Miscellaneous: Ratios, Analysis, and Ethical Judgment
This section tests the analytical and ethical tools that tie the statements together. Know the major liquidity ratios (current ratio = current assets ÷ current liabilities; quick ratio = (cash + marketable securities + receivables) ÷ current liabilities), solvency ratios (debt-to-equity; times interest earned = operating income ÷ interest expense), and profitability ratios (gross margin, net margin, return on assets, return on equity, earnings per share). Turnover ratios-inventory turnover (COGS ÷ average inventory) and receivables turnover (net credit sales ÷ average receivables)-feed into days-outstanding calculations (365 ÷ turnover).
Understand the internal control framework: separation of duties, physical safeguards, independent verification, documentation, and authorization. Recognize the elements of the fraud triangle: pressure/incentive, opportunity, and rationalization. Know the roles of the FASB (private-sector standard setter), SEC (government regulator of public companies), IASB (international standards), and PCAOB (audit oversight).
Traps: (1) Using average balances when the question supplies only ending balances, or vice versa-read carefully. (2) Mixing up return on assets (net income ÷ average total assets) with return on equity (net income ÷ average stockholders' equity). (3) Forgetting that a high current ratio can hide poor inventory quality. (4) Assuming a favorable ratio always means good performance-context matters. (5) Overlooking that earnings per share uses weighted-average shares outstanding, not ending shares.
Worked example: Current assets $150,000; inventory $60,000; current liabilities $75,000. Current ratio = 2.0. Quick ratio = (150,000 − 60,000) ÷ 75,000 = 1.2. Both exceed 1, suggesting adequate short-term liquidity, though the quick ratio is the stricter test.
Rule of thumb: ratios are only meaningful compared to a benchmark-prior years, competitors, or industry averages-and a single ratio rarely tells the whole story.