Answers - Reading 13 Integration of Financial Statement Analysis Techniques

Question #1 of 22 Question ID: 1472665 Cash generated from operations (CGO) is least appropriately calculated as: A) operating cash flow + cash interest paid + cash taxes paid. B) net income − cash flow from operations − cash flow from investing. C) EBIT + non-cash charges − increase in working capital. Explanation The following is an appropriate formula for calculating cash flow based accruals, not CGO: cash flow based accruals = net income − cash flow from operations − cash flow from investing. (Module 13.5, LOS 13.e) Question #2 of 22 Question ID: 1472672 Endrun Company reported net income of $4.7 million in 1999, and $4.3 million in 2000. In reviewing the annual report an analyst notices that the Endrun took a charge of $2.4 million in 1999 for the costs of relocating its main office, and in 2000 booked a gain of $900,000 on the sale of its previous office building. What would "normalized earnings" be for 1999 and 2000 if we assume a tax rate of 36% for both years? A) $6.236 million and $3.724 million. B) $7.1 million and $5.2 million. C) $3.99 million and $2.54 million. Explanation You will increase 1999 earnings by the tax-adjusted value of the 2.4 million one-time charge (2.4 × (1 - 0.36) = +1.536), and you would decrease Y2000 earnings by the taxadjusted amount of the $0.9 million one-time gain (0.9 × (1 - 0.36) = -0.576). (Module 13.6, LOS 13.e) Question #3 of 22 Question ID: 1472674 Recently, Galaxy Corporation lowered its allowance for doubtful accounts by reducing bad debt expense from 2 percent of sales to 1 percent of sales. Ignoring taxes, what are the immediate effects on Galaxy's operating income and operating cash flow? Operating Operating cash income flow A) Lower Lower B) Higher No effect C) No effect Higher Explanation Lower bad debt expense will result in higher operating income. Operating cash flow is not affected until Galaxy actually collects the receivables. (Module 13.6, LOS 13.e) Question #4 of 22 Question ID: 1472664 If segmental cash flow data has not been reported, we can most appropriately approximate cash flow as: A) operating cash flow − cash interest − cash taxes. B) EBIT + non-cash charges + increase in working capital. C) EBIT + depreciation + amortization. Explanation We are most likely to approximate segment cash flow as EBIT plus depreciation and amortization. This calculation is necessary because segmental cash flow data is generally not reported. (Module 13.2, LOS 13.c) Question #5 of 22 Question ID: 1472657 An analyst is analyzing a discount manufacturer of parts and supplies. She has followed her firm's suggested financial analysis framework and has communicated with company suppliers, customers, and competitors. This is an input that occurs while: A) establishing the objective of the analysis. B) collecting data. C) processing data. Explanation Communication with management, suppliers, customers, and competitors is an input during the data collection step. Processing data is the third phase of the financial analysis framework. Establishing the objective of the analysis is part of the "define the purpose" phase of the financial analysis framework. (Module 13.1, LOS 13.a) Question #6 of 22 Question ID: 1472659 Inventories are listed on the balance sheet at $600,000, retained earnings are $1.9 Million. In the notes to financial statements, you find a LIFO reserve of $125,000. Also, the probability of a LIFO liquidation is high. Assuming a tax rate of 36%, what will be the adjusted value of retained earnings? A) $1,820,000.00 B) $1,980,000.00 C) $1,855,000.00 Explanation The highly probably LIFO liquidation suggests net income, income tax expense, and equity will rise. The analyst can make this adjustment now for forecasting purposes. The adjustment to retained earnings will be: $125,000 × (1 − 0.36). (Module 13.2, LOS 13.b) Question #7 of 22 Question ID: 1472663 In order to compare companies using a common size statement, the various line items in a company's income statement are most likely to be divided by the company's: A) total assets. B) net earnings. C) revenues. Explanation In a common size income statement, all the line items in a company's income statement are divided by the company's revenues. Common size statements make comparability across companies much easier. An analyst might use a common size statement to compare trends in income statement variables (such as gross margins) for a group of companies. (Module 13.2, LOS 13.c) Question #8 of 22 Question ID: 1472654 Wanda Brunner, CFA, is analyzing Straight Elements, Inc., (SE). SE is a discount manufacturer of parts and supplies for the railroad industry. She has followed her firm's suggested financial analysis framework, and has assembled output from processing data. When applying the financial analysis framework, which of the following is the best example of output from processing data? A) Common-size financial statements. B) Audited financial statements. C) A written list of questions to be answered by the analysis. Explanation Common-size financial statements are created in the data processing step of the framework for financial analysis. Audited financial statements would be obtained during the "collect input" phase of the financial analysis framework. Creating a written list of questions to be answered by the analysis is part of the "define the purpose" phase of the financial analysis framework. (Module 13.1, LOS 13.a) Question #9 of 22 Question ID: 1472658 Express Delivery Inc. (EDI) reported the following year-end data: Depreciation expense $30 million Net income $30 million Total assets $535 million Shareholder's equity $150 million Effective tax rate 35 percent Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI's management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate. How would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation assumptions? ROA and ROE would be closest to: A) ROA 5.0% and ROE 18.2%. B) ROA 5.3% and ROE 20.5%. C) ROA 5.7% and ROE 19.5%. Explanation The reported ROA and ROE are 5.6% (30/535) and 20.0% (30/150) respectively. Under the new depreciation assumptions, depreciation expense would be (140-14)/5 = 25.2 million. Under the original assumptions depreciation of the fleet was 20 million. Therefore depreciation increases by 5.2 million. With the change in depreciation methods EDI would have reported: Depreciation expense $35.20 million (30 + 5.2) Net income $26.62 million (30 − (5.2 × (1-0.35))) Total assets $529.80 million (535 − 5.2 ) Shareholder's equity $146.62 million (150 − 3.38) Note that assets would have been lower by $5.2 million due to the new depreciation assumptions and shareholder's equity by $3.38 million (5.2 × (1 − 0.35)) due to lower retained earnings. Tax liabilities would have fallen by $1.82 million to balance the $5.2 million reduction in assets. Therefore, ROA would have been 5.0% (26.62 / 529.80) and ROE would have been 18.16% (26.62 / 146.62). (Module 13.2, LOS 13.b) Question #10 of 22 Question ID: 1472669 Which of the following statements is CORRECT when inventory prices are falling? A) LIFO results in higher COGS, lower earnings, higher taxes, and higher cash flows. B) LIFO results in lower COGS, lower earnings, lower taxes, and higher cash flows. C) LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows. Explanation Remember, prices are falling. Under LIFO, the most recent purchases flow to COGS. So, LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows. (Module 13.6, LOS 13.e) Question #11 of 22 Question ID: 1472662 Star Chemical Inc. (SCI) reported the following year-end data: Depreciation expense $25 million Net income $35 million Dividends $10 million Total assets $250 million Shareholder's equity $195 million Effective tax rate 35 percent SCI also reported that it changed from an accelerated depreciation method to straight line depreciation. The change resulted in a decrease in depreciation expense of $5 million. Management felt that the change "would not have a material effect on financial performance measures." Ignoring deferred taxes, what are the return on assets (ROA) and return on equity (ROE) measures under the old depreciation methods? A) ROA is 12.96% and ROE is 16.56%. B) ROA is 13.30% and ROE is 17.05%. C) ROA is 13.50% and ROE is 17.51%. Explanation The change in depreciation methods results in net income increasing by $3.25 million ($5 million × (1-0.35)) and total assets increasing by $5 million. Without the change in depreciation methods SCI would have reported: Depreciation expense $30 million ($25 + $5) Net income $31.75 million ($35 – $3.25) Total assets $245 million ($250 – $5) Shareholder's equity $191.75 million ($195 − $3.25) Note that assets would have been lower by $5 million due to the accelerated depreciation and equity would be lower by $3.25 million ($5 × (1 − 0.35)) due to lower retained earnings. In order to balance the $5 million reduction in assets, equity will fall by $3.25 million and tax liabilities will fall by $1.75 million. Therefore, ROA would have been 12.96% ($31.75 / $245) and ROE would have been 16.56% ($31.75 / $191.75). (Module 13.2, LOS 13.b) Question #12 of 22 Question ID: 1472670 MKF Consolidated reports $500 million in goodwill on its balance sheet. The market consensus indicates that the value of MKF's intangible assets is $300 million. How should an analyst adjust MKF's balance sheet? Reduce goodwill and: A) equity by $500 million while increasing liabilities by $300 million. B) increase liabilities by $200 million. C) equity by $200 million. Explanation If goodwill has no economic value apart from the firm, it should be eliminated from the balance sheet. If the value of the intangibles can be reliably estimated they can be substituted for accounting goodwill. (Module 13.6, LOS 13.e) Question #13 of 22 Question ID: 1472667 ABC Tie Company reports income for the year 2009 as $450,000. The notes to its financial statements state that the firm uses the last in, first out (LIFO) convention to value its inventories, and that had it used first in, first out (FIFO) instead, inventories would have been $62,000 greater for the year 2008 and $78,000 greater for the year 2009. If earnings were restated using FIFO to determine the cost of goods sold (COGS), what would the net income be for the year 2009? Assume a tax rate of 36%. Net income would have been: A) $460,240. B) $439,760. C) $455,760. Explanation The reduction in COGS would result in an increase in net income (62,000 − 78,000) × (1 − 0.36). (Module 13.6, LOS 13.e) Question #14 of 22 Question ID: 1472655 An analyst is developing a framework for financial statement analysis for his firm. The primary goal of financial statement analysis is to: A) justify trading decisions for purposes of the Statement of Code and Standards. B) facilitate an economic decision. C) document portfolio changes for purposes of the Prudent Investor Rule. Explanation The primary goal of financial statement analysis is to facilitate an economic decision. For example, the firm may use financial analysis to decide whether to recommend a stock to its clients. Documentation and justification of trading decisions may be aided by financial statement analysis, but these are not the primary purposes. (Module 13.1, LOS 13.a) Question #15 of 22 Question ID: 1472660 A firm seeking to lower current tax liability may elect to use which method of inventory valuation during an inflationary period? A) LIFO. B) FIFO. C) Average cost. Explanation During an inflationary period, using LIFO would increase COGS, since the most recent (highest cost) inventory would be sold. Therefore, earnings and taxes would be lowest under LIFO. (Module 13.2, LOS 13.b) Question #16 of 22 Question ID: 1472668 An investor relations spokesperson for the Square Door Corporation was quoted as saying that Square Door shares were a bargain, selling at a price-to-earnings (P/E) ratio of 12, relative to the S&P 500 average P/E of 15.3. The financial statements reported net earnings of $126 million, or $4.00 per share. The notes to the financial statements included a statement that income for the year included a $31.5 million (after-tax) gain from the reclassification of certain assets from its investment portfolio to its trading portfolio. What would be the normalized P/E? A) 15. B) 16 C) 13 Explanation Since the P/E ratio was 12 and EPS was $4, the price of the stock was $48 (12 × 4). After removing the nonrecurring gain, earnings will be $94.5 million (126 − 31.5). We know the number of shares is 31.5 million (126 Million ÷ 4). So the new EPS number is 3 (94.5 million ÷ 31.5 million) and new P/E ratio is 16 (48 ÷ 3). (Module 13.6, LOS 13.e) Question #17 of 22 Question ID: 1472673 An analyst finds return-on-equity (ROE) (based on beginning of the year equity) a good measure of management performance and wants to compare two firms: Firm A and Firm B. Firm A reports net income of $3.2 million and has a ROE of 18. Firm B reports income of $16 million and has an ROE of 16. A review of the notes to the financial statements for Firm A, shows that the earnings include a loss from smelting operations of $400,000 and that the firm has exited this business. In addition, the firm sold the smelting equipment and had a gain on the sale of $300,000. A similar review of the notes for Firm B discloses that the $16 million in net income includes $2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for both firms is 36%, and that the notes describe pre-tax amounts. Which of the following is closest to the "normalized" ROE for Firm A and for Firm B, respectively? A) 17.1 and 16.9. B) 16.0 and 18.0. C) 18.4 and 14.3. Explanation The ROE for Firm A is adjusted for the $400,000 loss on discontinued operations and the $300,000 non-recurring gain. The ROE for Firm B is adjusted to remove the effects of the $2.6 million one-time gain. The first step in this problem is to solve for equity using ROE. Then, "normalize" net income by adjusting for discontinued operations and non-recurring items. Then, solve for "normalized" ROE. Firm A: 18% = 3,200,000 / EquityA EquityA = 17,777,778 (rounding) Normalized Net IncomeA = 3,200,000 + (1 – 0.36)(400,000 – 300,000) Normalized ROEA = 3,264,000 / 17,777,778 = 18.360% Firm B: 16% = 16,000,000 / EquityB EquityB = 100,000,000 Normalized Net IncomeB = 16,000,000 + (1 – 0.36)(–2,600,000) Normalized ROEB = 14,336,000 / 100,000,000 = 14.336% 18.360 and 14.336 are closest to 18.4 and 14.3 (Module 13.6, LOS 13.e) Question #18 of 22 Question ID: 1472656 An analyst is developing a framework for financial statement analysis for his firm. This framework is most likely to include: A) Define the purpose of the analysis, process input data, and follow up. B) C) Determine the allocation of firm fees, interpret processed data, and communicate conclusions. Maintain integrity of capital markets, perform duties to clients and employers, and avoid conflicts of interest. Explanation Proper analysis framework should include: 1. Define the purpose of the analysis. 2. Collect input data. 3. Process input data. 4. Interpret processed data. 5. Develop and communicate conclusions. 6. Follow up. (Module 13.1, LOS 13.a) Question #19 of 22 Question ID: 1472666 Coastal Drilling Corp (CDC) reported the following year-end data: EBIT $23 million EBT $20 million Effective tax rate 40 percent CDC reported in the footnotes to its financial statements that it had increased the expected return on pension plan assets assumption which resulted in an increase of EBIT of $2 million. Analyst Wanda Brunner, CFA, thinks this change in assumptions is unfounded and removes the $2 million increase in EBIT. Which of the following is closest to the tax burden ratio after adjustment? A) 55.6%. B) 60.0%. C) 61.9%. Explanation Tax burden = NI/EBT or 1 - the effective tax rate. The increase in the return on pension plan assets assumption increased EBIT, EBT, Income Taxes, and Net Income from what it would have been. Removing $2 million from the reported numbers will reduce EBIT, EBT, Income Taxes, and Net Income. However, the tax burden ratio will still be 1 - the effective tax rate. (Module 13.6, LOS 13.e) Question #20 of 22 Question ID: 1472653 An analyst is analyzing TRK Construction (TRK) for possible recommendation to his firm's clients. He wants to use TRK's financial statements to answer such questions as "Is TRK suitable for firm clients?", "Is TRK priced properly relative to peers?", "What is TRK's earnings quality?" The analyst is most likely to begin with: A) analysts adjustments to the financial statements. B) a review of his firm’s framework for analysis of financial statements. C) a DuPont analysis. Explanation Analysis of financial statements should be performed in the context of an overall framework for the analysis of financial statements. Specific adjustments or analysis of specific ratios is a secondary concern. (Module 13.1, LOS 13.a) Question #21 of 22 Question ID: 1472671 A firm has reported net income of $136 million, but the notes to financial statements includes a statement that the results "include a $27 million charge for non-insured earthquake damage" and a "gain on the sale of certain assets during restructuring of $16 million." If we assume that both of these items are given on a pre-tax basis and the effective tax rate is 36%, what would be the "normal income"? A) $94.08 million. B) $147.00 million. C) $143.04 million. Explanation To normalize earnings you would increase it by the non-recurring charge of $27 million and decrease it by the non-recurring gain, both tax adjusted. $136 + (27 - 16)(1 - 0.36) = $143.04. (Module 13.6, LOS 13.e) Question #22 of 22 Question ID: 1472661 Holdall Corporation recently reclassified many of their assets such that the average useful life of their depreciable assets was reduced. Which of the following is the most likely result from this change on net income and inventory turnover? (Assume everything else remains constant.) Net income will: A) increase and inventory turnover will not change. B) decrease and inventory turnover may or may not change. C) decrease and inventory turnover will rise. Explanation Depreciation expense increases as the depreciable life of an asset decreases. Thus, net income will decline. Depreciation will only affect inventory turnover if depreciation has been allocated to individual inventory items; when and why this happens is outside the scope of the Level II curriculum. (Module 13.2, LOS 13.b)