financial statement analysis: applications(Reading 35)

Exercise Problems:

1. In adjusting financial statements for comparability under IFRS and U.S.GAAP, an analyst would be most likely to:

A. Add goodwill to stockholders’ equity.

B. Eliminate all intangible assets from the balance sheet.

C. Adjust the IFRS statements from LIFO inventory costing to FIFO method.

Ans: B.

Removing all intangible assets, including goodwill, from the balance sheet leaves tangible book value. Tangible book value would be easiest to compare across different accounting frameworks.

A is incorrect. There is no rational basis to ass goodwill, an asset account, to stockholders’ equity.

C is incorrect. IFRS statements prohibit LIFO costing. Therefore, it would not be possible to recast an IFRS-basis statement from LIFO method.

2. An equity analyst developing a screen tool to exclude potentially weak companies would most likely accept companies with:

A. Negative net income.

B. A debt-to equity ratio above some cutoff point.

C. A debt-to-total assets ratio below some cutoff point.

Ans: C.

A debt-to-equity assets ratio below some cutoff point as a screening tool would exclude companies that are financially weak and have excessive debt in their capital structure. The other choices would potentially include weak companies rather than exclude them.

3. An equity analyst is forecasting the next year’s net profit margin of a heavy equipment manufacturing firm, by using the average net profit margin over the past three years. In making his profit projection, he is concerned about the following three items:

·         The company suffered losses from discontinued operations in each of the past three years.

·         The most recent year’s tax rate was only one half the prior two years’ rate as a result of a fiscal stimulus.

·         The company experienced gains on the sale of investments in each of the past three years.

Which of the following statements about the preparation of the forecast is most accurate? The analyst would:

A. use the most recent tax rate because that is the best predictor of future tax rates.

B. exclude the gains on the sale from investments because the company is a manufacturing firm.

C. include the discontinued operations because they appear to be an on-going feature for this company.

Ans: B.

The company is a heavy equipment manufacturer - since gains on investments is not a core part of its business, they should not be viewed as an ongoing source of earnings.

A is incorrect. The change in the current tax rate is best viewed as temporary (in the absence) of additional information and should not be the basis of the calculation of the average tax rate.

C is incorrect. Discontinued operations are considered to be nonrecurring items (even though they have occurred in the past three years); they are normally treated as random and unsustainable and should not be included in a short-term forecast.

4. An equity manager conducted a stock screen on 5,000 U.S. stocks that comprise her investment universe. The results of the screen are presented in the table below.

If all the criteria were completely independent of each other, the number of stocks meeting all four criteria would be closest to:

A. 293.

B. 371.

C. 540.

Ans: B.

If the criteria are independent of one another, the probability that all will occur is the product of the individual probabilities (Multiplication Rule for Independent Events), i.e., 0.35 x 0.482 x 0.586 x 0.75 = 0.074, or 7.4%, which would produce 371 meeting the criteria, i.e., 7.4% x 5,000.

5. When analyzing a company that prepares its financial statements according to U.S. GAAP, calculating the price/tangible book value ratio instead of the price/book value ratio is most appropriate if it:

A. grows primarily through acquisitions.

B. develops its patents and processes internally.

C. invests a substantial amount in new capital assets.

Ans: A.

A company that grows primarily through acquisition will have more goodwill and other intangible assets on its balance sheet than a company with fewer acquisitions or that has grown internally. To provide for comparisons with companies that do not follow such a growth strategy, an analyst would remove all intangibles and focus on tangible book value.

6. An analyst uses a stock screener and selects the following metrics: a global equity index, P/E ratio lower than the median P/E ratio, and a price-book value ratio lower than the median price-book value ratio. The stocks so selected would be most appropriate for portfolios of which type of investors?

A. Value investors.

B. Growth investors.

C. Market-oriented investors.

Ans: A.

Value investors look for relatively cheap stocks, so they often use relative valuation methods such as P/E and P/BV criteria.

Metrics such as low P/E and low price-book are aimed at selecting value companies; therefore the portfolio is most appropriate for value investors.

B is incorrect. Growth investors typically look for growing earnings, and some refine that further to accelerating growth in earning.

C is incorrect. Market-oriented investors look for securities in which they can make an excess return regardless of the style.

7. Kim Lee, CFA, is trying to forecast net income for Robinson’s Ltd, a chain of retail furniture outlets. He has prepared the following common sized data from their recent annual report and has estimated sales for 2013 using a forecast model his firm developed for consumer goods.

The capital structure of the company has not changed. The projected net income (in $ millions) for 2008 is closest to:

A. 110.1.

B. 162.8.

C. 167.4.

Ans: C.

The COGS and operating expenses are relatively constant over the tow-year period and averages of then can reasonably be used to forecast 2013. Interest expense is declining as a percent of sales, implying it is a fixed cost. Conversion into dollars for each year shows what interest expense has been (2007=$80, 2006 +$80) and that would be a reasonable projected amount to use. The restructuring charge should not be included as it is a non-recurring item. The tax rate, 30%, is given.

8. The 2012 income statement for a subject company is as follows:

For 2013, net sales are projected to increase by 12%, gross profit margin is expected to increase by 2% while SG&A expenses as a percent of net sales is expected to remain constant, total debt is not expected to change, and the effective tax rate is expected to remain constant.

Based on the above information, the company’s 2013 projected net income (in millions) is closest to:

A. $33.

B. $44.

C. $55.

Ans: B.

Projected 2013 net income is determined as follows:

NOTE: 2% increase in gross profit margin means that COGS percentage drops by 2%.

9. At the beginning of a year, Company X has opted to sell all of its $450,000 of receivables to finance a reduction in its long-term debt. The receivables and the risk of default are transferred at 80% of their book value. The debt reduction will reduce interest expense from $50,000 to $25,000 per year. The effective tax rate is 30%. Assuming that the current year’s EBIT is $142,500, at the end of the year, the results of the receivables sale will be an interest coverage ratio closest to:

A. 1.1X.

B. 2.1X.

C. 3.1X.

Ans: B.

Interest coverage = EBIT / Interest expense

                             = 52,500 / 25,000 = 2.10 X

10. Selected information about a company is as follows:

The forecasted net income (in ‘000) for 2013 is closest to:

A.    $169.

B.     $202.

C.     $244.

Ans: C.

Net income is calculated as follows:

11. As a result of a change in strategy to selling differentiated products at premium prices, a company’s gross margin ratio increased by 5% (i.e., from 35% to 40%). The most likely effect on the company’s operating margin ratio as a result of the change in strategy would be an increase:

A. equal to 5%.

B. less than 5%.

C. greater than 5%.

Ans: B.

A strategy of selling differentiated products at premium prices usually requires additional advertising or research and development to support the differentiating features, therefore, the effect on operating profit is normally less than the effect on gross profit margin.

12.  An analyst gathers the following information about 2011 actual results for a company and its projected sales, COGS, and assets for 2012:

Based on the projected sales increase, the best estimate of 2010 projected current assets is closest to:

A. ￡1,890,000.

B. ￡1,980,000.

C. ￡2,070,000.

Ans: B.

Current assets are sales driven and hence would be expected to increase by 10%, the same amount as sales. The increase is sales is (9,900,000-9,000,000)/9,000,000=10%. Therefore, projected current assets are 1.10x1,800,000=1,980,000

13. When preparing pro forma income statements, which one of the following items is least likely to be sales driven?

A. Current assets.

B. Interest expense.

C. Administrative expenses.

Ans: B.

Interest expense is considered a fixed burden and a function of a firm’s capital structure, not sales.

A is incorrect. Current assets are normally a sales driven account.

C is incorrect. Administrative expenses, although they may contain fixed costs, are primarily sales driven.

14. Which of the following pairs of general categories are least likely to be considered in the formulas used by credit rating agencies to determine the capacity of a borrower to repay a debt?

A. Operational efficiency; leverage.

B. Margin stability, availability of collateral.

C. Leverage; scale and diversification.

Ans: B.

The four general categories are: (1) scale and diversification, (2) operational efficiency, (3) margin stability, and (4) leverage. Larger companies and those with more different product lines and greater geographic diversification are better credit risks. High operating efficiency indicative of a better credit risk. Stable profit margins indicate a higher probability of repayment and thus, a better credit risk. Firms with greater earning in relation to their debt level are better credit risks. While the availability of collateral certainly reduces lender risk, it is not one of the general categories used by credit rating agencies to determine capacity to repay. Specifically, they would consider (1) several specific accounting ratios and (2) business characteristics. The availably of collateral falls into neither category.

15. A firm presents the following income statement, which complies with the standards under which it must report:

Based on the differences between U.S.GAAP and International Financial Reporting Standards, this firm:

A. must report any dividends received as operating cash flows.

B. is permitted to recognize upward revaluations of long-lived assets.

C. cannot have used LIFO as its inventory cost assumption.

Ans: A.

The income statement shows an extraordinary item, which is permitted under U.S.GAAP but not under IFRS. From this we can conclude that the firm reports under U.S.GAAP. U.S.GAAP requires dividends received to be classified as CFO, while IFRS allows them to be classified as either CFO or CFI. A firm reporting under U.S.GAAP may not revalue assets upward by may use LIFO.

16. Which of the following effects is most likely to occur when using ratio screens for high dividend yield stocks and low P/E stocks, respectively?

Ans: A.

Screening for high dividend yield stocks will likely include a disproportionately high number of financial services firms as such firms typically have higher dividend payouts. A screen to identify firm with low P/E ratios will likely exclude growth firms from the sample as high expected earnings growth leads to high P/Es.

17. Yang Liu, CFA, is comparing the financial performance of a firm that presents its results under IFRS to that of a firm that complies with U.S.GAAP. the U.S. firm uses the LIFO method for inventory accounting, and the other firm uses FIFO method. If Liu performs the appropriate adjustments to make the U.S. firm’s financial statements comparable to the firm that reports under IFRS, her adjustments are least likely to change the firm’s:

A. quick ratio.

B. debt-to-equity ratio.

C. cash conversion cycle.

Ans: A.

The analyst should add the U.S.GAAP firm’s LIFO reserve to its balance sheet inventory and subtract the change in the LIFO reserve from its COGS. This adjustment will increase the firm’s total assets and change its pretax income, income taxes, net income, and retained earnings (increasing them if the LIFO reserve increased, or decreasing them if the LIFO reserve decreased). These adjustments will change the firm’s debt-to-equity ratio by changing total equity, and change the cash conversion cycle by changing inventories. The adjustments do not change current liabilities or current assets other than inventories, so the quick ratio is not affected.

18. When comparing two firms, an analyst should most appropriately adjust the financial statements when they include significant:

A. acquisition goodwill, if one of the firms reports under IFRS and the other under U.S.GAAP.

B. property, plant, and equipment, if one of the firms uses accelerated depreciation and the other uses straight-line depreciation.

C. unrealized losses from securities held for trading, if one of the firms uses fair value reporting for securities investments and the other does not.

Ans: B.

Depreciation methods are an example of a difference that may require an analyst to adjust financial statements to make them comparable. Acquisition goodwill is treated the same way under IFRS and U.S.GAAP: it is not amortized but is tested for impairment at least annually. Securities held for trading are reported at fair value with unrealized gains and losses reported on the income statement.

19.  Zhan Wang, CFA, is analyzing Bao Company by projecting pro forma financial statements. Zhan expects Bao to generate sales of $3 billion and a return on equity of 15% in the next year. Zhan forecasts that Bao’s total assets will be $5 billion and that the company will maintain its financial leverage ratio of 2.5. based on these forecasts, Zhan should project Bao’s net income to be:

A. $100 million.

B. $300 million.

C. $500 million.

Ans: B.

Based on the data given, use the basic DuPont equation and solve for expected net income.

ROE=xx

0.15 =  x  x 2.5

=0.1

Net income =$300 million

Alternatively,

A/E=2.5 and assets = $5 billion, so equity=$2 billion.

20. Firms that prepare their financial statements according to International Financial Reporting Standards are least likely to:

A. use LIFO inventory accounting.

B. use proportionate consolidation for a joint venture.

C. recognize unrealized losses from held-for-trading securities in net income.

Ans: A.

The LIFO inventory method is permitted under U.S.GAAP but is not allowed under IFRS.

B is incorrect. Proportionate consolidation of joint ventures is permitted under IFRS but not under U.S.GAAP.

C is incorrect. Unrealized gains and losses from held-for-trading securities are recognized on the income statement under both IFRS and U.S.GAAP.

21. Nan Chen, CFA, is comparing a firm with two of its industry competitors. She obtains the following financial excerpts from the firm’s financial statements, as well as the inventory turnover ratio on two of its competitors.

The firm uses the LIFO inventory costing method under U.S.GAAP, which is consistent with its industry competitors. What conclusions should the analyst reach when comparing the firm’s inventory turnover ratio to those of ties competitors?

A. Outperformed both competitors.

B. Outperformed Company 1 only.

C. Outperformed Company 2 only.

Ans: C.

To calculate inventory, the FIFO inventory value must be adjusted to a FIFO value to be consistent with the other firms. With a $10,000 LIFO reserve that means that the FIFO inventory value is $10,000 more than a LIFO value inventory.

Inventory turnover =  =  =  = 1.43 which is less than 1.90 (#1) and more than 1.05 (#2).

Note: if the LIFO reserve had changed the COGS would have to also be adjusted by adding the increase, or subtractive the decrease, from COGS to adjust the FIFO COGS to LIFO.