, $84 million operating income over $28 million interest, below the 3.5 benchmark. This indicates weaker solvency, aligning with principles of needing buffers for interest payments. Choice A is incorrect because 3.0 does not exceed 3.5. Choice C is wrong as it misattributes to liquidity, and choice D errs by equating to ROE. Framework: Benchmark and trend analysis for ratios. Integrate with cash flow metrics for solvency depth.

Question 20

A public real estate services company is considering additional borrowing to invest in new offices. Selected year-end data (in millions): Total liabilities 780; Total equity 520. Debt-to-equity is 780/520 = 1.50; industry benchmark is 0.95. How does the debt-to-equity ratio reflect the company's solvency position?

  1. The company is more leveraged than peers because 1.50 exceeds 0.95, indicating greater reliance on debt and potentially higher solvency risk if cash flows weaken. (correct answer)
  2. The company is less leveraged than peers because 1.50 is below 0.95, indicating ample capacity to issue new debt.
  3. Liquidity is strong because debt-to-equity measures current assets divided by current liabilities.
  4. Profitability is strong because debt-to-equity directly measures return on assets.
Explanation: The financial concept being tested is the debt-to-equity ratio, evaluating solvency leverage. The key data are 1.50 ratio, $780 million liabilities over $520 million equity, exceeding 0.95 benchmark. This shows higher leverage, consistent with risk principles. Choice B is incorrect as 1.50 is not below 0.95. Choice C confuses with liquidity, choice D with profitability. Compare to norms and context for ratios. Pair with coverage for solvency assessment.