CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 28

CFA Level 1 - Financial Reporting and Analysis Session 8 - Reading 28 (Notes, Practice Questions, Sample Questions) 1. Which of the following reasons is least likely a valid limitation of ratio analysis? A)It is difficult to find comparable industry ratios. B)Calculation of ratios involves a large degree of subjectivity. C)Determining the target or comparison value for a ratio is difficult Explanation: There is not a great deal of subjectivity involved in calculating ratios. The mechanical formulas for the calculations are fairly standard and objective for the activity, liquidity, solvency, and profitability ratios, for instance. On the other hand, determining the target or comparison value for a ratio is difficult as it requires some range of acceptable values and that introduces an element of subjectivity. Conclusions cannot be made from viewing one set of ratios as all ratios must be viewed relative to one another in order to make meaningful conclusions. It can be difficult to find comparable industry ratios, especially when analyzing companies that operate in multiple industries 2. Ratio analysis is most useful for comparing companies: A)in different industries that use the same accounting standards. B)that operate in multiple lines of business. C)of different size in the same industry Explanation: Ratio analysis is a useful way of comparing companies that are similar in operations but different in size. Ratios of companies that operate in different industries are often not directly comparable. For companies that operate in several industries, ratio analysis is limited by the difficulty of determining appropriate industry benchmarks 3. Comparing a company’s ratios with those of its competitors is best described as: A)longitudinal analysis. B)cross-sectional analysis. C)common-size analysis Explanation: Comparing a company’s ratios with those of its competitors is known as cross-sectional analysis 4. To study trends in a company’s cost of goods sold (COGS), an analyst should standardize COGS by dividing it by: A)net income. B)sales. C)prior year COGS Explanation: In a common-size income statement, each income statement account is divided by sales. COGS is then production costs as a percentage of the sales price 5. Common size income statements express all income statement items as a percentage of: A)net income. B)assets. C)sales. Explanation: Common size income statements express all income statement items as a percentage of sales. Note that common size balance sheets express all balance sheet accounts as a percentage of total assets 6. Which of the following statements best describes vertical common-size analysis and horizontal common-size analysis? Statement #1 – Each line item is expressed as a percentage of its base-year amount. Statement #2 – Each line item of the income statement is expressed as a percentage of revenue and each line item of the balance sheet is expressed as a percentage of ending total assets. Statement #3 – Each line item is expressed as a percentage of the prior year’s amount Vertical analysis Horizontal analysis A) Statement #1 Statement #2 B) Statement #2 Statement #1 C) Statement #2 Statement #3 Explanation: Horizontal common-size analysis involves expressing each line item as a percentage of the base-year figure. Vertical common-size analysis involves expressing each line item of the income statement as a percentage of revenue and each line item of the balance sheet as a percentage of ending total assets 7. Are the following statements about common-size financial statements correct or incorrect? Statement #1 – Expressing financial information in a common-size format enables the analyst to make better comparisons between two firms of similar size that operate in different industries. Statement #2 – Common-size financial statements can be used to highlight the structural changes in the firm’s operating results and financial condition that have occurred over time. With respect to these statements: A)both are correct. B)only one is correct. C)both are incorrect. Explanation: Vertical common-size statements enable the analyst to make better comparisons of two firms of different sizes that operate in the same industry. Horizontal common-size financial statements express each line as a percentage of the base year figure; thus, horizontal common-size statements can be used to identify structural changes in a firm’s operating results and financial condition over time 8. Which of the following is least likely a routinely used operating profitability ratio? A)Net income/net sales. B)Sales/Total Assets C)Gross profit/net sales. Explanation: Sales/Total Assets, or Total Asset Turnover is a measure of operating efficiency, not operating profitability 9. As of December 31, 2007, Manhattan Corporation had a quick ratio of 2.0, current assets of $15 million, trade payables of $2.5 million, and receivables of $3 million, and inventory of $6 million. How much were Manhattan’s current liabilities? A)$4.5 million. B)$12.0 million. C)$7.5 million. Explanation: Manhattan’s quick assets were equal to $9 million ($15 million current assets – $6 million inventory). Given a quick ratio of 2.0, quick assets were twice the current liabilities. Thus, the current liabilities must have been $4.5 million ($9 million quick assets / 2.0 quick ratio) 10. Which of the following ratios would least likely measure liquidity? A)Quick ratio. B)Return on assets (ROA). C)Current ratio. Explanation: ROA = (EBIT / average total assets) which measures management's ability and efficiency in using the firm's assets to generate operating profits. Other ratios that measure liquidity (if a company can pay its current bills) besides the quick, cash, and current ratios are the: receivables turnover, inventory turnover, and payables turnover ratios 11. Are the following ratios best classified as profitability ratios?Ratio #1 – Cash plus short-term marketable investments plus receivables divided by average daily cash expenditures. Ratio #2 – Earnings before interest and taxes divided by average total assets. A)Both of the ratios are profitability ratios. B)Only one of the ratios is a profitability ratio. C)Neither of the ratios is a profitability ratio Explanation: (Cash + short-term marketable investments + receivables) divided by average daily cash expenditures is known as the defensive interval ratio. The defensive interval ratio is a liquidity ratio that measures the firm’s ability to pay cash expenditures in the absence of external cash flows, but does not directly measure profitability. EBIT / average total assets is one variation of the return on assets ratio. Return on assets is a profitability ratio that measures the efficiency of managing assets and generating profits 12. Given the following information about a firm: ● Net Sales = $1,000. ● Cost of Goods Sold = $600. ● Operating Expenses = $200. ● Interest Expenses = $50. ● Tax Rate = 34%. What are the gross and operating profit margins? A) Gross Operating Margin Operating Profit Margin 40% 20% B) 40% 10% C) 20% 15% Explanation: Gross profit margin = ($1,000 net sales − $600 COGS) / $1,000 net sales = 400 / 1,000 = 0.4 Operating profit margin = ($1,000 net sales − $600 COGS − $200 operating expenses) / $1,000 net sales = $200 / $1000 = 0.2 13. An analyst gathered the following data about a company: ·Current liabilities are $300. ·Total debt is $900. ·Working capital is $200. ·Capital expenditures are $250. ·Total assets are $2,000. ·Cash flow from operations is $400. If the company would like a current ratio of 2, they could: A)increase current assets by 100 or decrease current liabilities by 50. B)decrease current assets by 100 or increase current liabilities by 50. C)increase current assets by 100 or increase current liabilities by 50. Explanation: For the current ratio to equal 2.0, current assets would need to move to $600 (or up by $100) or current liabilities would need to decrease to $250 (or down by $50). Remember that CA − CL = working capital (500 − 300 = 200) 14. To calculate the cash ratio, the total of cash and marketable securities is divided by: A)total liabilities. B)current liabilities. C)total assets. Explanation: Current liabilities are used in the denominator for the: current, quick, and cash ratios 15. Earnings before interest and taxes (EBIT) is also known as: A)gross profit. B)operating profit. C)earnings before income taxes. Explanation: Operating profit = earnings before interest and taxes (EBIT) Gross profit = net sales – COGS Net income = earnings after taxes = EAT 16. A company has a receivables turnover of 10, an inventory turnover of 5, and a payables turnover of 12. The company’s cash conversion cycle is closest to: A)79 days. B)30 days. C)37 days. Explanation: Cash conversion cycle = receivables days + inventory processing days – payables payment period. Receivables days = 365 / receivables turnover = 365 / 10 = 36.5 days. Inventory processing days = 365 / inventory turnover = 365 / 5 = 73.0 days. Payables payment period = 365 / payables turnover = 365 / 12 = 30.4 days. Cash collection cycle = 36.5 + 73.0 – 30.4 = 79.1 days 17. An analyst has gathered the following information about a firm: ·Net sales of $500,000. ·Cost of goods sold = $250,000. ·EBIT of $150,000. ·EAT of $90,000. What is this firm’s operating profit margin? A)30%. B)18%. C)50%. Explanation: Operating profit margin = (EBIT / net sales) = ($150,000 / $500,000) = 30% 18. Use the following data from Delta's common size financial statement to answer the question: Earnings after taxes = 18% Equity = 40% Current assets = 60% Current liabilities = 30% Sales = $300 Total assets = $1,400 What is Delta's after-tax return on equity? A)18.0% B)5.0% C)9.6% Explanation: Net income after taxes = 300 × 0.18 = 54 Equity = 1400 × 0.40 = 560 ROE = Net Income / Equity = 54 / 560 = 0.0964 = 9.6% 19. A firm has a cash conversion cycle of 80 days. The firm's payables turnover goes from 11 to 12, what happens to the firm's cash conversion cycle? It: A)lengthens. B)shortens. C)may shorten or lengthen. Explanation: CCC = collection period + Inv Period – Payment period. Payment period = (365 / payables turnover) = (365 / 11) = 33; (365 / 12) = 30. This means the CCC actually increased to 83 20. Paragon Company's operating profits are $100,000, interest expense is $25,000, and earnings before taxes are $75,000. What is Paragon's interest coverage ratio? A)4 times. B)1 time. C)3 times. Explanation: ICR = operating profit ÷ I = EBIT ÷ I = 100,000 ÷ 25000 = 4 21. Assume a firm with a debt to equity ratio of 0.50 and debt equal to $35 million makes a commitment to acquire raw materials with a present value of $12 million over the next 3 years. For purposes of analysis the best estimate of the debt to equity ratio should be: A)0.500. B)0.671. C)0.573. Explanation: The original debt / equity ratio = 35 / 70 = 0.5. Now adjust the numerator but not the denominator. Why? You have commitments (liabilities) but no new equity because (non-current) liabilities and assets are increased by the same amount. D/E = (35 + 12) / 70 = 0.671. 22. An analyst has collected the following data about a firm: ·Receivables turnover = 20 times. ·Inventory turnover = 16 times. ·Payables turnover = 24 times. What is the cash conversion cycle? A)26 days. B)Not enough information is given. C)56 days. Explanation: Cash conversion cycle = receivables collection period + inventory processing period – payables payment period. Receivables collection period = (365 / 20) = 18 Inventory processing period = (365 / 16) = 23 Payables payment period = (365 / 24) = 15 Cash conversion cycle = 18 + 23 – 15 = 26 23. Which of the following items is NOT in the numerator of the quick ratio? A)Inventory. B)Cash. C)Receivables. Explanation: Quick ratio = (cash + marketable securities + receivables) / current liabilities Current ratio = (cash + marketable securities + receivables + inventory) / current liabilities 24. If the inventory turnover ratio is 7, what is the average number of days the inventory is in stock? A)52 days. B)70 days. C)25 days. Explanation: Average Inventory Processing Period = 365 / inventory turnover = 365 / 7 = 52 days. 25. Using a 365-day year, if a firm has net annual sales of $250,000 and average receivables of $150,000, what is its average collection period? A)1.7 days. B)46.5 days. C)219.0 days. Explanation: Receivables turnover = $250,000 / $150,000 = 1.66667 Collection period = 365 / 1.66667 = 219 days 26. Goldstar Manufacturing has an accounts receivable turnover of 10.5 times, an inventory turnover of 4 times, and payables turnover of 8 times. What is Goldstar’s cash conversion cycle? A)6.50 days. B)80.38 days. C)171.64 days. Explanation: The cash conversion cycle = average receivables collection period + average inventory processing period – payables payment period. The average receivables collection period = 365 / average receivables turnover or 365 / 10.5 = 34.76. The average inventory processing period = 365 / inventory turnover or 365 / 4 = 91.25. The payables payment period = 365 / payables turnover ratio = 365 / 8 = 45.63. Putting it all together: cash conversion cycle = 34.76 + 91.25 – 45.63 = 80.38. 27. Given the following income statement: Net Sales 200 Cost of Goods Sold 55 Gross Profit 145 Operating Expenses 30 Operating Profit (EBIT) 115 Interest 15 Earnings Before Taxes (EBT) 100 Taxes 40 Earnings After Taxes (EAT) 60 What are the gross profit margin and operating profit margin? Gross Profit Margin Operating Profit Margin A) 0.725 0.575 B) 2.630 1.226 C) 0.379 0.725 Explanation: Gross profit margin = gross profit / net sales = 145 / 200 = 0.725Operating profit margin = EBIT / net sales = 115 / 200 = 0.575 28. Adams Co.'s common sized balance sheet shows that: ● Current Liabilities = 20% ● Equity = 45% ● Current Assets = 45% ● Total Assets = $2,000 What are Adams' long-term debt to equity ratio and working capital? Debt to Equity Working Capital A) 0.78 $250 B) 1.22 $500 C) 0.78 $500 Explanation: If equity equals 45% of assets, and current liabilities equals 20%, then long-term debt must be 35%. Long-Term Debt / Equity = 0.35 / 0.45 = 0.78 Working capital = CA − CL = 45% - 20% = 25% of assets WC = 2,000(0.25) = $500 29. The cash conversion cycle is the: A)length of time it takes to sell inventory. B)sum of the time it takes to sell inventory and the time it takes to collect accounts receivable. C)sum of the time it takes to sell inventory and collect on accounts receivable, less the time it takes to pay for credit purchases. Explanation: Cash conversion cycle = (average receivables collection period) + (average inventory processing period) − (payables payment period) 30. Given the following income statement: Net Sales 200 Cost of Goods Sold 55 Gross Profit 145 Operating Expenses 30 Operating Profit (EBIT) 115 Interest 15 Earnings Before Taxes (EBT) 100 Taxes 40 Earnings After Taxes (EAT) 60 What are the interest coverage ratio and the net profit margin? Interest Coverage Ratio Net Profit Margin A) 2.63 0.30 B) 7.67 0.30 C) 0.57 0.56 Explanation: Interest coverage ratio = (EBIT / interest expense) = (115 / 15) = 7.67 Net profit margin = (net income / net sales) = (60 / 200) = 0.30 31. Which of the following is a measure of a firm's liquidity? A)Equity Turnover. B)Cash Ratio. C)Net Profit Margin. Explanation: Equity turnover and net profit margin are each measures of a company's operating performance. 32. McQueen Corporation prepared the following common-size income statement for the year ended December 31, 20X7: Sales 100% Cost of goods sold 60% Gross profit 40% For 20X7, McQueen sold 250 million units at a sales price of $1 each. For 20X8, McQueen has decided to reduce its sales price by 10%. McQueen believes the price cut will double unit sales. The cost of each unit sold is expected to remain the same. Calculate the change in McQueen’s expected gross profit for 20X8 assuming the price cut doubles sales. A) $150 million increase. B) $80 million increase. C) $50 million increase. Explanation: 20X7 gross profit is equal to $100 million ($1 × 250 million units sold × 40% gross profit margin). The 10% price cut to $0.90 will increase cost of goods sold to 67% of sales [COGS=0.6($1) = $0.60; $0.60 / $0.90 = 67%.]. As a result, gross profit will decrease to 33% of sales. If unit sales double in 20X8, gross profit will equal $150 million ($0.90 × 500 million units × 33% gross profit margin). Therefore, gross profit will increase $50 million ($150 million 20X8 gross profit – $100 million 20X7 gross profit). 33. Lightfoot Shoe Company reported sales of $100 million for the year ended 20X7. Lightfoot expects sales to increase 10% in 20X8. Cost of goods sold is expected to remain constant at 40% of sales and Lightfoot would like to have an average of 73 days of inventory on hand in 20X8. Forecast Lightfoot’s average inventory for 20X8 assuming a 365 day year. A)$8.0 million. B)$22.0 million. C)$8.8 million. Explanation: 20X8 sales are expected to be $110 million [$100 million × 1.1] and COGS is expected to be $44 million [$110 million sales × 40%]. With 73 days of inventory on hand, average inventory is $8.8 million [($44 million COGS / 365) × 73 days]. 34. In preparing a forecast of future financial performance, which of the following best describes sensitivity analysis and scenario analysis, respectively?Description #1 – A computer generated analysis based on developing probability distributions of key variables that are used to drive the potential outcomes. Description #2 – The process of analyzing the impact of future events by considering multiple key variables.Description #3 – A technique whereby key financial variables are changed one at a time and a range of possible outcomes are observed. Also known as “what-if” analysis. Sensitivity analysis Scenario analysis A) Description #3 Description #2 B) Description #3 Description #1 C) Description #2 Description #3 Explanation: Sensitivity analysis develops a range of possible outcomes as specific inputs are changed one at a time. Sensitivity analysis is also known as “what-if” analysis. Scenario analysis is based on a specific set of outcomes for multiple variables. Computer generated analysis, based on developing probability distributions of key variables, is known as simulation analysis.