Financial Analysis Flashcards
Tulta & Munille, Inc. has operating income of $3,950,000, depreciation and amortization of $200,000, interest expense of $2,190,000, capital expenditures of $1,400,000, and long-term debt of $6,800,000. The tax rate applied to the company is 35%. Given this information, what is the interest coverage ratio of the company?
- 23
- 71
- 89
- 53
The interest coverage ratio measures how many times a company’s income covers its interest expense. It is calculated by dividing the EBITDA [earnings before interest and taxes (EBIT or operating income) plus depreciation and amortization], by the interest expense ($3,950,000 + $200,000 / $2,190,000). The ratio for Tulta & Munille, is calculated to be 1.89, ($4,150,000 / $2,190,000).
You are assisting on the corporate financing team for Westwind, a multinational transportation company. Westwind takes a minor restructuring charge that includes employee severance and asset write-downs. The extent of these charges would be found by:
Looking at a footnote to the income statement
Looking at the operating expenses on the income statement
Computing the change in retained earnings
Reviewing the financing section of the statement of cash flows
I and III only
I and II only
III and IV only
II and IV only
B: Restructuring charges are reflected on the income statement in the operating section, as well as the footnotes of the 10-K. For example, if Westwind took a restructuring charge consisting of asset write-downs and employee severance that resulted in negative operating earnings, this would be reflected in the operating expenses on the income statement and in a footnote to the income statement. The asset write-downs would also impact the balance sheet through lower carrying values of fixed assets. Adjustments would also be made in the operating cash flow section, as asset write-downs do not consume cash. Liabilities related to severance would be reflected on the balance sheet. (79506)
Axis Chemicals has contacted your firm with the intention of expanding its capital base through an additional offering of common stock. The company’s results show an increase in sales of 33% during the last quarter; however, in the past, the company has been involved in channel stuffing. As an investment banking representative, which TWO areas should be reviewed to gain a better understanding of the company’s revenues during the last quarter?
Footnotes and the disclosure statement of nonrecurring items
Accounts receivable growth exceeding sales growth
Days sales outstanding (DSO)
Revenue recognition policy
I and II
I and IV
II and III
III and IV
C: Channel stuffing is a deceptive business practice used by a company to inflate its sales and earnings figures by deliberately sending retailers along its distribution channel more products than they are able to sell to the public. Through channel stuffing, distributors temporarily increase accounts receivables. However, if unable to sell the excess products, retailers will return the excess items to the distributor. The distributor must adjust accounts receivable and its bottom line. Channel stuffing ultimately catches up with the company. It cannot maintain sales at the rate it is stuffing. This is usually done fraudulently to raise the value of the stock. Channel stuffing is illegal. An investment banking representative would want to carefully review a company’s financial statements to see if the accounts receivable growth rate exceeds the sales growth rate and analyze any significant changes in a company’s Days Sales Outstanding (DSO). [60487]
Relevant financial information to answer the following question is found in Exhibit 33.
You are reviewing the financial statements of Company W. Which of the following choices could describe the activities related to the company from Year 1 to Year 2?
It issued common stock It issued preferred stock It increased investment in depreciable assets It issued debt I and IV only I, II, and IV only III only All of the above
B: Relevant financial information to answer the following question is found in Exhibit 33.
You are reviewing the financial statements of Company W. Which of the following choices could describe the activities related to the company from Year 1 to Year 2?
It issued common stock It issued preferred stock It increased investment in depreciable assets It issued debt I and IV only I, II, and IV only III only All of the above
A manufacturing company has the following changes to its financials. Its depreciation expense has decreased, and it has declared and paid a cash dividend. Which TWO of the following statements are NOT TRUE? Operating cash flow would increase Operating cash flow would decrease Retained earning would increase Retained earnings would decrease I and III I and IV II and III II and IV
A: Operating cash flow takes into consideration depreciation in its calculation. A decrease in depreciation will mean less of an add-back when calculating operating cash flow and, therefore, it will decrease. Cash dividends are paid out of retained earnings, which would result in a decrease in retained earnings. Remember to read the question carefully since it is asking which statements are not true. [61388]
Exhibit 17.
Your firm has been retained by the Clara Mae Candy Company to advise its management on operational and capital structure changes to improve the company’s bottom line. Your firm has recommended restructuring that will reduce selling, general, and administration expenses (SGA) by 20% in 2014, and interest expense by 50%. The tax rate applied to the company in 2013 is expected to remain unchanged for 2014. If the company follows your firm’s advice and all other expenses (including extraordinary items) remain the same as in 2013, what will be the percentage increase in net income for 2014?
19%
31%
40%
67%
SGA is cut by 20% in 2014; interest expense is reduced by 50%, while the tax rate remains the same. Changes are based on a 20% reduction in SGA.
Sales $7,000,000 Cost of goods sold 4,000,000 Gross profit $3,000,000 SGA 1,520,000 ($1,900,000 x 20% = $380,000 $1,900,000 - $380,000 = 1,520,000) Operating income $1,480,000 Depreciation and amortization 200,000 Operating profit $1,280,000 Interest expense 35,000 ($70,000 x 50%) Non-operating income 150,000 Non-operating expense 0 Pretax income $1,395,000 Total income taxes 599,850 ($420,000 / $980,000 = 43% Tax Rate) ($1,395,000 x 43% = 599,850) Income before extraordinary items $795,150 Extraordinary items 210,000 Net income $585,150 Increase in net income is $235,150 ($585,150 - $350,000) Percentage of increase is 67% ($235,150 / $350,000) (79538)
Two automobile manufacturers have defined benefit pension plans. Company ZBT uses a discount rate of 5% to calculate its pension fund liabilities, and Company SMI uses a 7.5% discount rate to calculate its pension fund liabilities. Which of the following statements is TRUE?
Company ZBT is using a more aggressive method of accounting
Company SMI is using a more aggressive method of accounting
Company ZBT will have higher pension fund assets
Company SMI will have higher pension fund assets
B:Aggressive accounting refers to a method of accounting that is used to report lower expenses and higher income, or to overstate assets while understating (not recognizing or lowering) liabilities.
**In regard to accounting practices for defined benefit pension plans, using a low discount rate is conservative, and using a higher discount rate would be aggressive. The present value calculation is based on dividing the liabilities by (1.0 + discount rate). Therefore, the higher the discount rate, the lower the present value of the fund’s long-term liabilities.
In order to calculate either company’s pension fund assets, you would need to be given the expected return on the assets in the plan. [61378]
The Big N, a company listed on the Nasdaq Global Select Market, currently has 4,000,000 shares outstanding. Its net income is currently $8,600,000 and is expected to grow at 16%. If Big N conducts a public offering of 2,500,000 shares of common stock, with the company selling 1,500,000 shares and the shareholders selling 1,000,000 shares, what is the impact of the offering on expected EPS?
It would not be accretive or dilutive to EPS
It would be dilutive by 96 cents
It would be dilutive by 49 cents
It would be dilutive by 68 cents
D: The expected net income can be found by multiplying the current amount by the expected growth rate ($8,600,000 x 1.16 = $9,976,000). The EPS would be $2.49 ($9,976,000 / 4,000,000 shares) without the additional shares being offered. The number of outstanding shares would increase by 1,500,000 if the company conducted an offering of additional shares. (The shares sold by selling shareholders do not increase the number of outstanding shares since this amount is already included in the amount of shares outstanding.) The EPS after the offering is $1.81 and, therefore, would be dilutive by 68 cents ($2.49 - $1.81).
Company R has $300 MM in sales and a net profit margin of 10%. It has earnings of $1.00 per share and is subject to a tax rate of 32%. The company is considering a relocation that would reduce its effective tax rate. It has a significant amount of cash and equivalents and may want your firm to handle a common stock repurchase. The company has recently begun marketing a new product and expects its sales to increase. Which of the following events would have the smallest impact on the company’s EPS?
The company’s effective tax rate falls to 29%
The company buys back 2 million shares of common stock
Sales increase by 5%
Sales increase by 3% and it buys back 1 million share
A: The company has $300 MM in sales and a net profit margin of 10%. Therefore, the company’s net income is $30 MM. Since EPS is $1.00, there are 30 MM shares outstanding. Pretax income was $44.12 MM which is determined by dividing the net income by 68% ($30 MM / [1 - tax rate] or $30 MM / 68%). If the effective tax rate declines to 29%, the net income would rise to $31.32 MM ($44.12 MM x [1 - 29%]). The EPS would be $1.04. If the company buys back 2 million shares of common, the shares outstanding would be 28 MM, divided into $30 MM net income which equals $1.07 EPS. If sales increased by 5%, from $300 MM to $315 MM, given the net profit margin of 10%, net income would increase to $31.5 MM divided by 30 shares outstanding which would be EPS of $1.05. If sales increased by 3% to $309 MM, net income would increase to $30.9 MM. A share buyback of 1 million shares would reduce the shares outstanding to 29 MM. The EPS would increase to $1.07 ($30.9 MM / 29 MM).
Exhibit 4.
What is the Quick Assets Ratio of Tick Tock Clocks, Inc.?
- 11
- 22
- 84
- 93
A: The Quick Assets Ratio (Acid Test Ratio) is generally expressed as (Current Assets - Inventories) / Current Liabilities. In the event a company has other current assets (such as prepaid expenses), these are deducted as well. Another often-used form of the Quick Assets Ratio is (Cash + Cash Equivalents + Accounts Receivable) / Current Liabilities. In the case of Tick Tock Clocks, the Quick Assets Ratio can be expressed as [66.15 - (24.85 + 3.25)] / 34.25 = 1.11, or (9.10 + 13.25 + 15.70) = 38.05 / 34.25 = 1.11
Assuming no change in working capital, which of the following calculations could an analyst use to determine a firm’s free cash flow?
Cash flow from operations + capital expenditures
Net income + taxes - depreciation + capital expenditures
Net income + interest expense + capital expenditures
EBITDA - taxes - capital expenditures
D: Although there are many ways to calculate free cash flow to the firm, the most common method is cash flow from operations less capital expenditures. Other methods to define free cash flow are: EBITDA - taxes - CAPEX +/- changes in working capital, or EBIT - taxes - net CAPEX (CAPEX - depreciation) +/- change in working capital. Both of these formulas take into consideration taxes and interest expense. If a firm was unleveraged (no debt), the formula would be: net income + depreciation - CAPEX +/- changes in working capital. [60521]
What would be the effect on a company’s financial statements if depreciation declined by $50 MM and the company paid out an
$8 MM dividend?
Depreciation would be added to calculate cash flow from operations
Depreciation would be subtracted to calculate cash flow from operations
Retained earnings would increase on the balance sheet
Retained earnings would decrease on the balance sheet
I and III
I and IV
II and III
II and IV
B: Operating cash flow is part of the Statement of Cash Flows. Depreciation is a source of cash in operating cash and, therefore, any depreciation would increase operating cash flow. Even if depreciation is less than the previous year, it would still be added to calculate cash flow from operations. In terms of financial accounting, cash dividends are paid out of retained earnings that are part of shareholders’ equity. Therefore, cash dividends paid will reduce retained earnings. (79504)
You are an investment banking representative who is evaluating the capital structure of The Stevens Company, as a possible takeover candidate. The company has EBIT of $2,000,000 and 650,000 common shares outstanding. Stevens' capitalization also consists of $5,000,000 of 9% convertible bonds, which are convertible into 20 shares of common stock. The bonds are considered a common stock equivalent and the tax rate is 40%. What is the EPS of Stevens? $0.80 $1.43 $1.60 $2.40
First, compute the earnings without converting the bonds into stock.
EBIT $ 2,000,000
Less: interest $ 450,000 (9% x $5 million)
Taxable income $ 1,550,000
Less: taxes $ 620,000 ($1,555,000 x 40%)
Net income $ 930,000
Divide by the shares outstanding (650,000) and EPS is $1.43 ($930,000 / 650,000).
Now, make the calculation assuming conversion of the bonds into stock. Interest expense is eliminated and the number of shares is higher.
EBIT $ 2,000,000 Less: interest $ 0 Taxable income $ 2,000,000 Less: taxes $ 800,000 ($2,000,000 x 40%) Net income $ 1,200,000 Each $1,000 face amount of bonds is convertible into 20 shares of common stock, producing an additional 100,000 shares to bring the total number of outstanding shares to 750,000. Dividing the net income of $1,200,000 by 750,000 shares results in $1.60/share. Since the net income per share is higher, this is referred to as an antidilutive situation, and the lower EPS number of $1.43 per share would be reported as the basic earnings per share figure. [60513]
What was the company’s return on common equity for 2013?
17.3%
18.9%
20%
20.7%
The formula for return on equity is net income divided by average common stockholders’ equity. The year-end equity is given for 2013, but it is necessary to determine the beginning value. The 2013 year-end equity ($1,850 MM) has increased by $320 MM. This is based on net income generated of $350 MM, of which $30 MM was paid out in dividends. This indicates that common equity increased by $320 MM during 2013 ($350 MM - $30 MM). The beginning period equity for the company was $1,530 MM ($1,850 MM - $320 MM). The average equity was $1,690 MM ([$1,530 MM + $1,850 MM] / 2). The return on equity for 2013 is 20.7% ($350 MM / $1,690 MM).
In the third quarter of the fiscal year, the Bonneville Corporation has changed from expensing software expenditures to capitalizing them. The effect on the company’s cash flow from operations is that it will:
Increase
Decrease
Not change
Increase or decrease depending on the capitalization period
A: The capitalization of software would treat the purchase as a depreciable asset, rather than an expense in the year incurred. The cash expenses for the company are reduced. This will increase the cash flow from operations. [60525]
