Financial Statement Analysis Chapter 1

Chapter 1: Overview of Financial Statement Analysis Sample Multiple Choice Questions 1. Which of the following is likely to be the most informative source if you were interested in a company’s business plan or strategy? A)auditor’s letter B)management discussion and analysis C)proxy statement D)Footnotes Answer: B 2. Which of the following would not be considered a source of financing? A)notes receivable B)common stockholders’ equity C)retained earnings D)capital lease obligations Answer: A 3. Wilco Company reports the following: 20052004 Retained Earnings$2,000,000$ 1,300,000

Common Stock$ 500,000$ 500,000 Paid-in Capital$3,000,000$ 3,000,000 Net Income for year$ 900,000$ 400,000 Dividend payout ratio for 2005 was: A)27% B)12% C)22. 2% D)Not determinable Answer: C 4. If a company receives an unqualified audit opinion it means the auditors: A)did not complete a full audit and therefore do not feel qualified to give and opinion on financial statements B)are providing assurance that the company will remain financially viable for at least the next year C)are providing assurance that the company’s financial statements fairly present company’s financial performance and position

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D)are providing assurance that the company’s financial statements are free from misstatement, fraudulent accounting and fairly indicate future performance Answer: C 5. The Management Discussion and Analysis Section of the annual report: A)is required by the SEC B)is optional but normally included in the annual report C)is required by the SEC only if the company has suffered from unfavorable trends or there are significant uncertainty concerning liquidity of the company D)is required by the SEC only if they have a qualified audit opinion Answer: A Use the following to answer questions 6-7:

You are analyzing a large stable company. For the year ending 12/31/05 the company reported earnings of $58,900K and book value at the end of 2005 was $371,700K. You expect earnings to grow at 5% a year in perpetuity, and the dividend payout ratio of 70% to continue. The company borrows at 8%, and has a cost of equity of 12%. The company has 25,000K shares outstanding. 6. What is your estimate of price per share using the dividend discount model at 12/31/05? A)$20. 62 B)$21. 65 C)$23. 56 D)$24. 74 Answer: D 7. What is your estimate of price using the residual income valuation model at 12/31/05? A)$20. 62

B)$21. 65 C)$23. 56 D)$24. 72 Answer: D 8. Which of the following is not a common tool used in financial statement analysis? A)random walk analysis B)ratio analysis C)common size statement analysis D)trend series analysis Answer: A 9. A common size income statement would typically be prepared by dividing: A)All items on income statement in Year t by their corresponding value in Year t-1 B)All items on income statement in Year t by their corresponding balance sheet account in Year t C)All items on income statement in Year t by net income in Year t-1 D)All items on income statement in Year t by sales in Year t

Answer: D 10. You are examining the common size income statements of two companies, A and B, for 2005. This data is most likely to help you answer which of the following questions? A)Which company had the largest net income B)Which company utilized its assets most efficiently C)Which company had the highest gross margin D)Which company had the biggest increase in sales from the prior year Answer: C 11. When conducting comparative analysis by reviewing consecutive balance sheets: A)All items on the balance sheet in Year t must be divided by their corresponding value in Year t-1 and subtract 1

B)All items on balance sheet in Year t-1 must be subtracted from their corresponding value in Year t C)All items on balance sheet in Year t must be divided by net income in Year t-1 D)Both A and B are correct Answer: D Use the following to answer questions 12-13: You have prepared a trend series for Company XYZ for three years, 2003-2005 inclusive, using 2000 as the base year. Below are selected data. 200320042005 Sales100120135 Net Income100118128 Total Assets100119130 12. From the above information you can infer that: A)Rate of sales growth has decreased B)Net income to sales (return on sales) is increasing over time

C)Asset turnover is decreasing over time D)None of the above Answer: A 13. Which of the following statements is incorrect? A)Net Income in 2005 increased by 28% compared to 2003 B)XYZ’s net income to sales (return on sales) increased in 2005 compared to 2003 C)XYZ’s net income to sales (return on sales) decreased in 2004 compared to 2003 D)Assets have increased over time Answer: B 14. You are trying to determine which of two companies is the most profitable. Which of the following would be the best indicator of relative profitability? A)highest net income B)highest retained earnings C)highest return on equity

D)highest operating margin Answer: C 15. Which of the following statements concerning financial ratios is incorrect? A)accounting principles and methods used by a company will not affect financial ratios B)the informational value of a ratio in isolation is limited C)a ratio is one number expressed as a percentage or fraction of another number D)calculation of financial ratios is not sufficient for a complete financial analysis of a company Answer: A 16. Which of the following ratios is not generally considered to be helpful in assessing short-term liquidity? A)Acid test ratio B)Current ratio

C)Days to collect receivables D)Days goodwill held Answer: D 17. Liquidity of a company is generally defined as a measure of: A)the ability of a company to pay its employees in a timely manner B)the ability to pay interest and principal on all debt C)the ability to pay dividends D)the ability to pay current liabilities Answer: D Use the following to answer questions 18-21: Following is some financial information for Dell Inc. 20052004 Revenues$49,205$41,444 Net income3,0432,645 Total assets23,21519,311 Shareholder’s equity6,4856,280 Cash flow from operations5,3103,670 Basic earnings per share1. 211. 03

Book value per share2. 612. 46 Closing stock price33. 4423. 86 18. What is Dell’s profit margin for 2004? A) 6. 27% B) 6. 18% C) 6. 38% D) 6. 86% Answer: C 19. What is Dell’s profit margin for 2005? A) 6. 27% B) 6. 18% C) 6. 38% D) 6. 86% Answer: B 20. What is Dell’s P/E ratio for 2005? A) 27. 63 B) 12. 81 C) 23. 65 D) 9. 70 Answer: A 21. What is Dell’s asset turnover for 2005? A) 2. 12 B) 3. 58 C) 3. 65 D) 2. 31 Answer: D 22. Given the following information, calculate the inventory turnover for ABC Co. for 2005 (pick closest number). (in thousands of dollars)20052004 Sales$19,535$15,470

Cost of Goods Sold$15,101$11,184 Inventory$ 2,708$ 2,180 A)8. 96 B)7. 22 C)6. 93 D)6. 18 Answer: D 23. You have been provided the following information about Wert Inc. (in thousands of dollars)20042005 Sales$2,456$3,778 Net Income$ 172$ 202 Interest expense$ 50$ 55 Total Assets$1,800$1,950 Tax Rate 35% 35% Return on Assets for 2005 is: A)13. 71% B)12. 68% C)10. 77% D)13. 21% Answer: B Use the following to answer questions 24-27: You have been provided the following information about High Inc. (in thousands of dollars)20042005 Current Assets$ 158$ 163 Long Term Assets$ 453$ 502

Current Liabilities $ 102$ 143 Long Term Liabilities$ 302$ 348 Net Income$ 32$ 42 24. Working Capital for 2004 is: A)$56,000 B)$20,000 C)$151,000 D)$207,000 Answer: A 25. Owner’s Equity for 2005 is: A)$20,000 B)$154,000 C)$174,000 D)$207,000 Answer: C 26. Current Ratio for 2004 is: A)1. 55 B)1. 51 C)1. 50 D)1. 14 Answer: A 27. Return on Common Equity for 2005 is: A)15. 46% B)24. 14% C)16. 79% D)22. 04% Answer: D 28. Which of the following statements is correct? A)The more efficiently a company utilizes its assets the greater its return on investment, all other things being equal

B)If return on equity increases, the return on assets must have also increased C)If the number of days inventory is held increases, then return on assets will increase, all other things being equal D)If the gross margin decreases, then inventory turnover must have increased all other things being equal Answer: A 29. Which of the following statistics would be the most useful in determining the efficiency of a car rental company? A)inventory turnover B)number of employees per car rental C)average length of car rental D)number of days cars rented as percentage of number of days available for rent Answer: D 30.

Which of the following statistics would you be most interested in for a high powered consulting firm? A)Research and development as a percentage of sales B)Wages as a percentage of sales C)Inventory turnover D)Fixed asset turnover Answer: B 31. If the market is semi-strong form efficient this implies that: A)stock prices fully reflect all inside information B)stock prices do not reflect information contained in past trading volume C)stock prices fully reflect all information found in 10Ks D)stock prices fully reflect all information about future price changes Answer: C 32. Which of the following statements is incorrect?

A)It is possible for some markets to be more efficient than others B)It is possible for markets to be efficient with respect to some information and inefficient with respect to other information C)The market is likely to be more efficient with respect to companies where there is greater analyst following D)The market is totally efficient with respect to all information rendering security analysis pointless Answer: D 33. Which of the following ratios would be considered useful in assessing operating profitability? A)Debt/Equity ratio B)Acid test ratio C)Return on assets D)Return on equity Answer: C 34.

How much would you be prepared to pay for a $500 bond which comes due in 5 years, pays $80 interest annually, and your required return is 8% (pick closest answer)? A)$740 B)$660 C)$608 D)$500 Answer: B 35. Fluno Corporation has 1M shares outstanding at the end of fiscal 2005. Its stock is trading at $15 per share. It issued $0. 6M in dividends, and had net income of $1M in fiscal 2005. At the end of 2000 its total assets, liabilities and retained earnings were $25M, $15M and $7. 5M, respectively. Fluno’s price to book ratio and dividend yield ratios for 2005 are: Price to BookDividend Yield A)260% B)1. 560% C)1. 4% D)24% Answer: C 36. Urban Company has 5M shares outstanding and issued dividends of $1 per share in fiscal 2005. Dividends are expected to grow at a rate of 6% per annum in perpetuity. Urban’s cost of equity is 10%. What is the implicit value of Urban Company at the end of 2005? A)$50M B)$53M C)$125M D)$132. 5M Answer: D 37. Which of the following statements are correct? The intrinsic value of a company can be calculated as: A)Book value plus the present value of future expected dividends, discounted at the cost of equity capital B)Present value of future expected dividends, discounted at the cost of debt

C)Present value of future expected residual income, discounted at the cost of equity capital D)Book value plus the present value of future expected residual income, discounted at the cost of equity capital Answer: D 38. Two otherwise equal companies have significantly different dividend payout ratios. Which of the following statements is most likely to be correct? The company with higher the dividend payout ratio: A)will have a higher inventory turnover ratio B)will have a lower inventory turnover ratio C)will have higher earnings growth D)will have lower earnings growth Answer: D (CFA Adapted) 39.

On January 1, 2005, Systil Corporation issues $50M 10 year bonds with a coupon rate of 10%. Interest is payable annually at the end of the year. If the required return on bonds of similar risk at January 1, 2006 is 8%, what will the price of the bonds be at this date? A)$56. 71M B)$56. 25M C)$44. 24M D)$43. 86M Answer: B 40. Which of the following statements is most correct? A)Technical analysis concerns itself with determining the intrinsic value of a stock B)Active investing is defined as buying and selling stock within six months C)Fundamental analysis attempts to value a company by examining the past prices patterns of a company’s stock

D)Individuals who engage in technical analysis by definition do not subscribe to the weak form of the efficient market hypothesis Answer: D Use the following to answer questions 41-43: Rivaz Corporation 2005 Net Income$ 3,000 Dividends$ 1,000 Total Assets – 12/31/05$ 35,000 Total Liabilities – 12/31/05$ 21,225 Number of shares outstanding1,000 Cost of Equity12% 41. Net income is expected to increase by 10% for the next year, and dividend payout ratio is expected to remain constant. After 2006, retained earnings are expected to decrease to zero. Using the residual income method what is the value per share of Rivaz stock as of 12/31/05?

A)$15. 42 B)$15. 16 C)$14. 38 D)$13. 77 Answer: A 42. Using the dividend discount model, assuming dividends grow at 10% per year for the next two years and at 5% thereafter, what is the value per share of Rivaz Corporation at 12/31/05? A)$16. 61 B)$16. 51 C)$16. 42 D)$14. 87 Answer: C 43. Assuming total assets grew by $5,000 from 2004 to 2005, what is the return on assets of Rivaz Corporation for 2005? A) 9. 23% B) 8. 57% C)10. 00% D) 6. 15% Answer: A 44. Which of the following statements is incorrect? A)Current assets are expected to be converted into cash sooner than noncurrent assets

B)Equity investors have unlimited downside exposure if the company declares bankruptcy C)Paid-in capital of company is not affected by the payment of dividends D)Retained earnings at the inception of a company equals zero. Answer: B 45. A company issues 12%, 10-year $1,000 bonds paying interest semi-annually. Required return for bonds of this risk is 15%. What price will the bond sell at (pick closest answer)? A)$663 B)$849 C)$ 847 D)$ 894 Answer: C Note: If the students calculate this assuming annual payments (N=10, PMT=120, I=15%), they will get answer B, not C.

The correct solution is calculated with N=20, PMT=60 and I=7. 5%. You may wish to award half marks for answer B. 46. You wish to compare the performance of two companies. Which of the following statements is most likely to be incorrect? A)If the companies operate in different industries this will hinder comparability B)The use of different accounting methods will hinder comparability C)If the companies are of significantly different sizes this will hinder comparability D)If companies have different auditors this will hinder comparability Answer: D 47.

As of December 31, 2005, two otherwise identical companies in the same industry, Eastco and Westco, have dividend payouts of 20% and 40%, respectively: Looking forward one year, which outcomes are least likely? I. Eastco requires debt financing II. Westco increases its dividend payout III. Westco’s share price is twice that of Eastco’s IV. Eastco repurchases outstanding shares A)I and II B)II and IV C)I, II and III D)II, III and IV Answer: C 48. Which of the following, if increased by 10%, results in a 10% higher stock price? A)dividend yield B)earnings yield C)net profit margin D)none of the above Answer: D