Reading 27: applications of financial statements analysis

Question 1

An analyst who is projecting a company’s net income and cash flows is least likely to assume a constant relationship between the company’s sales and its:
interest expenses.
cost of goods sold.
noncash working capital.

Answer 1

Projections of net income and cash flows are typically based on assumptions that cost of goods sold, operating expenses, and noncash working capital remain a constant percentage of sales. The projections then show whether additional borrowing is needed during the forecast period. If so, the analyst will adjust the interest expense to reflect the additional debt. (Module 27.1, LOS 27.b)

Question 2

Credit analysts are likely to consider a company’s credit quality to be improving if the company reduces its:
scale and diversification.
margin stability.
leverage.

Answer 2

Lower leverage improves a company’s creditworthiness. Larger scale, more diversification, higher operating efficiency, and more stable margins also tend to indicate better credit quality. (Module 27.2, LOS 27.c)

Question 3

Which of the following stock screens is most likely to identify stocks with high earnings growth rates?
Dividend payout ratio greater than 30%.
Price to cash flow per share ratio less than 12.
Book value to market value ratio less than 25%.

Answer 3

Firms with high growth rates will tend to have high market values relative to the book value of their equity. Low price to cash flow ratios would tend to identify value stocks rather than growth stocks. Screening for high dividend payout ratios would tend to identify mature firms with relatively few growth opportunities. (Module 27.2, LOS 27.d)

Question 4

An analyst needs to compare the financial statements of Firm X and Firm Y. Which of the following differences in the two firms’ financial reporting is least likely to require the analyst to make an adjustment?

firm x firm y
straight-line depreciation accelerated depreciation
direct method cash flows indirect method cash flows
IFRS financial reporting US GAAP financial reporting

Answer 4

Cash flows are the same under either method. Differences in depreciation methods and IFRS versus U.S. GAAP reporting can require an analyst to adjust financial statements to make them comparable. (Module 27.2, LOS 27.e)

Question 5

When comparing a firm that uses LIFO inventory accounting to firms that use FIFO, an analyst should:
subtract the LIFO reserve from cost of sales.
add the change in the LIFO reserve to inventories.
subtract the change in the LIFO reserve from cost of sales.

Answer 5

To adjust LIFO financial statement data to a FIFO basis, add the LIFO reserve to inventories on the balance sheet and subtract the change in the LIFO reserve from cost of sales on the income statement. Remember that the balance sheet is cumulative (use the full LIFO reserve) while the income statement refers to the most recent period (use the change for the period in the LIFO reserve). (Module 27.2, LOS 27.e)

Question 6

The ratio of a firm’s property, plant, and equipment, net of accumulated depreciation, to its annual depreciation expense is best interpreted as an estimate of the:
average age of the firm’s assets.
average useful life of the firm’s assets.
remaining useful life of the firm’s assets.

Answer 6

Remaining useful life = net PP&E / depreciation expense.
Average age of assets = accumulated depreciation / depreciation expense.

Average useful life = gross PP&E / depreciation expense.

(Module 27.2, LOS 27.e)