MCQ Vol. 3 LM10 Flashcards
Projecting profit margins into the future on the basis of past results would be most reliable when the company:
A. is in the commodities business.
B. operates in a single business segment.
C. is a large, diversified company operating in mature industries.
P1
C is correct.
For a large, diversified company, margin changes in different business segments may offset each other. Furthermore, margins are most likely to be stable in mature industries.
Galambos Corporation had an average receivables collection period of 19 days in 2003. Galambos has stated that it wants to decrease its collection period in 2004 to match the industry average of 15 days. Credit sales in 2003 were $300 million, and analysts expect credit sales to increase to $400 million in 2004. To achieve the company’s goal of decreasing the collection period, the change in the average accounts receivable balance from 2003 to 2004 that must occur is closest to:
A. –$420,000.
B. $420,000.
C. $836,000.
P2
C is correct. Accounts receivable turnover is equal to 365/19 (collection period in days) = 19.2 for 2003 and needs to equal 365/15 = 24.3 in 2004 for Galambos to meet its goal. Sales/turnover equals the accounts receivable balance. For 2003, $300,000,000/19.2 = $15,625,000, and for 2004, $400,000,000/24.3 = $16,460,905.
The difference of $835,905 is the increase in receivables needed for Galambos to achieve its goal.
Credit analysts are likely to consider which of the following in making a rating recommendation?
A. Business risk but not financial risk
B. Financial risk but not business risk
C. Both business risk and financial risk
P3
C is correct.
Credit analysts consider both business risk and financial risk.
When screening for potential equity investments based on return on equity, to control risk, an analyst would be most likely to include a criterion that requires:
A. positive net income.
B. negative net income.
C. negative shareholders’ equity.
P4
A is correct.
Requiring that net income be positive would eliminate companies
that report a positive return on equity only because both net income and shareholders’ equity are negative.
One concern when screening for stocks with low price-to-earnings ratios is that companies with low P/Es may be financially weak. What criterion might an analyst include to avoid inadvertently selecting weak companies?
A. Net income less than zero
B. Debt-to-total assets ratio below a certain cutoff point
C. Current-year sales growth lower than prior-year sales growth
P5
B is correct.
A lower value of debt/total assets indicates greater financial strength.
Requiring that a company’s debt/total assets be below a certain cutoff point would allow the analyst to screen out highly leveraged and, therefore, potentially financially weak companies.
When a database eliminates companies that cease to exist because of a merger or
bankruptcy, this can result in:
A. look-ahead bias.
B. back-testing bias.
C. survivorship bias.
P6
C is correct.
Survivorship bias exists when companies that merge or go bankrupt are dropped from the database and only surviving companies remain.
Look-ahead bias involves using updated financial information in back-testing that would not have been available at the time the decision was made. Back-testing involves testing models in prior periods and is not, itself, a bias.
When comparing a US company that uses the last in, first out (LIFO) method of inventory with companies that prepare their financial statements under international financial reporting standards (IFRS), analysts should be aware that according to IFRS, the LIFO method of inventory:
A. is never acceptable.
B. is always acceptable.
C. is acceptable when applied to finished goods inventory only.
P8
A is correct.
LIFO is not permitted under IFRS.
An analyst is evaluating the balance sheet of a US company that uses last in, first out (LIFO) accounting for inventory. The analyst collects the following data:
Inventory reported on balance sheet: 05: $500,000 06: $600,000
LIFO reserve: 05: $50,000 06: $70,000
Average tax rate: 05: 30% 06: 30%
After adjusting the amounts to convert to the first in, first out (FIFO) method, inventory at 31 December 2006 would be closest to:
A. $600,000.
B. $620,000.
C. $670,000.
P9
C is correct.
To convert LIFO inventory to FIFO inventory, the entire LIFO reserve must be added back: $600,000 + $70,000 = $670,000.
In a comprehensive financial analysis, financial statements should be:
A. used as reported without adjustment.
B. adjusted after completing ratio analysis.
C. adjusted for differences in accounting standards, such as international financial reporting standards and US generally accepted accounting principles
P7
C is correct.
Financial statements should be adjusted for differences in accounting standards (as well as accounting and operating choices).
An analyst gathered the following data for a company ($ millions):
gross investment in fixed assets (2000) $2.8 (2001) $2.8
accumulated depreciation (2000) $1.2 (2001) $1.6
The average age and average depreciable life of the company’s fixed assets at the end of 2001 are closest to:
A. average age 1.75 years 7 years
B. average age 1.75 years 14 years
C. average age 4.00 years 7 years
P10
C is correct.
The company made no additions to or deletions from the fixed asset
account during the year, so depreciation expense is equal to the difference in accumulated depreciation at the beginning of the year and the end of the year, or $0.4 million. Average age is equal to accumulated depreciation/depreciation expense, or $1.6/$0.4 = 4 years. Average depreciable life is equal to ending gross investment/depreciation expense = $2.8/$0.4 = 7 years.
To compute tangible book value, an analyst would:
A. add goodwill to stockholders’ equity.
B. add all intangible assets to stockholders’ equity.
C. subtract all intangible assets from stockholders’ equity.
C is correct.
Tangible book value removes all intangible assets, including goodwill, from the balance sheet.
