CFA Level 1: Financial Statement Analysis (Session 11 - Reading 49)

CFA Level 1 - Corporate Finance Session 11 - Reading 49 Financial Statement Analysis - LOS a (Notes, Practice Questions, Sample Questions) 1. Which of the following financial statement items is least likely proportional to sales in a sales-driven pro-forma financial statement? A) Interest expense. B) Operating margin. C) Selling, general and administrative expenses. Explanation — A 2. Which item is least likely assumed to be a constant percentage of sales on a pro forma balance sheet? A) Property, plant and equipment. B) Long-term debt. C) Inventory. Explanation — B The projected level of long-term debt will depend on the financing need or surplus that results from the net income projection and the assumptions about how the surplus will be used or the need will be financed. Current assets, long-term assets, and current liabilities are all more likely to grow proportionately with sales 3. Jane Epworth, CFA, is preparing pro forma financial statements for Gavin Industries, a mature U.S. manufacturing firm 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) appropriate. B) inappropriate, because sales should be forecast on a firm-wide basis and are unlikely to be related to GDP growth. C) inappropriate, because sales should be forecast on a firm-wide basis. Explanation — A 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 firm 4. A firm has a capital structure of 60% debt and 40% equity and a dividend payout ratio of 50%. If a surplus results from first-pass pro forma financial statements based on estimated sales growth and assuming the capital structure and dividend payout ratio are maintained, which of the following changes in assumptions would eliminate any surplus in a single step? A) The entire surplus will be used to repurchase common stock. B) The entire surplus will be used to pay down long-term debt. C) No change in assumptions is necessary. Explanation — A If the entire surplus is used to repurchase common stock, total equity would be reduced by the amount of the surplus without affecting any of the other projected balance sheet or income statement items. This would balance assets with liabilities and equity without further iterations. If any of the surplus is used to pay down long-term debt, interest expense and taxes would change, requiring more iterations to reconcile the pro forma financial statements. To reconcile the pro forma statements in a single step by changing the dividend payout ratio, it would have to increase enough so that the entire surplus would be paid as additional dividends 5. Gerome Masseratti, CFA, and Charles Bataglia are working together to develop pro forma financial statements for one of their firm’s clients. During their initial meeting, Bataglia made a statement with which Masseratti did not agree. Which of the following is most likely the statement that Masseratti objected to? A) “A firm’s return on equity (ROE) will not necessarily increase just because the firm’s total asset turnover increases.” B) “It is acceptable to forecast future sales using the average compound growth rate of historic sales.” C) “If sales are forecast accurately, there is no need to reconcile the pro-forma income statement and balance sheet.” Explanation — C A normal part of constructing pro forma statements is to reconcile the income statement and balance sheet. After the first iteration, there is typically a discrepancy between the total assets account and the total liabilities plus total equity accounts on the firm’s balance sheet. This discrepancy must be resolved through subsequent iterations in the pro forma statement based on assumptions about how a deficit is funded or how a surplus is used 6. Which of the following financial statement items is least likely proportional to sales in a sales-driven pro-forma financial statement? A) Operating margin. B) Interest expense. C) Selling, general and administrative expenses Explanation — B Interest expense is usually forecast based on current payments on long-term debt and expected future long-term debt 7. Jane Epworth, CFA, is preparing pro forma financial statements for Gavin Industries, a mature U.S. manufacturing firm 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 firm-wide basis and are unlikely to be related to GDP growth. B) appropriate. C) inappropriate, because sales should be forecast on a firm-wide basis. Explanation — B 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 firm 8. A firm has a capital structure of 60% debt and 40% equity and a dividend payout ratio of 50%. If a surplus results from first-pass pro forma financial statements based on estimated sales growth and assuming the capital structure and dividend payout ratio are maintained, which of the following changes in assumptions would eliminate any surplus in a single step? A) The entire surplus will be used to pay down long-term debt. B) The entire surplus will be used to repurchase common stock. C) No change in assumptions is necessary. Explanation — B If the entire surplus is used to repurchase common stock, total equity would be reduced by the amount of the surplus without affecting any of the other projected balance sheet or income statement items. This would balance assets with liabilities and equity without further iterations. If any of the surplus is used to pay down long-term debt, interest expense and taxes would change, requiring more iterations to reconcile the pro forma financial statements. To reconcile the pro forma statements in a single step by changing the dividend payout ratio, it would have to increase enough so that the entire surplus would be paid as additional dividends 9. Gerome Masseratti, CFA, and Charles Bataglia are working together to develop pro forma financial statements for one of their firm’s clients. During their initial meeting, Bataglia made a statement with which Masseratti did not agree. Which of the following is most likely the statement that Masseratti objected to? A) “A firm’s return on equity (ROE) will not necessarily increase just because the firm’s total asset turnover increases.” B) “If sales are forecast accurately, there is no need to reconcile the pro-forma income statement and balance sheet.” C) “It is acceptable to forecast future sales using the average compound growth rate of historic sales.” Explanation — B A normal part of constructing pro forma statements is to reconcile the income statement and balance sheet. After the first iteration, there is typically a discrepancy between the total assets account and the total liabilities plus total equity accounts on the firm’s balance sheet. This discrepancy must be resolved through subsequent iterations in the pro forma statement based on assumptions about how a deficit is funded or how a surplus is used.