Financial Reporting and Analysis

A cash flow statement is made up of three main pieces. Cash Flow Operations from the company’s day-to-day activities. Cash Flow from investing activities comes from the purchase and sale of assets that aren’t related to normal business activities. And Cash Flow from financing activities that comes from capital financing activities.

There are plenty of ratios using information from a cash flow statement to figure out the financial health of a company including free cash flow to the firm and free cash flow to equity.

Cash Flow Statements Practice Question

A statement of cash flows most likely enhances the reliability of the:

1. Statement of changes in equity
2. Statement of financial position
3. Statement of comprehensive income

Answer: B. Statement of financial position. The statement of cash flows ultimately shows the change in cash during an accounting period. Cash is an asset. The beginning and ending balances of cash are shown on a company’s balance sheets for the previous and current years, and the bottom of the cash flow statement reconciles beginning cash with ending cash.

Ratio Analysis and Common-Size Analysis are two techniques to help understand a company’s financial data. Additionally, there are several categories of ratios used for performance analysis.

These include activity ratios, liquidity ratios, solvency ratios, profitability ratios, and valuation ratios. You’ll find examples of each on a formula sheet. Finally, the DuPont Analysis method of decomposing return on equity is a core part of this section and breaks down the ROE into component parts to analyze the drivers of returns.

Financial Analysis Techniques Practice Question

If a firm issues convertible debt securities and these convertible debt securities are exercised, the growth rate will most likely:

1. Increase
2. Decrease
3. Remain the same

Answer: B. Decrease. Growth rate = Retention ratio × Return on equity = (1 – Dividend payout ratio) × (Net income / Equity) = (1 – Dividend per share / Earnings per share) × Return on equity

If a firm issues convertible debt then it will dilute the EPS of the firm and reduce the retention ratio. Also, the return on equity will decrease as the number of common shares in equity will increase. Hence, the growth rate of the firm will decrease.

Inventories, along with the Cost of Goods Sold are two core pieces within a company’s financial statement. To get a better understanding of Inventories, you’ll need to become familiar with the four methods for valuing inventory as it relates to the cost of goods sold.

They are Specific Identification, Weighted Average Cost, First-In-First-Out (FIFO), and Last-In-First-Out (LIFO).

The reading also covers financial statement effects of a change in inventory valuation method, the measurement and reporting of inventory when its value changes, the presentation of inventories on the financial statements, related disclosures, and much more.

Inventories Practice Question

Relative to other industry players, which of the following BEST describes a firm reporting high sales growth and high inventory turnover?

1. The firm has obsolete inventory
2. The firm incurs lost sales by not carrying insufficient inventory
3. The firm is efficient in managing its inventory

Answer: C. The firm is efficient in managing its inventory. Relative to the industry, high sales growth, coupled with high inventory turnover, suggests greater efficiency in inventory management.

Long-lived assets are resources that are expected to provide benefits to a company for more than one year. They may be tangible, intangible, or financial assets.

The reading includes a description and illustration of accounting for the acquisition of long-lived assets, the allocation of costs of long-lived assets over their useful lives, and the revaluation model based on the fair value of an asset. It also covers the concepts of impairment, accounting for the derecognition of long-lived assets, and financial presentation, disclosure, and analysis of long-lived assets.

Long-lived Assets Practice Question

Which of the following costs related to the requisition of a long-lived asset must generally be expensed in the United States?

1. Installation costs
2. Freight and delivery costs
3. Related research and development costs

Answer: C. Related research and development costs. Research and development costs in the United States should be treated as an expense when they occur (except for certain software development costs).

The Income Taxes reading takes a look at Deferred Tax Assets and Deferred Tax Liability. Deferred Tax Assets crop up when a company’s taxable income is greater than its accounting profit. And Deferred Tax Liability is what occurs when the opposite occurs and a tax deficit is created.

The reading also covers types of timing differences between the recognition of taxable and accounting profit, unused tax losses and tax credits, the recognition and measurement of current and deferred tax, and the disclosure and presentation of income tax information on companies’ financial statements.

Income Taxes Practice Question

Deferred tax liabilities that are unexpected to be reversed in the future shall be:

1. Recognized as liabilities
2. Recognized as equity
3. Not recognized in the financial statements

Answer: B. Recognized as equity.

Non-current Liabilities are a likely sacrifice of economic benefits in periods greater than one year. The most common include bonds payable, leases, pension liabilities, and deferred tax liabilities.

The reading introduces bonds and discusses the recording of interest expenses and interest payments. It also dives into fair value accounting for bonds, looks at the repayment of principal when bonds are redeemed or reach maturity, and provides an overview of debt covenants and disclosures about debt financing.

Non-current (Long-term) Liabilities Practice Question

If a company using US generally accepted accounting principles (GAAP) issues a zero-coupon bond, an analyst should:

1. Reduce cash flow from operations
2. Increase cash flow from investing
3. Increase cash flow from operations

Answer: A. Reduce cash flow from operations. Cash flow from operations is overstated since the full repayment of maturity value is treated as a financing cash flow whereas it represents interest repayments, which should be classified as an operating cash flow.

Financial Reporting Quality is an important skill for analysts and investors. Those who are able to recognize poor financial reporting quality before deficiencies are known are more likely to make profitable investment decisions to reduce losses. The reading looks closely at reporting quality and the interrelated attribute of results quality.

Financial Reporting Quality Practice Question

The information provided by a high-quality financial report will most likely:

1. Increase company value
2. Indicate earnings are sustainable
3. Faithfully represent the economic reality of the company

Answer: faithfully represent the economic reality of the company. High-quality financial reports provide decision-useful information that faithfully represents the economic reality of the company. Low-quality financial reports impede assessment of earnings quality.

Financial reporting quality relates to the quality of the information contained in financial reports whereas earnings quality pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition. High quality earnings are sustainable and increase company value.

Learning how to apply Financial Statement Analysis to real-world situations is the focus of this reading. Some valuable items the reading discusses include unpacking the key questions to address in evaluating a company’s past financial performance, how an analyst should approach forecasting a company’s future net income and cash flow, and how financial statement analysis can be used to evaluate the credit quality of a fixed-income investment.

Additionally, the reading addresses how financial statement analysis can be used to screen for potential equity investments and how differences in accounting methods affect financial ratio comparisons between companies.

Financial Statement Analysis: Applications Practice Question

Which of the following companies is most likely to have low credit risk?

1. Small start-up companies
2. Companies with high free cash flow to total debt ratios
3. Companies that have a low return on their assets

Answer: B. Companies with high free cash flow to total debt ratios. Small start-up companies and companies that earn a lower return on their assets have higher credit risk as compared to those that have a high free cash flow to total debt ratio.