Fundamental Analysis Flashcards
Publicly traded companies are:
A. required to use accrual accounting
B. required to use cash accounting
C. required to use cost accounting
D. have a choice of using either accrual, cash, or cost accounting
The best answer is A.
Corporate financial records are kept using accrual accounting - a method that attempts to match revenues and expenses. Very small non-public companies can use cash accounting, which simply records revenues when cash payment is received; and liabilities when payment is made. In contrast, accrual accounting books revenue when services or product is delivered (but payment typically occurs in the future); and liabilities when incurred (again, payment of the liability typically occurs in the future).
All assets minus all liabilities equals:
A. net worth
B. net working capital
C. book value
D. net tangible assets
The best answer is A.
Total Assets - Total Liabilities = Net Worth
(In contrast, the formula for Net Working Capital is: Current Assets minus Current Liabilities.)
If current liabilities of a company are subtracted from current assets of a company, the result is the company’s:
A. market value
B. net worth
C. capitalization
D. net working capital
The best answer is D.
Current Assets - Current Liabilities = Net Working Capital
(In contrast, the formula for Net Worth is: Total Assets minus Total Liabilities.)
Current assets minus current liabilities equals:
A. net worth
B. net working capital
C. book value
D. net tangible assets
The best answer is B.
Current Assets - Current Liabilities = Net Working Capital
(In contrast, the formula for Net Worth is: Total Assets minus Total Liabilities.)
All of the following ratios measure a company’s ability to pay bills as they come due, EXCEPT:
A. Cash assets ratio
B. Quick ratio
C. Current ratio
D. Inventory turnover ratio
The best answer is D.
The cash assets ratio is the ratio of cash to current liabilities; this is the most stringent test of liquidity.
The quick ratio (or “acid test”) is the ratio of current assets - inventories and prepaid expenses to current liabilities. This is a less stringent test than the cash assets ratio.
The current ratio is the ratio of all current assets to current liabilities. This is the least stringent test of liquidity.
The inventory turnover ratio is the ratio of annual cost of sales to year end inventory. It shows how quickly a company is selling and replacing its inventory.
All of the following are methods of depreciation EXCEPT:
A. Double Declining Balance
B. Last In; First Out
C. Sum of Years Digits
D. Straight Line
The best answer is B.
Methods of depreciation include straight line, double declining balance (an accelerated method), and sum of the year’s digits (another accelerated method). Last-in; first-out (LIFO) is a method of accounting for inventories.
Accelerated depreciation deductions:
A. increase reported income in early years
B. result in higher taxes in early years
C. increase reported expenses in early years
D. may only be used for natural resources
The best answer is C.
Accelerated depreciation deductions, when compared to straight-line depreciation deductions, are “front loaded.” The depreciation deduction is higher in earlier years; but the deduction is lower in later years (as compared to straight line depreciation). Because there are higher deductions in the earlier years, this will reduce reported income in those years and reduce tax liability. While in later years, lower deductions in later will increase reported income and increase tax liability. Remember, depreciation expense is applied to man-made items while depletion allowances are used for natural resources.
Accelerated depreciation deductions:
A. decrease reported expenses but increase reported income in early years
B. increase reported expenses but decrease reported income in early years
C. increase reported income and expenses in later years
D. decrease reported income and expenses in later years
The best answer is B.
Accelerated depreciation deductions, when compared to straight-line depreciation deductions, are “front loaded.” The depreciation deduction is higher in earlier years; but the deduction is lower in later years (as compared to straight line depreciation). Because there are higher deductions in the earlier years, this will increase reported expenses in those years while reducing reportable income. The lower deductions in later years will decrease reported expenses but increase reportable income .
Accelerated depreciation deductions:
A. increase reported income in early years
B. do not impact the income statement since these are balance sheet items
C. increase reported income in later years
D. increase each quarter
The best answer is C.
Accelerated depreciation deductions, when compared to straight-line depreciation deductions, are “front loaded.” The depreciation deduction is higher in earlier years; but the deduction is lower in later years (as compared to straight line depreciation). Because there are higher deductions in the earlier years, this will reduce reported income in those years; while the lower deductions in later years will increase reported income for those years.
All of the following are components of common stockholders’ equity EXCEPT:
A. Common at Par
B. Capital in Excess of Par
C. Retained Earnings
D. Intangibles
The best answer is D.
If a corporation sells stock at a price above par value, the par value received is shown on the balance sheet as “par value,” while the excess funds are credited to the corporation’s capital surplus account. Retained earnings and earned surplus are different names for the same account - corporate earnings that are not paid out as dividends are credited annually to retained earnings; this is technically owned by the common shareholders.
Intangibles are assets of a corporation, such as the value of copyrights, patents or trademarks. These items are not a component of common stockholders’ equity.
All of the following are components of total long term capital of a corporation EXCEPT:
A. Common Stockholders’ Equity
B. Preferred Stockholders’ Equity
C. Long Term Bonded Debt
D. Current Liabilities
The best answer is D.
A corporation’s long term capital consists of common stockholders’ equity (common at par; capital in excess of par; and retained earnings); preferred stockholders’ equity; and long term debt. These are all sources of long term capital for the corporation.
Current liabilities are just that, bills that must be paid within 1 year. They are not a source of capital for a corporation.
All of the following items are included on a company’s income statement EXCEPT:
A. Installment sales
B. Interest income revenue
C. Sales of fixed assets
D. Reinvested dividends
The best answer is D.
All sales made by the company are included on the income statement. These include sales of fixed assets (shown as a non-recurring item); interest and dividend income received from investments; and sales, including installment sales (in an installment sale, a company might sell an expensive product like a large piece of machinery, with the price to be paid over 3 years. Each year it books 1/3 of the sale as revenue).
Reinvested dividends are dividends paid to a shareholder that are reinvested in new share purchases and these are not shown in a company’s financial statements.
Which item would be found on a company’s income statement?
A. Retained earnings
B. Taxes paid
C. Reinvested dividends
D. Accumulated depreciation
The best answer is B.
Taxes paid for that period show on a company’s income statement. Retained earnings shows on the company’s balance sheet. Dividends paid show on a company’s Statement of Retained Earnings; reinvested dividends would be dividends paid to a shareholder that are reinvested in new share purchases and these are not shown in a company’s financial statements.
Finally, while annual depreciation expense shows on a company’s income statement; the accumulation depreciation that reduces an asset’s book value shows only on the balance sheet.
Which item would NOT be found on a corporation’s income statement?
A. Interest
B. Dividends
C. Revenue
D. Expenses
The best answer is B.
There could be a little more clarity here, but dividends are the best choice. The income statement details all items of revenue and expense to arrive at net income after tax. This is the income figure that is used to compute earnings per share. Dividends are paid out of a corporation’s net income after tax.
Interest income from investments is a revenue item on the income statement; interest expense on bonds outstanding is a deduction. The question does not say whether the interest is income or an expense, but in either case, they are income statement items.
The actual dividends paid are shown in a different smaller financial statement - the retained earnings statement. This starts with year prior retained earnings; then adds that year’s net income after tax; then subtracts dividends paid; to arrive at the year-end retained earnings for that company.
A corporation’s annual report shows that the reported net income before tax is falling at a faster rate than operating income. Which of the following expenses must have grown at a faster rate?
A. Depreciation
B. Bond Interest
C. Preferred Dividend
D. Cost of Goods Sold
The best answer is B.
The basic corporate income statement is:
Gross Sales - Operating Expenses -------------------------------------- Operating Income - Bond Interest --------------------------------------- Net Income Before Tax - Taxes -------------------------------------- Net Income After Tax
For net income before tax to fall at a faster rate than operating income, then bond interest expenses must be increasing at a faster rate than operating expenses such as cost of goods sold and depreciation. Dividends are paid out of after tax net income and would not impact either operating income or reported net income
If net income before tax falls at a faster rate than operating income, then which statement is TRUE?
A. Bond interest expense is increasing at a faster rate than operating expenses
B. Bond interest expense is decreasing at a faster rate than operating expenses
C. Dividends are increasing at a faster rate than operating income
D. Dividends are decreasing at a faster rate than operating income
The best answer is A.
The basic corporate income statement is:
Gross Sales - Operating Expenses -------------------------------------- Operating Income - Bond Interest --------------------------------------- Net Income Before Tax - Taxes -------------------------------------- Net Income After Tax
For net income before tax to fall at a faster rate than operating income, then bond interest expenses must be increasing at a faster rate than operating expenses such as cost of goods sold and depreciation. Dividends are paid out of after tax net income and would not impact either operating income or reported net income
A corporation has an operating margin of profit of 9.50%. This means that for every $9.50 of profit, the company had $100 of:
A. expenses
B. revenues
C. assets
D. liabilities
The best answer is B.
An income statement starts with revenues and deducts all operating expenses to arrive at operating income.
Gross Sales
- Operating Expenses
————————————-
Operating Income
The “margin” is a profitability or loss percentage. The Operating Margin of Profit is: Operating Income / Revenues.
(Also note that the term “Operating Margin of Profit” is a wording that is now rarely used - instead the current wording is simply Operating Profit Margin or Operating Margin - but it may still be used on the exam.)
A corporation has an operating margin of profit of 9.50%. What does this mean?
A. For every $9.50 of expenses, the company had $1 of revenue
B. For every $9.50 of expenses, the company had $100 of revenue
C. For every $90.50 of expenses, the company had $1 of revenue
D. For every $90.50 of expenses, the company had $100 of revenue
The best answer is D.
An income statement starts with revenues and deducts all operating expenses to arrive at operating income.
Gross Sales
- Operating Expenses
—————————————-
Operating Income
The “margin” is a profitability or loss percentage. The Operating Margin of Profit is: Operating Income / Revenues. (Also note that the term “Operating Margin of Profit” is a wording that is now rarely used - instead the current wording is simply Operating Profit Margin or Operating Margin - but it may still be used on the exam.)
If the company has an Operating Margin of Profit of 9.50%, this means that it had operating income of $9.50 for each $100 of revenue ($9.50 / $100 = 9.50%). Because operating expenses are deducted from revenue to arrive at the operating margin, this means that for every $100 of revenue, there were $90.50 of expenses.
Gross Sales $ 100.00
- Operating Expenses $ 90.50
——————————————————-
Operating Income $ 9.50
The Operating Margin is $9.50 / $100 = $9.50%
If a corporation has an operating margin of profit of 9.50%, this means that for every $1 of revenue, the company has:
A. $.095 of expenses
B. $.95 of expenses
C. $.905 of expenses
D. $.0905 of expenses
The best answer is C.
An income statement starts with revenues and deducts all operating expenses to arrive at operating income. The “margin” is a profitability or loss percentage.
Gross Sales
- Operating Expenses
————————————-
Operating Income
The “margin” is a profitability or loss percentage. The Operating Margin of Profit is: Operating Income / Revenues. (Also note that the term “Operating Margin of Profit” is a wording that is now rarely used - instead the current wording is simply Operating Profit Margin or Operating Margin - but it may still be used on the exam.)
If the company has an Operating Margin of Profit of 9.50%, this means that it had operating income of $.095 for each $1 of revenue ($.095 / $1 = 9.50%). Because operating expenses are deducted from revenue to arrive at the operating margin, this means that for every $1 of revenue, there were $.905 of expenses.
All of the following will affect the reported net income per share of a corporation EXCEPT:
A. Decrease in the number of common shares outstanding
B. Change in accounting method for valuing inventories
C. Declaration of a common dividend
D. Discontinuance of operations of an operating division
The best answer is C.
Since dividends are paid out of reported net income, they have no effect on the amount of net income that the corporation reports.
If a corporation discontinues operations of a division, it usually takes a charge to net income to pay for the cost of the shut down.
If the number of common shares is increased, reported net income per share will fall.
If a corporation changes accounting methods for valuing inventories, any decrease in inventory value is taken as a charge to net income; while any increase in inventory value will increase reported net income.
ACME Corporation Income Statement
Net Sales $20,000,000
Cost of Goods Sold 5,000,000
—————
Gross Margin 15,000,000
Operating Expenses 4,000,000
—————-
Operating Income 11,000,000
Bond Interest 1,000,000
—————-
Net Income Before Tax 10,000,000
Tax at 50% 5,000,000
——————-
Net Income After Tax $5,000,000
What is ACME’s Bond Interest Coverage Ratio?
A. 5:1
B. 10:1
C. 11:1
D. 12:1
The best answer is C.
The formula for the Interest Coverage Ratio is:
Ttl Incme Bfr Bnd Intrst Expnc
——————————————– = Intrst Cvrge Ratio
$11,000,000
—————— = 11X
$1,000,000
A company has reported operating income of $5,000,000. The bond interest expense for the year is $500,000 and principal repayments on bonds totaled $1,500,000. The company’s debt service coverage ratio is:
A. 10:1
B. 3.33:1
C. 2.5:1
D. 1:1
The best answer is C.
The debt service coverage ratio determines if operating income is sufficient to pay not only interest on the bonds but upcoming principal repayments (within the coming year). The ratio is:
Operating Income ----------------------------------- = Debt Service Coverage Annual Interest Cost + Ratio Principal Repayments
$5,000,000
———————————- = 2.5:1
$500,000 + 1,500,000
A corporation declares a cash dividend to shareholders. All of the following choices are affected EXCEPT:
A. Current Assets
B. Current Liabilities
C. Net Worth
D. Net Working Capital
The best answer is A.
If a dividend is declared, then it is not yet paid. Dividends payable increases (a current liability) and net worth decreases (since the dividend is appropriated from retained earnings). If current liabilities increase, then net working capital falls.
A corporation has previously declared a cash dividend. When the dividend is actually paid, which of the following are reduced?
A. Current Assets only
B. Current Assets and Current Liabilities
C. Net Worth
D. Net Working Capital
The best answer is B.
When the dividend is paid, cash drops (a current asset) and dividends payable drop (a current liability). Because both current assets and current liabilities fall by the same amount, net working capital is unchanged. This transaction has no effect on net worth.
A corporation has previously declared a cash dividend. When the dividend is actually paid, all of the following choices are affected EXCEPT:
A. Cash
B. Current Assets
C. Current Liabilities
D. Net Working Capital
The best answer is D.
When the dividend is paid, cash drops (a current asset) and dividends payable drop (a current liability). Because both current assets and current liabilities fall by the same amount, net working capital is unchanged. This transaction has no effect on net worth.
A corporation issues a stock dividend. All of the following are affected EXCEPT:
A. Net Worth
B. Capital in Excess of Par
C. Common at Par
D. Retained Earnings
The best answer is A.
If a corporation “pays” a stock dividend, it is taken from retained earnings and transferred to the common stock account. Common at par will increase in aggregate, as will capital in excess of par. while retained earnings will drop by an equal amount. Net worth as a whole, and stockholders’ equity as a whole, will remain unchanged.
The primary purpose of a corporate stock split is to:
A. dilute the reported earnings per share
B. reduce the market price of the stock to increase its attractiveness to investors
C. avoid paying a cash dividend to shareholders
D. lower the risk of a takeover by increasing the number of shares outstanding
The best answer is B.
Corporations will split their stock when the market price gets too high, making the stock more accessible to investors.
ABC Corporation declares a 1:5 stock split. As a result of this action all of the following will occur EXCEPT the:
A. market price of ABC common stock will increase
B. number of common shares of ABC outstanding will decrease
C. Earnings per Share of ABC common stock will increase
D. Price / Earnings ratio of ABC common stock will increase
The best answer is D.
In a reverse stock split, the number of common shares outstanding is decreased and the market price per share is increased proportionately on the “ex” date. Because the corporations’ earnings will be spread over fewer shares, earnings per share will increase. However, the company’s Price / Earnings ratio will remain constant because both the stock market price and the earnings per share will increase in the same proportion keeping the Price / Earnings ratio unchanged.
A corporate issuer declares a reverse 2 for 3 stock split. After the split is effected, which statement is TRUE?
A. The market price of the corporation’s shares will increase
B. The reported earnings per common share will decrease
C. The number of common shares outstanding will increase
D. Each common shareholder’s proportionate ownership interest will increase
The best answer is A.
In a reverse split, the number of outstanding shares of the corporation is reduced. This increases reported earnings per share. If earnings per share increases, this tends to raise the price of the company’s stock in the market.
After the reverse split, each shareholder’s proportionate ownership interest remains the same. The only difference is that the shareholder’s ownership interest is represented by fewer shares.
XYZ Company has 100,000,000 authorized common shares. 25,000,000 shares have been issued and another 10,000,000 shares are currently in registration. The sale of the 10,000,000 shares will result in all of the following EXCEPT a(n)
A. decrease in earnings per share
B. increase in net worth
C. decrease in net working capital
D. increase in the number of shares outstanding
The best answer is C.
If a company sells additional common shares, the funds from the sale increase cash (thus increasing net working capital) and are credited to the company’s capital at par and capital surplus (thus increasing net worth). As the number of outstanding shares increase, earnings per common share will fall (become diluted).
A convertible bondholder converts. Which of the following is reduced?
A. Current Assets
B. Total Liabilities
C. Net Worth
D. Retained Earnings
The best answer is B.
If a convertible bondholder converts, then long term debt falls (reducing total liabilities) and common stock increases. Since common stock increases, net worth rises.
There is no cash payment upon conversion and so current assets are unaffected.
Retained earnings is only affected by income or loss; or dividend payments.
A corporation issues $100,000,000 of 10% convertible debentures, convertible at $50. Upon issuance, all of the following are affected EXCEPT:
A. Total Assets
B. Total Liabilities
C. Net Working Capital
D. Stockholders’ Equity
The best answer is D.
When bonds are issued, the corporation receives the cash from the sale (increasing current assets) and shows the long term liability to repay the bonds (increasing long term debt). Therefore, Total Assets increase; Total Liabilities increase; and Net Working Capital increases because of the increase in current assets. Stockholders’ Equity is unaffected since only a profit or loss, or the sale of new equity securities, or the declaration of a cash dividend, will cause a change in Stockholders’ Equity.
A corporation issues convertible debentures at par. Which of the following is affected?
A. Shares outstanding
B. Current Liabilities
C. Net Worth
D. Net Working Capital
The best answer is D.
If convertible debentures are issued, long term debt increases as does cash, (a current asset) since the proceeds of the sale go to the issuer. If cash increases, net working capital increases. There is no effect on net worth; nor on current liabilities. Shares outstanding will only rise if the debt is converted into common.
A corporation would repurchase its debt for all of the following reasons EXCEPT to:
A. refinance at lower interest rates
B. increase its capitalization
C. increase the market value of its equity issues
D. reduce its sensitivity to earnings fluctuations due to cyclical conditions
The best answer is B.
If a corporation repurchases its debt, then its capitalization will decrease (a corporation’s long term capital consists of equity and long term debt).
Corporations will repurchase debt to refinance at lower interest rates; to increase the market value of the corporation’s common stock (since the corporation has less debt, the common stock would be valued more highly by the market); and to reduce the corporation’s earnings fluctuations due to cyclical conditions.
Corporate sales decrease due to cyclical conditions, but fixed interest charges do not. This causes earnings for common shareholders to fall greatly or become non-existent in period of falling sales. To reduce this possibility, a corporation can repurchase its debt.
If a corporation repurchases its debt, which statement is TRUE?
A. The corporation’s capitalization will increase
B. Interest costs will rise
C. The company will be deleveraged
D. The market value of the common stock will decrease
The best answer is C.
Deleveraged is a slang term that means a corporation has reduced its debt load, so its capitalization will decrease. “Leverage” is the use of debt in a corporation’s capital base - the term comes from the fact that as corporate income increases, its fixed interest cost does not increase, and the increase accrues to the shareholders, “leveraging” earnings.
Corporations will repurchase debt to refinance at lower interest rates (not higher ones); to increase the market value of the corporation’s common stock (since the corporation has less debt, the common stock would be valued more highly by the market); and to reduce the corporation’s earnings fluctuation’s due to cyclical conditions. Corporate sales decrease due to cyclical conditions, but fixed interest charges do not. This causes earnings for common shareholders to fall greatly or become non-existent in period of falling sales. To reduce this possibility, a corporation can repurchase its debt.
A corporation would repurchase its debt for each of the following reasons EXCEPT:
A. to increase the market value of its equity issues
B. to reduce its sensitivity to earnings fluctuations due to cyclical conditions
C. to refinance at higher interest rates
D. to increase its leverage
The best answer is C.
If a corporation repurchases its debt, then its capitalization will decrease (a corporation’s long term capital consists of equity and long term debt). Decreasing debt levels results in reduced leverage. Leverage is a slang term used to describe the capitalization mix of a company. A highly leveraged company has a large percentage of its capitalization in debt.
Corporations will repurchase debt to refinance at lower interest rates (not higher ones); to increase the market value of the corporation’s common stock (since the corporation has less debt, the common stock would be valued more highly by the market); and to reduce the corporation’s earnings fluctuations due to cyclical conditions.
Corporate sales decrease due to cyclical conditions, but fixed interest charges do not. This causes earnings for common shareholders to fall greatly or become non-existent in period of falling sales. To reduce this possibility, a corporation can repurchase its debt.
Which of the following will reduce net working capital?
A. Declaration of a cash dividend
B. Declaration of a stock dividend
C. Reduction in the allowance for bad debts
D. Increase in depreciation deductions taken
The best answer is A.
When a cash dividend is declared, it is appropriated from retained earnings and set up as a current liability - Dividends Payable. An increase in current liabilities reduces net working capital.
When a stock dividend is declared, it is appropriated from retained earnings and used to increase common at par and capital in excess of par. There is no effect on net working capital.
If a company reduces its allowance for bad debts, this increases accounts receivable (a current asset). If current assets rise, working capital rises.
Increased depreciation deductions decrease the value of fixed assets and do not affect working capital.
Stockholders’ Equity (Net Worth) is affected by all of the following EXCEPT:
A. declaration of a cash dividend
B. the purchase of Treasury stock
C. the issuance of new stock
D. declaration of a stock dividend
The best answer is D.
Stockholders’ Equity consists of: Common at Par + Capital in Excess of Par + Retained Earnings.
- **When a cash dividend is declared, it is deducted (debited) from Retained Earnings and credited to Dividends Payable - a current liability. Thus, Stockholders’ Equity drops.
- **When Treasury Stock is purchased, Common at Par and Capital in Excess of Par are reduced by the purchase amount and cash (a current asset) is reduced (to reflect the payment made to buy the Treasury stock). Thus, Stockholders’ Equity decreases.
- **When new stock is issued, Common at Par and Capital in Excess of Par are increased by the sale amount and cash (a current asset) is increased (to reflect the cash received from selling the new stock). Thus, Stockholders’ Equity increases.
- **When a stock dividend is “paid,” it is debited to Retained Earnings (a reduction) and credited to Common at Par and Capital in Excess of Par. Since these are all accounts within Stockholders’ Equity, there is no net change to the total Stockholders’ Equity amount.
If a corporation has a dividend payout ratio of 75%, the undistributed earnings (25%) will:
A. increase earnings per share
B. decrease book value
C. increase capital in excess of par
D. increase retained earnings
The best answer is D.
Corporate earnings that are not paid out as dividends will be credited to the company’s retained earnings account at the end of the year. This increases the net worth, and hence the book value of the company.
