Multiple Choice
Which of the following statements about the combined ratio is true?
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14. Financial Statement Analysis
Introduction to Ratios
Multiple Choice
Which of the following formulas is used to determine the margin of safety?
A
Margin of Safety = Actual Sales - Break-even Sales
B
Margin of Safety = Gross Profit / Net Sales
C
Margin of Safety = Net Income / Sales
D
Margin of Safety = Current Assets / Current Liabilities
Verified step by step guidance1
Step 1: Understand the concept of Margin of Safety. It represents the difference between actual sales and break-even sales, indicating how much sales can drop before the business incurs a loss.
Step 2: Review the formula options provided in the problem. The correct formula for Margin of Safety is: Margin of Safety = Actual Sales - Break-even Sales.
Step 3: Eliminate incorrect formulas by analyzing their components. For example, 'Margin of Safety = Gross Profit / Net Sales' calculates the gross profit margin, not the margin of safety.
Step 4: Similarly, 'Margin of Safety = Net Income / Sales' calculates the net profit margin, and 'Margin of Safety = Current Assets / Current Liabilities' calculates the current ratio, neither of which are related to the margin of safety.
Step 5: Conclude that the correct formula for Margin of Safety is: Margin of Safety = Actual Sales - Break-even Sales, as it directly measures the sales buffer above the break-even point.
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