CFA2020L1QbanksAnswers financial reporting analysis

Reading 19: Introduction to Financial Statement Analysis Question #1 of 25 Question ID: 1204934 Which of the following is an independent auditor least likely to with respect to a company's nancial statements? A) Con rm assets and liabilities contained in them B) Prepare and accept responsibility for them C) Provide an opinion concerning their fairness and reliability Explanation Auditors make an independent review of nancial statements, which are prepared by company management and are management's responsibility It is the responsibility of auditors to rm the assets, liabilities, and other items included in the statements and then issue an opinion concerning their fairness and reliability (Study Session 6, Module 19.2, LOS 19.d) Question #2 of 25 Question ID: 1204937 Which of the following is an analyst least likely to rely on as objective information to include in a company analysis? A) Government agency statistical data on the economy and the company’s industry B) Corporate press releases C) Proxy statements Explanation Corporate reports and press releases are written by management and are often viewed as public relations or sales materials An analyst should review information on the economy and the company's industry and compare the company to its competitors This information can be acquired from sources such as trade journals, statistical reporting services, and government agencies Securities and Exchange Commission (SEC) lings include Form 8-K, which a company must le to report events such as acquisitions and disposals of major assets or changes in its management or corporate governance and proxy statements, which are a good source of information about the election of (and quali cations of) board members, compensation, management quali cations, and the issuance of stock options (Study Session 6, Module 19.2, LOS 19.e) Question #3 of 25 Question ID: 1204927 An analyst who wants to examine a rm's nancing transactions during the most recent period is most likely to evaluate the rm's statement of: A) cash ows B) comprehensive income C) nancial position Explanation The statement of cash ows describes a rm's in ows and out ows of cash during a reporting period from operating, investing, and nancing activities Financing transactions such as issuance of debt or stock are shown on the statement of cash ows The statement of nancial position (balance sheet) presents the rm's assets, liabilities, and equity at a point in time The statement of comprehensive income (income statement) does not directly re ect a rm's nancing transactions Cash raised is not included in a rm's revenues and dividends paid and debt principal repaid are not included in its expenses (Study Session 6, Module 19.1, LOS 19.b) Question #4 of 25 Question ID: 1204941 The step in the nancial statement analysis framework that includes making any appropriate adjustments to the nancial statements and calculating ratios is best described as: A) processing the data B) gathering the data C) analyzing and interpreting the data Explanation The nancial statement analysis framework consists of six steps: State the objective and context Determine what questions the analysis is meant to answer, the form in which it needs to be presented, and what resources and how much time are available to perform the analysis Gather data Acquire the company's nancial statements and other relevant data on its industry and the economy Ask questions of the company's management, suppliers, and customers, and visit company sites Process the data Make any appropriate adjustments to the nancial statements Calculate ratios Prepare exhibits such as graphs and common-size balance sheets Analyze and interpret the data Use the data to answer the questions stated in the rst step Decide what conclusions or recommendations the information supports Report the conclusions or recommendations Prepare a report and communicate it to its intended audience Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations Update the analysis Repeat these steps periodically and change the conclusions or recommendations when necessary (Study Session 6, Module 19.2, LOS 19.f) Question #5 of 25 Question ID: 1204933 Which of the following would NOT require an explanatory paragraph added to the auditors' report? A) Doubt regarding the "going concern" assumption B) Uncertainty due to litigation C) Statements that the nancial information was prepared according to GAAP Explanation The statements that the nancial information was prepared according to GAAP should be included in the regular part of the auditors' report and not as an explanatory paragraph The other information would be contained in explanatory paragraphs added to the auditors' report (Study Session 6, Module 19.2, LOS 19.d) Question #6 of 25 Question ID: 1204942 The step in the nancial statement analysis framework of "processing the data" is least likely to include which activity? A) Making appropriate adjustments to the nancial statements B) Preparing exhibits such as graphs C) Acquiring the company’s nancial statements Explanation The nancial statement analysis framework consists of six steps Step 2: "Gather data" includes acquiring the company's nancial statements and other relevant data on its industry and the economy Step "Process the data" includes activities such as making any appropriate adjustments to the nancial statements and preparing exhibits such as graphs and common-size balance sheets (Study Session 6, Module 19.2, LOS 19.f) Question #7 of 25 Question ID: 1204935 A rm's internal controls are most accurately described as: A) outside the scope of an audit report under IFRS and U.S GAAP B) a responsibility of the rm’s board of directors C) directly a ecting the rm’s nancial reporting quality Explanation Weak internal controls provide an opportunity for low-quality or even fraudulent nancial reporting A rm's management, not its board of directors, is responsible for ensuring the e ectiveness of a rm's internal controls Under U.S GAAP, auditors are required to state an opinion on a rm's internal controls (Study Session 6, Module 19.2, LOS 19.d) Question #8 of 25 Question ID: 1204929 Which of the following statements regarding footnotes to the nancial statements is least accurate? Financial statement footnotes: A) provide information about assumptions and estimates used by management B) may contain information regarding contingent losses C) typically include a discussion of the rm’s past performance and future outlook Explanation Discussion of a rm's past performance and future outlook is most likely to be found in management's commentary (Study Session 6, Module 19.2, LOS 19.c) Question #9 of 25 Question ID: 1204924 A company's operating revenues for a reporting period are most likely to be shown on its: A) cash ow statement B) income statement C) balance sheet Explanation Revenues for a reporting period are presented on a company's income statement They can be, but are not required to be, classi ed as operating and nonoperating revenues Cash from operating activities is presented on the company's statement of cash ows, but this is not necessarily equal to operating revenues because revenue might be recognized in a di erent period than cash is collected The balance sheet displays a company's nancial position at a xed point in time (Study Session 6, Module 19.1, LOS 19.b) Question #10 of 25 Question ID: 1204930 According to IFRS guidance for management's commentary, addressing the company's key relationships is: A) neither recommended nor required B) required C) recommended Explanation IFRS recommends that management commentary address the company's key relationships, resources, and risks, as well as the nature of the business, management's objectives, the company's past performance, and the performance measures used Securities regulators may impose requirements for publicly traded rms to address certain topics in management's commentary, but accounting standards not (Study Session 6, Module 19.2, LOS 19.c) Question #11 of 25 Question ID: 1204938 Which of the following is least likely to be available on EDGAR (Electronic Data Gathering, Analysis, and Retrieval System)? A) SEC lings B) Corporate press releases C) Form 10Q Explanation Securities and Exchange Commission (SEC) lings are available from EDGAR (Electronic Data Gathering, Analysis, and Retrieval System, www.sec.gov) Companies' annual and quarterly nancial statements are also led with the SEC (Form 10-K and Form 10-Q, respectively) (Study Session 6, Module 19.2, LOS 19.e) Question #12 of 25 Question ID: 1204943 In the nancial statement analysis framework, using the data to address the objectives of the analysis and deciding what conclusions or recommendations the information supports is best described as: A) processing the data B) analyzing and interpreting the data C) reporting the conclusions Explanation The nancial statement analysis framework consists of six steps: State the objective and context Determine what questions the analysis is meant to answer, the form in which it needs to be presented, and what resources and how much time are available to perform the analysis Gather data Acquire the company's nancial statements and other relevant data on its industry and the economy Ask questions of the company's management, suppliers, and customers, and visit company sites Process the data Make any appropriate adjustments to the nancial statements Calculate ratios Prepare exhibits such as graphs and common-size balance sheets Analyze and interpret the data Use the data to answer the questions stated in the rst step Decide what conclusions or recommendations the information supports Report the conclusions or recommendations Prepare a report and communicate it to its intended audience Be sure the report and its dissemination comply with the Code and Standards that relate to investment analysis and recommendations Update the analysis Repeat these steps periodically and change the conclusions or recommendations when necessary (Study Session 6, Module 19.2, LOS 19.f) Question #13 of 25 Question ID: 1204923 The role of nancial statement analysis is most accurately described as: A) the reports and presentations a company uses to show its nancial performance to investors, creditors, and other interested parties B) the use of information from a company’s nancial statements along with other information to make economic decisions regarding that company C) a common requirement for companies that are listed on public exchanges Explanation Financial statement analysis refers to the use of information from a company's nancial statements along with other information to make economic decisions regarding that company Financial reporting refers to the reports and presentations that a company uses to show its nancial performance to investors, creditors, and other interested parties Financial reporting is a requirement for companies that are listed on public exchanges (Study Session 6, Module 19.1, LOS 19.a) Question #14 of 25 Question ID: 1204939 In addition to the audited nancial statements included in a rm's annual report, which of the following sources of information is most likely to contain audited data? A) Footnotes to the annual nancial statements B) Interim nancial statements led with the SEC C) Management’s commentary Explanation The footnotes are an integral part of the audited nancial statements in a rm's annual report and are included in the audit opinion (Study Session 6, Module 19.2, LOS 19.e) Question #15 of 25 Question ID: 1204921 Which of the following is least likely to be considered a role of nancial statement analysis? A) Assessing the management skill of the company’s executives B) Determining whether to invest in the company’s securities C) To make economic decisions Explanation The role of nancial statement analysis is to use the information in a company's nancial statements, along with other relevant information, to make economic decisions Examples of such decisions include whether to invest in the company's securities or recommend them to other investors, or whether to extend trade or bank credit to the company Although the nancial statements might provide indirect evidence about the management skill of the company's executives, that is not generally considered the role of nancial statement analysis (Study Session 6, Module 19.1, LOS 19.a) Question #16 of 25 Question ID: 1204936 Which of the following statements about proxy statements is least accurate? Proxy statements are: A) available on the EDGAR web site B) a good source of information about the quali cations of board members and management C) not led with the SEC Explanation Proxy statements are issued to shareholders when there are matters that require a shareholder vote These statements, which are also led with the SEC and available from EDGAR, are a good source of information about the election of (and quali cations of) board members, compensation, management quali cations, and the issuance of stock options (Study Session 6, Module 19.2, LOS 19.e) Question #17 of 25 Question ID: 1204920 Which of the following best describes nancial reporting and nancial statement analysis? A) The objective of nancial analysis is to provide information about the nancial position of an entity that is useful to a wide range of users B) Financial reports assess a company’s past performance in order to draw conclusions about the company’s ability to generate cash and pro ts in the future C) Financial reporting refers to how companies show their nancial performance and nancial analysis refers to using the information to make economic decisions Explanation Financial reporting refers to the way companies show their nancial performance to investors, creditors, and other interested parties by preparing and presenting nancial statements The objective of nancial statements, not analysis, is to provide information about the nancial position, performance and changes in nancial position of an entity that is useful to a wide range of users in making economic decisions The role of nancial statement analysis, not reporting, is to use the information in a company's nancial statements, along with other relevant information, to assess a company's past performance in order to draw conclusions about the company's ability to generate cash and pro ts in the future (Study Session 6, Module 19.1, LOS 19.a) Question #18 of 25 Question ID: 1204932 The standard auditor's report is most likely required to: A) provide reasonable assurance that management is reliable B) provide an "unquali ed" opinion if material uncertainties exist C) provide reasonable assurance that the nancial statements contain no material errors Explanation The standard auditor's report contains three parts: The nancial statements are prepared by management and are their responsibility and the auditor has performed an independent review The audit was conducted using generally accepted auditing standards, which provides reasonable assurance that there are no material errors in the nancial statements The auditor is satis ed the statements were prepared in accordance with accepted accounting principles, and the principles chosen and estimates are reasonable Under U.S GAAP, the auditor is required to state an opinion on the company's internal controls The auditor may add this opinion as a fourth element of the auditor's report or provide it separately (Study Session 6, Module 19.2, LOS 19.d) Question #19 of 25 Question ID: 1204926 Information about a company's nancial position at a point in time is most likely found in the: A) cash ow statement B) income statement C) balance sheet Explanation The balance sheet reports the company's nancial position at a point in time In contrast, the income statement reports on nancial performance over a period of time and the cash ow statement reports a company's cash receipts and payments over a period of time (Study Session 6, Module 19.1, LOS 19.b) Question #20 of 25 Question ID: 1204919 Which of the following statements about nancial statement analysis and reporting is least accurate? A) Financial statement analysis focuses on the way companies show their nancial performance to investors by preparing and presenting nancial statements B) Providing information about changes in a company’s nancial position is a role of nancial reporting C) Deciding whether to recommend a company’s securities to investors is a role of nancial statement analysis Explanation Financial reporting refers to the way companies show their nancial performance to investors, creditors, and other interested parties by preparing and presenting nancial statements, including information about changes in a company's nancial position The role of nancial statement analysis is to use the information in a company's nancial statements, along with other relevant information, to make economic decisions, such as whether to invest in the company's securities or recommend them to other investors Analysts use nancial statement data to evaluate a company's past performance and current nancial position in order to form opinions about the company's ability to earn pro ts and generate cash ow in the future (Study Session 6, Module 19.1, LOS 19.a) Question #21 of 25 Question ID: 1204928 Which of the following statements concerning the notes to the audited nancial statements of a company is least accurate? Financial statement notes: A) include management's assessment of the company's operating performance and nancial results B) contain information about contingent losses that may occur C) are audited Explanation Management's perspective on the company's results is provided in the Management's Discussion and Analysis supplement to the nancial statements Financial statement notes (footnotes) provide information about matters such as the company's accounting methods and assumptions, contingencies, and acquisitions and disposals Footnotes to the nancial statements are audited (Study Session 6, Module 19.2, LOS 19.c) Question #22 of 25 Question ID: 1204940 Which of the following is the best description of the nancial statement analysis framework? A) Gather data, analyze and interpret the data, determine the context, report the conclusions, update the analysis B) Gather data, analyze and interpret the data, process the conclusions, assess the context, report the recommendations, update the analysis C) State the objective and context, gather data, process the data, analyze and interpret the data, report the conclusions or recommendations, update the analysis Explanation The nancial statement analysis framework consists of six steps: State the objective and context Gather data Process the data Analyze and interpret the data Report the conclusions or recommendations Update the analysis (Study Session 6, Module 19.2, LOS 19.f) Question #23 of 25 Question ID: 1204931 For publicly traded rms in the United States, the Management Discussion and Analysis (MD&A) portion of the nancial disclosure is least likely required to discuss: A) unusual or infrequent items B) capital resources and liquidity C) results of operations Explanation For publicly traded U.S rms, the MD&A portion of the nancial disclosure is required to discuss results of operations, capital resources and liquidity and a general business overview based on known trends A discussion of unusual or infrequent items may be included in the MD&A, but is not required (Study Session 6, Module 19.2, LOS 19.c) Question #24 of 25 Question ID: 1204925 Which of the following statements represents information at a speci c point in time? A) The balance sheet B) The income statement and the balance sheet C) The income statement Explanation The balance sheet represents information at a speci c point in time The income statement represents information over a period of time (Study Session 6, Module 19.1, LOS 19.b) Question #25 of 25 Question ID: 1204922 According to the IASB, which of the following least accurately describes nancial reporting? Financial reporting: A) provides information about changes in nancial position of an entity B) is useful to a wide range of users C) uses the information in a company’s nancial statements to make economic decisions Explanation The role of nancial reporting is described by the International Accounting Standards Board (IASB) in its "Framework for the Preparation and Presentation of Financial Statements": The objective of nancial statements is to provide information about the nancial position, performance and changes in nancial position of an entity that is useful to a wide range of users in making economic decisions Using the information in a company's nancial statements to make economic decisions is nancial analysis, not nancial reporting (Study Session 6, Module 19.1, LOS 19.a) Question #26 of 28 Question ID: 1205606 On a spectrum for assessing nancial reporting quality, which of the following represents the highest quality? A) Reporting is not compliant with GAAP but the numbers presented re ect the company’s actual activities B) Reporting is compliant with GAAP but reporting choices and estimates are biased C) Reporting is compliant with GAAP and decision useful but earnings are not sustainable Explanation A rm can have high nancial reporting quality even if its earnings quality is low, such as a rm that recognizes one-time gains in a period and identi es them clearly Biased accounting choices and noncompliance with GAAP represent lower-quality nancial reporting (Study Session 9, Module 29.1, LOS 29.b) Question #27 of 28 Question ID: 1205623 Joe Carter, CFA, believes Triangle Equipment, a maker of large, specialized industrial equipment, has overstated the salvage value of its equipment This would: A) overstate liabilities B) understate earnings C) overstate earnings Explanation Overstating the salvage value reduces depreciation expense, which in turn increases earnings (Study Session 9, Module 29.2, LOS 29.h) Question #28 of 28 Question ID: 1205621 With regard to a rm's nancial reporting quality, an analyst should most likely interpret as a warning sign a focus by management on an increase in the rm's: A) cash from operations B) pro forma earnings C) asset turnover ratios Explanation One potential warning sign of low-quality nancial reporting is management's focus on "pro forma" or non-GAAP measures of earnings Increases in operating cash ows or asset turnover ratios are not typically viewed as warning signs of poor nancial reporting quality (Study Session 9, Module 29.1, LOS 29.g) Reading 30: Applications of Financial Statement Analysis Question #1 of 26 Question ID: 1205641 Selected nancial information gathered from Alpha Company and Omega Corporation follows: Alpha Revenue Omega $1,650,000 $1,452,000 Earnings before interest, taxes, depreciation, and amortization 69,400 79,300 Quick assets 216,700 211,300 Average xed assets 300,000 323,000 Current liabilities 361,000 404,400 Interest expense 44,000 58,100 Which of the following statements is most accurate? A) Omega uses its xed assets more e ciently than Alpha B) Omega has lower interest coverage than Alpha C) Alpha has a higher operating pro t margin than Omega Explanation Using the EBITDA coverage ratio (EBITDA / Interest expense), Omega's EBITDA coverage is 1.4 ($79,300 EBITDA / $58,100 interest expense) and Alpha's EBITDA coverage is 1.6 ($69,400 EBITDA / $44,000 interest expense) Using EBITDA to measure operating pro t, Alpha has a lower operating pro t margin than Omega Alpha's EBITDA margin is 4.2% ($69,400 EBITDA / $1,650,000 revenue) and Omega's EBITDA margin is 5.5% ($79,300 EBITDA / $1,452,000 revenue) Using xed asset turnover to measure the e ciency of xed assets, Omega uses its xed assets less e ciently than Alpha Alpha's xed asset turnover is 5.5 ($1,650,000 revenue / $300,000 average xed assets) and Omega's xed asset turnover is 4.5 ($1,452,000 revenue / $323,000 average xed assets) (Study Session 9, Module 30.2, LOS 30.c) Question #2 of 26 Question ID: 1205640 When assessing credit risk, which of the following ratios would best measure a rm's tolerance for additional debt and a rm's operational e ciency? Ratio #1 – Retained cash ow (CFO – dividends) divided by total debt Ratio #2 – Current assets divided by current liabilities Ratio #3 – Earnings before interest, taxes, depreciation, and amortization divided by revenues Tolerance for leverage Operational e ciency A) Ratio #3 Ratio #1 B) Ratio #2 Ratio #3 C) Ratio #1 Ratio #3 Explanation A rm's tolerance for additional debt can be measured by its capacity to repay debt Retained cash ow divided by total debt is one of several measures that can be used Operational e ciency refers to the rm's cost structure and can be measured by the "margin" ratios EBITDA divided by sales is one version of an operating margin ratio The current ratio is a measure of short-term liquidity (Study Session 9, Module 30.2, LOS 30.c) Question #3 of 26 Question ID: 1205651 A rm recognizes a goodwill impairment in its most recent nancial statement, reducing goodwill from $50 million to $40 million How should an analyst most appropriately adjust this nancial statement for goodwill when calculating nancial ratios? A) Decrease earnings but make no adjustment to assets B) Make no adjustments to assets or earnings because both re ect the impairment C) Decrease assets and increase earnings Explanation The recommended adjustment for goodwill before calculating nancial ratios is to remove goodwill from the balance sheet (decreasing assets) and reverse any losses recognized due to goodwill impairment (increasing earnings) (Study Session 9, Module 30.2, LOS 30.e) Question #4 of 26 Question ID: 1205646 Comet Corporation is a capital intensive, growing rm Comet operates in an in ationary environment and its inventory quantities are stable Which of the following accounting methods will cause Comet to report a lower price-to-book ratio, all else equal? Inventory method Depreciation method A) Last-in, First-out Accelerated B) First-in, First-out Accelerated C) First-in, First-out Straight-line Explanation FIFO results in higher assets and higher equity in an in ationary environment as compared to LIFO Equity is higher because COGS is lower (and inventory higher) under FIFO Straight-line depreciation will result in greater assets and equity compared to accelerated depreciation for a stable or growing rm Equity is greater because depreciation expense is less with straight-line depreciation Greater equity will result in greater book value per common share, the denominator of the price-to-book ratio Greater book value per share will result in a lower price-to-book ratio (Study Session 9, Module 30.2, LOS 30.e) Question #5 of 26 Question ID: 1205644 An analyst screening potential equity investments to identify value stocks is most likely to exclude companies with: A) high dividend payout ratios B) low earnings growth rates C) high price-to-earnings ratios Explanation Value stocks are considered to be those that have low prices relative to earnings (or relative to sales, cash ow, or book value) Screens that exclude rms with low earnings growth rates or high dividend payout ratios are more likely to be used to identify growth stocks (Study Session 9, Module 30.2, LOS 30.d) Question #6 of 26 Question ID: 1205653 LIFO ending inventory can be adjusted to a FIFO basis by: A) adding the LIFO reserve B) adding the change in the LIFO reserve C) subtracting the change in the LIFO reserve Explanation LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve, which a rm using LIFO must disclose in the notes to its nancial statements (Study Session 9, Module 30.2, LOS 30.e) Question #7 of 26 Question ID: 1205635 Baetica Company reported the following selected nancial statement data for the year ended December 31, 20X7: in millions % of Sales For the year ended December 31, 20X7: $500 100% Sales Cost of goods sold (300) 60% Selling and administration expenses (125) 25% Depreciation (50) 10% Net income $25 5% Non-cash operating working capitala $100 20% Cash balance $35 N/A As of December 31, 20X7: aNon-cash operating working capital = Receivables + Inventory – Payables Baetica expects that sales will increase 20% in 20X8 In addition, Baetica expects to make xed capital expenditures of $75 million in 20X8 Ignoring taxes, calculate Baetica's expected cash balance, as of December 31, 2008, assuming all of the common-size percentages remain constant A) $30 million B) $40 million C) $80 million Explanation 2008 sales are expected to be $600 million ($500 million 2007 sales × 1.2) and 20X8 net income is expected to be $30 million ($600 million 20X8 sales × 5%) 2008 non-cash operating working capital is expected to be $120 million ($600 million 20X8 sales × 20%) The change in cash is expected to be –$5 million ($30 million 20X8 net income + $60 million 20X8 depreciation – $20 million increase in non-cash operating working capital – $75 million 20X8 capital expenditures) The 20X8 ending balance of cash is expected to be $30 million ($35 million beginning cash balance – $5 million decrease in cash) (Study Session 9, Module 30.1, LOS 30.b) Question #8 of 26 Question ID: 1205654 A rm that uses higher estimates of assets' useful lives or salvage values relative to its peers will report: A) lower depreciation expense and lower net income B) lower depreciation expense and higher net income C) higher depreciation expense and higher net income Explanation Estimates of useful lives or salvage values that are too high will result in lower depreciation expense and higher net income (Study Session 9, Module 30.2, LOS 30.e) Question #9 of 26 Question ID: 1205634 Would projecting future nancial performance based on past trends provide a reliable basis for valuation of the following rms? Firm #1 – A rapidly growing company that has made numerous acquisitions and divestitures Firm #2 – A large, well-diversi ed, company operating in a number of mature industries Firm #1 Firm #2 A) Yes No B) No Yes C) No No Explanation Using past trends to project future nancial performance would be reliable for a well-diversi ed rm operating in a number of mature industries The diversi ed rm would likely have relatively predictable earnings Using past trends to project future nancial performance would not likely be reliable for the rapidly growing rm involved in numerous acquisitions and divestitures Such a rm would likely have high earnings volatility (Study Session 9, Module 30.1, LOS 30.b) Question #10 of 26 Question ID: 1205645 An analyst has decided to identify value stocks for investment by screening for companies with high book-tomarket ratios and high dividend yields A potential drawback of using these screens to nd value stocks is that the rms selected may: A) have unsustainable dividend payments B) be concentrated in speci c industries C) be those that have signi cantly underperformed the market Explanation A screen for rms with high dividend yields and high book-to-market ratios would likely result in an inordinate proportion of nancial services companies and add a signi cant element of industry (sector) risk Uncertainty about sustainability of dividend payments and recent market underperformance are typical characteristics of value stocks in general and not a drawback to using this screen to identify them (Study Session 9, Module 30.2, LOS 30.d) Question #11 of 26 Question ID: 1205642 Other things equal, which of the following rm characteristics are most likely to be viewed favorably by credit rating agencies? A) Large size, diverse product lines, concentrated geographic regions B) Large size, diverse product lines, many geographic regions C) Small size, focused product lines, concentrated geographic regions Explanation Other things equal, credit rating agencies tend to rate larger companies and those with diversi ed product lines and greater geographic diversi cation to be better credit risks (Study Session 9, Module 30.2, LOS 30.c) Question #12 of 26 Question ID: 1205652 The price to tangible book value ratio subtracts what components from equity? A) Goodwill and property, plant and equipment B) Goodwill and intangible assets C) Intangible assets and property, plant and equipment Explanation Price to tangible book value is calculated by removing goodwill and intangible assets from equity This adjustment reduces assets and equity and produces a ratio that is not a ected by di erences in intangible asset values that may result from how the assets were acquired (Study Session 9, Module 30.2, LOS 30.e) Question #13 of 26 Question ID: 1212517 National Scooter Company and Continental Chopper Company are motorcycle manufacturing companies National's target market includes consumers that are switching to motorcycles because of the high cost of operating automobiles and they compete on price with other manufacturers The average age of National's customers is 24 years Continental manufactures premium motorcycles and aftermarket accessories and competes on the basis of quality and innovative design Continental is in the third year of a ve-year project to develop a customized hybrid motorcycle Which of the two rms would most likely report higher gross pro t margin, and which rm would most likely report higher operating expense stated as a percentage of total cost? Higher gross pro t margin Higher percentage operating expense A) Continental National B) Continental Continental C) National Continental Explanation Continental likely has the highest gross pro t margin percentage since it is selling a customized product and does not compete primarily based on price Because of the research and development costs of developing a new hybrid motorcycle, Continental likely has the higher operating expense stated as a percentage of total cost (Study Session 9, Module 30.1, LOS 30.a) Question #14 of 26 Question ID: 1205647 Falcon Financial Group is considering the purchase of Company A or Company B based on a low price-tobook investment strategy that also considers di erences in solvency Selected nancial data for both rms, as of December 31, 20X7, follows: in millions, except per-share data Company A Company B Current assets $3,000 $5,500 Fixed assets $5,700 $5,500 Total debt $2,700 $3,500 Common equity $6,000 $7,500 500 750 $26.00 $22.50 Outstanding shares Market price per share The rms' nancial statement footnotes contain the following: Company A values its inventory using the rst in, rst out (FIFO) method Company B's inventory is based on the last in, rst out (LIFO) method Had Company B used FIFO, its inventory would have been $700 million higher Company A leases its manufacturing plant The remaining operating lease payments total $1,600 million Discounted at 10%, the present value of the remaining payments is $1,000 million Company B owns its manufacturing plant To make the rms nancials ratios comparable, calculate the adjusted price-to-book ratios for Company A and Company B Company A A) $1.63 $2.06 B) $2.17 $2.06 C) $2.17 $2.81 Explanation Company B Company A should be adjusted for the operating lease liability and the related assets; however, adding the present value of the lease payments to both assets and liabilities does not change equity (book value) Thus, Company A's adjusted P/B ratio is 2.17 = [$26 price / ($6,000 million equity / 500 million shares)] Company B's inventory should be adjusted back to FIFO by adding the LIFO reserve to both assets and equity Thus, Company B's P/B ratio is 2.06 = $22.50 / [($7,500 million equity + $700 million LIFO reserve) / 750 million shares] (Study Session 9, Module 30.2, LOS 30.e) Question #15 of 26 Question ID: 1205650 To adjust for operating leases before calculating nancial statement ratios, what value should an analyst add to a rm's liabilities? A) Sum of future operating lease obligations B) Di erence between present values of lease payments and the asset’s future earnings C) Present value of future operating lease payments Explanation Before calculating ratios involving liabilities, an analyst should estimate the present value of operating lease obligations and add this value to the rm's liabilities (Study Session 9, Module 30.2, LOS 30.e) Question #16 of 26 Question ID: 1205656 Among companies in a peer group for analysis, which of the following accounting di erences would make the estimated useful life of property, plant, and equipment appear to be lower if an analyst does not adjust for them? A) Higher estimated salvage values compared to those of peer companies B) U.S GAAP cost model, if peer companies use the IFRS cost model C) Accelerated depreciation, if peer companies use straight-line depreciation Explanation Estimated useful life of PP&E assets (gross PP&E / annual depreciation expense) is likely to be lower for a company that uses an accelerated depreciation method than for a company that uses straight-line depreciation Higher salvage values would decrease annual depreciation expense and increase estimated useful life The cost model is identical under IFRS and U.S GAAP (Study Session 9, Module 30.2, LOS 30.e) Question #17 of 26 Question ID: 1205633 Sterling Company is a start-up technology rm that has been experiencing super-normal growth over the past two years Selected common-size nancial information follows: 2007 Actual % of Sales 2008 Forecast % of Sales Sales 100% 100% Cost of goods sold 60% 55% Selling and administration expenses 25% 20% Depreciation expense 10% 10% Net income 5% 15% 20% 25% Non-cash operating working capitala a Non-cash operating working capital = Receivables + Inventory – Payables For the year ended 2007, Sterling reported sales of $20 million Sterling expects that sales will increase 50% in 2008 Ignoring income taxes, what is Sterling's forecast operating cash ow for the year ended 2008, and is this forecast likely to be as reliable as a forecast for a large, well diversi ed, rm operating in mature industries? Operating cash ow Reliable forecast A) $4.0 million No B) $4.0 million Yes C) $4.5 million No Explanation 2008 sales are expected to be $30 million ($20 million 2007 sales × 1.5) and 2008 net income is expected to be $4.5 million ($30 million 2008 sales × 15%) 2007 non-cash operating working capital was $4 million ($20 million 2007 sales × 20%) and 2008 non-cash operating working capital is expected to be $7.5 million ($30 million 2008 sales × 25%) 2008 operating cash ow is expected to be $4 million ($4.5 million 2008 net income + $3 million 2008 depreciation – $3.5 million increase in non-cash operating working capital) Forecasts for small rms, start-ups, or rms operating in volatile industries may be less reliable than a forecast for a large, well diversi ed, rm operating in mature industries (Study Session 9, Module 30.1, LOS 30.b) Question #18 of 26 Question ID: 1212518 Portsmouth Industries has stated that in the market for their medical imaging product, their strategy is to grow their market share in the premium segment by leveraging their research and development capabilities to produce machines with greater resolution for the most challenging cases of spinal degeneration An analyst examining their nancials for subsequent periods would most likely conclude that they are successfully pursuing this strategy if she nds: A) increasing research and development expense and decreasing operating margins B) an increase in gross margins greater than the increase in operating margins C) an increase in revenue and operating margins Explanation A shift to premium, rather than commodity-like, products should result in higher gross margins, higher average revenue per unit (selling price per unit), and an increase in gross margins relative to operating margins (because of the increase in R&D and marketing expenditures) A successful shift to a premium product should increase operating margins rather than increase operating income through increased unit sales Revenue would not necessarily increase as the company shifted to premium products (Study Session 9, Module 30.1, LOS 30.a) Question #19 of 26 Question ID: 1205643 Cody Scott would like to screen potential equity investments to identify value stocks and selects rms that have low price-to-sales ratios Unfortunately, screening stocks based only on this criterion may result in stocks that have poor pro tability or high nancial leverage, which are undesirable to Scott Which of the following lters could be added to the stock screen to best control for poor pro tability and high nancial leverage? Filter #1 – Include only stocks with a debt-to-equity ratio that is above a certain benchmark value Filter #2 – Include only dividend paying stocks Filter #3 – Include only stocks with an assets-to-equity ratio that is below a certain benchmark value Filter #4 – Include only stocks with a positive return-on-equity Poor pro tability High nancial leverage A) Filter #4 Filter #3 B) Filter #2 Filter #3 C) Filter #4 Filter #1 Explanation Firms that have poor pro tability are more likely to be non-dividend paying Selecting only dividend paying stocks can serve as a check on poor pro tability Using positive ROE to control for poor performance can result in bogus results without additional lters For example, if both the numerator (net income) and the denominator (average equity) are negative, ROE will be positive The higher the assets-to-equity ratio, the higher the leverage Selecting only stocks with an assets-to-equity ratio below a certain cut-o point will eliminate stocks with high leverage Debt-to-equity above a certain point would include rms with higher, not lower, nancial leverage (Study Session 9, Module 30.2, LOS 30.d) Question #20 of 26 Question ID: 1205655 A rm has a debt-to-equity ratio of 0.50 and debt equal to $35 million The rm acquires new equipment with a 3-year operating lease that has a present value of lease payments of $12 million The most appropriate analyst treatment of this operating lease will: A) increase the debt-to-equity ratio to 0.57 B) leave the debt-to-equity ratio unchanged at 0.5 C) increase the debt-to-equity ratio to 0.67 Explanation Shareholders' equity = $35 million / 0.5 = $70 million The most appropriate analyst adjustment for an operating lease is to add the present value of lease payments to the rm's assets and long-term debt (leaving equity unchanged) This will result in a debt-to-equity ratio of ($35 million + $12 million) / $70 million = 0.6714 (Study Session 9, Module 30.2, LOS 30.e) Question #21 of 26 Question ID: 1205639 An analyst makes the following two statements: Statement #1 – From a lender's perspective, higher volatility of a borrower's pro t margins is undesirable for oating-rate debt but not for xed-rate debt Statement #2 – Product and geographic diversi cation should lower a borrower's credit risk With respect to these statements: A) both are correct B) both are incorrect C) only one is correct Explanation Margin stability is desirable from the lender's perspective for both oating-rate and xed-rate debt Higher volatility will increase credit risk Product and geographic diversi cation should lower credit risk as the borrower is less sensitive to adverse events and conditions (Study Session 9, Module 30.2, LOS 30.c) Question #22 of 26 Question ID: 1205637 Jane Epworth, CFA, is preparing pro forma nancial statements for Gavin Industries, a mature U.S manufacturing rm with three distinct geographic divisions in the Midwest, South and West Epworth prepares estimates of sales for each of Gavin's divisions using economists' estimates of next-period GDP growth and sums the three estimates to forecast Gavin's sales Epworth's approach to estimating Gavin's sales is: A) inappropriate, because sales should be forecast on a rm-wide basis and are unlikely to be related to GDP growth B) inappropriate, because sales should be forecast on a rm-wide basis C) appropriate Explanation Sales estimates can be more sophisticated than simply estimating a single growth rate One common approach is to estimate the linear relationship between sales growth and economic growth and use this relationship to estimate sales growth based on economists' forecasts of GDP growth Segment-by-segment analysis can also be applied, summing segment or division sales forecasts to produce an overall sales forecast for the rm (Study Session 9, Module 30.1, LOS 30.b) Question #23 of 26 Question ID: 1205638 In estimating pro forma cash ows for a company, analysts typically hold which of the following factors constant? A) Noncash working capital as a percentage of sales B) Sales C) Repayments of debt Explanation To estimate pro forma cash ows, the analyst must make assumptions about future sources and uses of cash The most important of these will be increases in working capital, capital expenditures on new xed assets, issuance or repayments of debt, and issuance or repurchase of stock A typical assumption is that noncash working capital will remain constant as a percentage of sales (Study Session 9, Module 30.1, LOS 30.b) Question #24 of 26 Question ID: 1205648 At the end of 2007, Decatur Corporation reported last-in, rst-out (LIFO) inventory of $20 million, cost of goods sold (COGS) of $64 million, and inventory purchases of $58 million If the LIFO reserve was $6 million at the end of 2006 and $16 million at the end of 2007, compute rst-in, rst-out (FIFO) inventory at the end of 2007 and FIFO COGS for the year ended 2007 FIFO Inventory FIFO COGS A) $36 million $54 million B) $26 million $54 million C) $36 million $74 million Explanation 2007 FIFO inventory was $36 million ($20 million LIFO inventory + $16 million reserve) 2007 FIFO COGS was $54 million ($64 million LIFO COGS – $10 million increase in LIFO reserve) (Study Session 9, Module 30.2, LOS 30.e) Question #25 of 26 Question ID: 1205649 Patch Grove Nursery uses the LIFO inventory accounting method Maria Hu , president, wants to determine the nancial statement impact of changing to the FIFO accounting method Selected company information follows: Year-end inventory: $22,000 LIFO reserve: $4,000 Change in LIFO reserve: $1,000 LIFO cost of goods sold: $18,000 After-tax income: $2,000 Tax rate: 40% Under FIFO, the nursery's ending inventory and after-tax pro t for the year would have been: FIFO ending inventory FIFO after-tax pro t A) $18,000 $2,600 B) $26,000 $1,400 C) $26,000 $2,600 Explanation FIFO ending inventory = LIFO ending inventory + LIFO reserve = 22,000 + 4,000 = $26,000 FIFO after-tax pro t = LIFO after-tax pro t + (change in LIFO reserve)(1 – t) = $2,000 + ($1,000)(1 – 0.4) = $2,000 + $600 = $2,600 (Study Session 9, Module 30.2, LOS 30.e) Question #26 of 26 Question ID: 1205636 For 2007, Morris Company had 73 days of inventory on hand Morris would like to decrease its days of inventory on hand to 50 Morris' cost of goods sold for 2007 was $100 million Morris expects cost of goods sold to be $124.1 million in 2008 Assuming a 365 day year, compute the impact on Morris' operating cash ow of the change in average inventory for 2008 A) $3.0 million use of cash B) $6.3 million source of cash C) $3.0 million source of cash Explanation 2007 inventory turnover was (365 / 73 days in inventory) Given inventory turnover and COGS, 2007 average inventory was $20 million ($100 million COGS / inventory turnover) 2008 inventory turnover is expected to be 7.3 (365 / 50 days in inventory) Given expected inventory turnover, 2008 average inventory is $17 million ($124.1 million COGS / 7.3 expected inventory turnover) To achieve 50 days of inventory on hand, average inventory must decline $3 million ($20 million 2007 average inventory – $17 million 2008 expected inventory) A decrease in inventory is a source of cash (Study Session 9, Module 30.1, LOS 30.b) ... future C) Financial reporting refers to how companies show their nancial performance and nancial analysis refers to using the information to make economic decisions Explanation Financial reporting. .. nancial reporting and nancial statement analysis? A) The objective of nancial analysis is to provide information about the nancial position of an entity that is useful to a wide range of users B) Financial. .. Explanation Financial statement analysis refers to the use of information from a company's nancial statements along with other information to make economic decisions regarding that company Financial reporting