FIN324 S212021 Practice Questions Solution PDF

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FIN 324FINANCIAL STATEMENT ANALYSISPRACTICE QUESTIONS.(Disclaimer: This set is created for the purpose of revision and practice questions for the students. It provides no guarantees that it has any similarities with the actual exam questions).CHAPTERS COVERAGEAnalysing Operating Activities Cash Flow...

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FIN324 FINANCIAL STATEMENT ANALYSIS PRACTICE QUESTIONS. (Disclaimer: This set is created for the purpose of revision and practice questions for the students. It provides no guarantees that it has any similarities with the actual exam questions). CHAPTERS COVERAGE Analysing Operating Activities Cash Flow Analysis Return on Invested Capital and Profitability Analysis Prospective Analysis Credit Analysis Equity Analysis and Valuation

Question 1

Describe and explain the following concepts:

1) Normal P/B ratio A normal P/B implies that the Residual Earnings (RE) of the firm are expected to be 0. That is, the firm is expected to neither generate nor destroy value, but rather to earn exactly the required rate of return on its operations.

2) Profit Margin Profit margin measures the firms ability to turns sales revenues into earnings. It is defined as earnings / sales. Firms with higher profit margins may sustain lower asset turnover whilst still generating high RNOA.

3) Abnormal Earnings Growth Abnormal Earnings growth (AEG) measures the ability of the firm to increase residual earnings through time. AEG can be defined as the cum-dividend earnings – normal earnings. Cum dividend earnings includes both current earnings and earnings on last years dividends, ie [ [𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠𝑡 + 𝑊𝐴𝐶𝐶 ∗ 𝑑𝑡−1 ] while normal earnings is last periods earnings from the firm, increased by the wacc. Since normal earnings are growing at the required rate of return, the only additional value we should be willing to pay for is growth in excess of this required rate.

4) Operating Leverage

Operating Leverage measures the reduction in net operating assets which has been achieved by using operating liabilities. In effect, you are borrowing some of the required assets of the firm from your suppliers. It may be measured u sing Operating liabilities / Net Operating Assets.

5) Residual Operating Income Residual Operating Income measures the ability of the firm to earn more than the required rate of return on the Net Operating Assets. Unlike Residual Earnings, this measure compares the total assets employed to the earnings of the entire firm. As such, the WACC is used as the required return. Any earning of the firm above the required rate on employed operating assets generate additional value for shareholders, and create value. However, if the firm earns less than the required rate, the Residual Operating Income will be negative, identifying value destruction. Question 2

Timber Corporation’s return on net operating assets (RNOA) is 12% and its tax rate is 40%. Its net operating assets ($20 million) are financed entirely by common shareholders’ equity. Management is considering using bonds to finance an expansion costing $10 million. It expects return on net operating assets to remain unchanged. There are two alternatives to finance the expansion: 1. Issue $4 million bonds with 5% coupon and $6 million common stock. 2. Issue $10 million bonds with 6% coupon. Required: a. Determine net income and net operating income after tax for each alternative financing plan.

First alternative: NOPAT = $30,000,000 X 12% = $3,600,000 Net income = $3,600,000 – ($4,000,000 × 5% x [1-.40]) = $3,480,000

Second alternative: NOPAT = $30,000,000 X 12% = $3,600,000 Net income = $3,600,000 – ($10,000,000 × 6% x [1-.40]) = $3,240,000

b. Compute return on common shareholders’ equity for each alternative (use ending equity). First alternative: ROCE = $3,480,000 / ($20,000,000 + $6,000,000) = 13.38% Second alternative: ROCE = $3,240,000 / ($20,000,000 + $0) = 16.2%

c. Explain how the level of leverage interacts with it in helping determine which alternative management should pursue. Since the after tax interest rate are less than the RNOA, Hence, the company earns more on its assets than it pays for debt on an after-tax basis. That is, it can successfully trade on the equity—use bondholders’ funds to earn additional profits. Since the company use more debt in second alternatives, the expected benefits from using leverages are greater as evidence in the computations in part b. Therefore, the company should pursue the second alternative in the interest of shareholders (assuming projected returns are consistent with current performance levels). Question 3

Comparative income statements and balance sheets for Genki Corp. are shown below (in $ millions). 2018

2017

Income Statement Net sales

30,652

24,988

Cost of goods sold

24,534

20,202

Gross profit

6,118

4,786

Selling, general, and administrative expense

4,502

3,456

334

206

1,282

1,124

Income tax expense

490

430

Net income

792

694

Outstanding shares

416

400

1,492

1,502

Receivables

626

524

Inventories

3,534

2,368

204

82

Depreciation and amortization expense Income before tax

Balance Sheet Cash

Other current assets

Total current assets

5,856

4,476

Property, plant, and equipment

3,974

2,186

Accumulated depreciation

1,086

790

Net property, plant, and equipment

2,888

1,396

932

118

Total assets

9,676

5,990

Accounts payable and accrued liabilities

4,946

3,408

Short-term debt and current maturities of long-term debt

228

32

Income tax liabilities

254

130

5,428

3,570

Long-term debt

606

30

Total long-term liabilities

606

230

Common stock

40

40

Capital surplus

1,152

494

Retained earnings

2,450

1,656

Shareholders’ equity

3,642

2,190

Total liabilities and equity

9,676

5,990

Other noncurrent assets

Total current liabilities

Required: Use the following ratios and assumptions to prepare a projected income statement and balance sheet for Year 2019. Assuming there are no other short-term debt and current maturity of long-term debt equal to prior year’s balance Sales growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.67% Gross profit margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.96% Selling, general, and administrative expense/Sales . . . . . . . . . . . . . . . . . . . . . 14.69% Depreciation expense/Prior-year PPE gross . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.28% Income tax expense/Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.22% Accounts receivable turnover (Sales/Accounts receivable) . . . . . . . . . . . . . . . 48.96 Inventory turnover (Cost of goods sold/Inventory) . . . . . . . . . . . . . . . . . . . . . 6.94 Accounts payable turnover (Cost of goods sold/Accounts payable). . . . . . . . . 4.96 Taxes payable/Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.84% Total assets/Stockholders’ equity (financial leverage) . . . . . . . . . . . . . . . . . . . 2.55 Dividends per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.00

Capital expenditures/Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6.71%

Answer Genki Corp

(Projected)

INCOME STATEMENT Net sales Cost of goods

2019

2018

2017

1

37,600.81

30,652

24,988

0.5

30,095.69

24,534

20,202

Gross profit

1

7,505.12

6,118

4,786

Selling general & administrative expense

1

5,523.56

4,502

3,456

Depreciation & amortization expense

1

607.23

334

206

1,374.34

1,282

1,124

1

525.27

490

430

Net income

0.5

849.06

792

694

Outstanding shares

0.5

416.00

416

400

Income before tax Income tax expense

0.5

(Projected) BALANCE SHEET

2018

2017

2016

Cash

1

407.88

1,492

1,502

Receivables

1

767.99

626

524

Inventories

1

4,336.55

3,534

2,368

204.00

204

82

5,716.26

5,856

4,476

Other Total current assets Property, plant & equipment

1

6,497.01

3,974

2,186

Accumulated depreciation

1

1,693.23

1,086

790

Net property & equipment

0.5

4,803.79

2,888

1,396

Other assets

0.5

932.00

932

118

11,452.21

9,676

5,990

Total assets

Accounts payable & accrued liabilities Short-term debt & current maturities of LTD Income taxes liabilities

1 0.5 1

Total current liabilities

6,067.68

4,946

3,408

228.00

228

32

272.30

254

130

6,567.98

5,428

3,570

Long term debt

0.5

393.17

362

30

Total liabilities

0.5

6961.15

606

230

Common stock

0.5

40.00

40

40

Capital surplus

0.5

1,152.00

1,152

494

Retained earnings

1

3,299.06

2,450

1,656

Shareholder equity

0.5

4,491.06

3,642

2,190

1

11,452.21

9,676

5,990

Total liabilities & net worth

Question 5

The management of a corporation wishes to improve the appearance of its current financial position as reflected in the current and quick ratios. Describe four ways in which management can window-dress the financial statements to accomplish this objective. 1. Pay off accounts payable with cash. This would have the effect of reducing both current assets and current liabilities by the same amount, thus increasing the current ratio and quick ratio. 2.* Invest additional capital funds at year-end. This would increase cash without affecting current liabilities. 3.* Sell fixed assets for cash or short-term notes. This would increase current assets, but decrease only fixed assets. Thus, the current and quick ratios would improve. 4.* Borrow cash by incurring long-term liabilities (notes or bonds). This would increase cash, but would not affect current liabilities, since the purpose is to make them long-term liabilities. 5.* Defer incurring various expenses, such as advertising, research and development, and marketing, along with reducing capital expenditures. 6. Keep the cash receipts books open longer, in an effort to show higher receivables or collections. This method is a highly irregular and manipulative device.

* These procedures are normal business transactions that cannot usually be considered manipulative in character. They may become manipulative when they have no sound business justification and are undertaken solely to influence the measures used by outside analysts.

Question 6

Identify and explain at least three types of earnings management. •

Changing accounting methods or assumptions with the objective of improving or modifying reported results. For example, to offset the effect on earnings of slumping sales and of other difficulties, Chrysler Corp. revised upwards the assumed rate of return on its pension portfolio, thus increasing income significantly. Similarly, Union Carbide improved results by switching to a number of more liberal accounting alternatives.

•

Misstatements, by various methods, of inventories as a means of redistributing income among the years.

•

The offsetting of extraordinary credits by identical or nearly identical extraordinary charges as a means of removing an unusual or sudden injection of income that may interfere with the display of a growing earnings trend.

Question 7

What is the difference between forecasting and extrapolation of earnings? Forecasting must be differentiated from extrapolation. The latter is based on an assumption of the continuation of an existing trend and involves a mechanical extension of the trend into the uncharted territory of the future .

Forecasting, on the other hand, is based on a careful analysis of as many individual components of income and expense as is possible and a considered estimate of future level taking into consideration interrelations among the components as well as probable future conditions. Thus, forecasting requires as much detail as is possible to obtain. Question 8 The importance of comprehensive income for financial statement analysis arises because it is the accountant’s proxy for economic income. Comprehensive income is preferred to net income, where the latter measure purports to estimate neither economic nor sustainable income. Required: a. Distinguish between net income, comprehensive income, and continuing income. Cite examples of items that create differences between these three income measures.

Net income is the excess of the revenues and gains of the company over the expenses and losses of the company. Net income often is called the “bottom line,” although that is a misnomer because certain unrealized holding gains and losses are charged directly to equity and bypass net income

Comprehensive income includes all changes in equity that result from non-owner transactions (excluding items such as dividends and stock issuances). Items creating differences between net income and comprehensive income include unrealized gains and losses on available for sale securities, foreign currency translation adjustments, minimum pension liability adjustments, and unrealized holding gains or losses on derivative instruments. Comprehensive income is the ultimate “bottom line” income number

Continuing income is a measure of net income earned by ongoing segments of the company Continuing income differs from net income because continuing income excludes the income or loss of segments of the company that are to be discontinued or sold (it also excludes extraordinary items and effects from changes in accounting principles) b. Explain the meaning of basic earning per shares and how diluted earnings per share differ from basic earnings per share. Basic earnings per share is the amount of earnings attributable to common shareholders (that is, net income less preferred dividends) divided by the weighted average number of common shares outstanding for that period

Diluted earnings per share is the amount of current earnings per share that reflects the maximum dilution that would result from the conversion of all convertible securities and the exercise of all warrants and options. The conversion of these securities individually would decrease earnings per share and in the aggregate would have a dilutive effect.

The computation of diluted earnings per share should be based upon the assumption that all such issued and issuable shares are outstanding from the beginning of the period, or from their inception if after the beginning of the period .

To summarize, whereas basic earnings per share does not reflect any securities convertible or exercisable into common shares, diluted earnings per share includes all such securities and considers their dilutive effect upon earnings per share, taking into account necessary adjustments to income resulting from the conversion process. Question 9

In reviewing the financial statements, you discover that net income increased while operating cash flows decreased for the most recent 2 consecutive years. Required: a. Explain how net income could increase while its operating cash flow decreases. Your answer should include at least three illustrative examples.

Revenues are, in certain instances, recognized before cash is received (that is, when earned). Expenses are, in certain instances, recognized after cash is paid (that is, matched with revenues). As a result, net income can be positive when operating cash flows are negative.Consider some examples: (1) If accounts receivable increase substantially during the year, this implies that revenues outpaced cash collections .(2) If a company builds up its inventory levels substantially, then cash is paid out but no expense is recognized. (3) If the company reduces its accounts payable balances substantially during the year, then cash flows can be negative when net income is positive . b. Describe how operating cash flow can serve as one indicator of earnings quality. Operating cash flows can serve as one indicator of earnings quality because over a number of years, cash flows should approximate earnings . If cash flows from operations are consistently lower than earnings, it is possible that the reported earnings are not of high quality. (As with any broad guideline, one must look for corroborating evidence.) Question 10

Green Ltd condensed balance sheet for Year 2020 is reproduced below: Assets Current assets . . . . . . . . . . . . . . . . . . . Noncurrent assets . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . .

$500,000 $3,500,000 $4,000,000

Liabilities and Equity Current liabilities . . . . . . . . . . . . . . . . Noncurrent liabilities (8% bonds). . . . Common stockholders’ equity. . . . . . Total liabilities and equity . . . . . . . . .

$400,000 $1,350,000 $2,250,000 $4,000,000

Additional Information: 1. Net income for Year 2020 is $315,000. 2. Income tax rate is 50%. 3. Amounts for total assets and shareholders’ equity are the same for Years 2019 and 2020. 4. All assets and current liabilities are considered to be operating. Required: a. Determine whether leverage (from long-term debt) benefits Green’s shareholders. (Hint: Examine ROCE with and without leverage.) At the present level of debt, ROCE = $315,000/ $2,250,000 = 14%. In the absence of leverage, the noncurrent liabilities would be substituted with equity. Accordingly, there would be no interest expense with all-equity financing. Consequently, in this case, net income would be as follows: Net income (with leverage)............................................

315,000

Plus interest s...