Chapter 3

Question 1

Interest Formula

Answer 1

Interest = Principal x Rate x Time

Question 2

Return on Investment

Answer 2

ROI = Net Income
Avg. Total Assets

Good ROI = 8 to 12%

Primary measure of a firm’s profitability. Describes the rate of return that management was able to earn on the assets it had available to use during the year.

Question 3

Dupont Model Return on Investment

Answer 3

ROI = Net Income x Sales
Sales Avg. Total Assets

Margin = Net Income
Sales

Margin is the percentage of net income to net sales. Good is 5 to 10%

Turnover = Sales
Avg. Total Assets

Turnover tells us the efficiency of which the firm uses its assets. Good is 1 to 1.5

Question 4

Return on Equity

Answer 4

ROE = Net Income
Avg. Stockholder’s Equity

Relates earnings to stockholder’s investment. Measures a firm’s profitability.

Good ROE is 12 to 18%.

Question 5

Liquidity

Answer 5

Liquidity refers to the firm’s ability to meet its current obligations and is measured by relating its current assets and current liabilities as reported on the balance sheet.

Measured with working capital, current ratio, and Acid-test ratio.

Question 6

Working Capital

Answer 6

Excess of firm’s current assets over it’s current liabilities.

Working Capital = Current Assets - Current Liabilities

• Current assets* are cash, inventory, and accounts receivable.
• Current liabilities* are loans, accounts payable, wages, interest payable, and rent payable.

Question 7

Current Ratio

Answer 7

Current Ratio = Current Assets
Current Liabilities

Ratio of 2.0 indicates good liquidity.

Current ratio is useful in judging a firm’s current bill paying ability.

Question 8

Acid-Test Ratio

Answer 8

Acid-Test Ratio = Cash + Acct. Receivable
​ Current Liabilities

Good ratio is 1.0.

The acid-test ratio is a more conservative short-term measure of liquidity because inventory is excluded from the computation. It’s a worst case scenario that measures the firm’s abilitiy to meet its current obligations even if none of its inventory is sold.