CFA Level 1 - Financial Reporting and Analysis Session 10 - Reading 35

CFA Level 1 - Financial Reporting and Analysis Session 10 - Reading 35 (Notes, Practice Questions, Sample Questions) 1. 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 five-year project to develop a customized hybrid motorcycle. Which of the two firms would most likely report higher gross profit margin, and which firm would most likely report higher operating expense stated as a percentage of total cost? Higher gross profit margin Higher percentage operating expense A)Continental National B)National Continental C)Continental Continental Explanation — Continental likely has the highest gross profit 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. 2. According to the Management Discussion and Analysis section of Frankfurt Supply Company’s annual report, Frankfurt recently decreased the sales prices of its products in order to increase market share. In addition, Frankfurt recently lowered its requirements for credit customers and increased the credit limits of some customers. What is the most likely impact on Frankfurt’s accounts receivable turnover and inventory turnover as a result of these changes? A)Only one will decrease. B)Both will decrease. C)Both will increase. Explanation — Accounts receivable turnover will likely decrease as a result of offering credit to customers with weak credit histories. Collections will likely slow down and bad debt expense will likely increase. Inventory turnover is likely to increase as sales of Frankfurt’s products increase from more liberal credit terms and the decrease in price 3. Sterling Company is a start-up technology firm that has been experiencing super-normal growth over the past two years. Selected common-size financial 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% Non-cash operating working capital a 20% 25% 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 flow for the year ended 2008, and is this forecast likely to be as reliable as a forecast for a large, well diversified, firm operating in mature industries? Operating cash flow Reliable forecast A) $4.5 million No B) $4.0 million No C) $4.0 million Yes 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 flow 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 firms, start-ups, or firms operating in volatile industries may be less reliable than a forecast for a large, well diversified, firm operating in mature industries 4. Would projecting future financial performance based on past trends provide a reliable basis for valuation of the following firms?Firm #1 – A rapidly growing company that has made numerous acquisitions and divestitures. Firm #2 – A large, well-diversified, 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 financial performance would be reliable for a well-diversified firm operating in a number of mature industries. The diversified firm would likely have relatively predictable earnings. Using past trends to project future financial performance would not likely be reliable for the rapidly growing firm involved in numerous acquisitions and divestitures. Such a firm would likely have high earnings volatility 5. 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 flow of the change in average inventory for 2008. A)$6.3 million source of cash. B)$3.0 million source of cash. C)$3.0 million use of cash Explanation — 2007 inventory turnover was 5 (365 / 73 days in inventory). Given inventory turnover and COGS, 2007 average inventory was $20 million ($100 million COGS / 5 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 6. Statement #1 – From a lender’s perspective, higher volatility of a borrower's profit margins is undesirable for floating-rate debt but not for fixed-rate debt.Statement #2 – Product and geographic diversification should lower a borrower's credit risk. With respect to these statements: A)only one is correct. B)both are incorrect. C)both are correct Explanation — Margin stability is desirable from the lender’s perspective for both floating-rate and fixed-rate debt. Higher volatility will increase credit risk. Product and geographic diversification should lower credit risk as the borrower is less sensitive to adverse events and conditions 7. Patch Grove Nursery uses the LIFO inventory accounting method. Maria Huff, president, wants to determine the financial 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 profit for the year would have been: FIFO ending inventory FIFO after-tax profit A) $18,000 $2,600 B) $26,000 $2,600 C) $26,000 $1,400 Explanation — FIFO ending inventory = LIFO ending inventory + LIFO reserve = 22,000 + 4,000 = $26,000 FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 − t) = $2,000 + ($1,000)(1 − 0.4) = $2,000 + $600 = $2,600