Topic 3: Financial Analysis Techniques

1. To study trends in a firm’s cost of goods sold (COGS), the analyst should
standardize the cost of goods sold numbers to a common-sized basis by
dividing COGS by:
A. assets.
B. sales.
C. net income.

2. An analyst who is interested in a company’s long-term solvency would most

likely examine the:
A. return on total capital.
B. current ratio.
C. fixed charge coverage ratio.

3. RGB, Inc.’s purchases during the year were $100,000. The balance sheet
shows an average accounts payable balance of $12,000. RGB’s payables
payment period is closest to:
A. 37 days.
B. 44 days.
C. 52 days.

4. RGB, Inc. has a gross profit of $45,000 on sales of $150,000. The balance
sheet shows average total assets of $75,000 with an average inventory balance
of $15,000. RGB’s total asset turnover and inventory turnover are closest to:
Asset turnover Inventory turnover
A. 7.00 times 2.00 times
B. 2.00 times 7.00 times
C. 0.50 times 0.33 times
5. A company’s current ratio is 1.9. If some of the accounts payable are paid off
from the cash account, the:
A. numerator would decrease by a greater percentage than the denominator,
resulting in a lower current ratio.
B. denominator would decrease by a greater percentage than the numerator,
resulting in a higher current ratio.
C. numerator and denominator would decrease proportionally, leaving the
current ratio unchanged.

6. RGB, Inc.’s receivable turnover is ten times, the inventory turnover is five
times, and the payables turnover is nine times. RGB’s cash conversion cycle is
closest to:
A. 69 days.
B. 104 days.
C. 150 days.

7. RGB, Inc.’s income statement shows sales of $1,000, cost of goods sold of
$400, pre-interest operating expense of $300, and interest expense of $100.
RGB’s interest coverage ratio is closest to:
A. 2 times.
B. 3 times.
C. 4 times.

8. Which of the following equations least accurately represents return on

equity?
A. (net profit margin) (equity turnover).
B. (net profit margin) (total asset turnover) (assets / equity).
C. (ROA) (interest burden) (tax retention rate).
9. Use the following information for RGB, Inc.:
EBIT / revenue = 10%
Tax retention rate = 60%
Revenue / assets = 1.8 times
Current ratio = 2 times
EBT / EBIT = 0.9 times
Assets / equity = 1.9 times
RGB, Inc.’s return on equity is closest to:
A. 10.5%.
B. 14.0%.
C. 18.5%.

10. An analyst who needs to model and forecast a company’s earnings for the
next three years would be least likely to:
A. assume that key financial ratios will remain unchanged for the forecast
period.
B. use common-size financial statements to estimate expenses as a percentage
of net income.
C. examine the variability of the predicted outcomes by performing a sensitivity
or scenario analysis.

11. The following table lists partial financial statement data for Alpha
Company:
Sales $5,000
Cost of goods sold 2,500
Average
Inventories $600
Accounts receivable 450
Working capital 750
Cash 200
Accounts payable 500
Fixed assets 4,750
Total assets $6,000
Annual purchases $2,400
Calculate the following ratios for Alpha Company:
Inventory turnover.
Days of inventory on hand.
Receivables turnover.
Days of sales outstanding.
Payables turnover.
Number of days of payables.
Cash conversion cycle.

12. Use the following information for problems A through D.

Beta Co. has a loan covenant requiring it to maintain a current ratio of 1.5 or
better. As Beta approaches year-end, current assets are $20 million ($1 million
in cash, $9 million in accounts receivable, and $10 million in inventory) and
current liabilities are $13.5 million.
A. Calculate Beta’s current ratio and quick ratio.
B. Which of the following transactions would Beta Co. most likely enter to
meet its loan covenant?
+ Sell $1 million in inventory and deposit the proceeds in the company’s
checking account.
+ Borrow $1 million short term and deposit the funds in their checking account.
+ Sell $1 million in inventory and pay off some of its short-term creditors.
C. If Beta sells $2 million in inventory on credit, how will this affect its current
ratio?
D. If Beta sells $1 million in inventory and pays off accounts payable, how will
this affect its quick ratio?
13. In periods of rising prices and stable inventory quantities, which of the
following best describes the effect on gross profit of using LIFO as compared to
using FIFO?
A. Lower.
B. Higher.
C. The same.

14. Which of the following is most likely for a firm with high inventory
turnover and lower sales growth than the industry average? The firm:
A. is managing its inventory effectively.
B. may have obsolete inventory that requires a write down.
C. may be losing sales by not carrying enough inventory.

15. Red Company immediately expenses its development costs while Black
Company capitalizes its development costs. All else equal, Red Company will:
A. show smoother reported earnings than Black Company.
B. report higher operating cash flow than Black Company.
C. report higher asset turnover than Black Company.

16. In the year after an impairment charge on a finite-lived identifiable

intangible asset, compared to not taking the charge, net income is most likely to
be:
A. lower.
B. higher.
C. unaffected.
17. Company A’s M-score is -1.62. Company B’s M-score is -1.1. Which of the
following statements about the M-scores is most accurate?
A. Company A’s M-score indicates a larger probability of earnings
manipulation than Company B’s M-score.
B. Company B’s M-score indicates a probability of earnings manipulation of
1.10%.
C. Using a cut off M-score of -2.22, both firms would be classified as potential
manipulator companies.

18. Suppose that we are provided the following financial data for MegaCo
Industries:
2016 2015
Operating income 20,000 18,000
Net income 12,000 10,000
Cash from operations 33,000 35,000
Cash from investing (30,000) (25,000)
Cash from financing (10,000) (10,000)

30 Sep, 2016 30 Sep, 2015 30 Sep, 2014

Operating assets 200,000 190,000 220,000
Operating liabilities 10,000 20,000 20,000

18.1. MegaCo’s balance sheet accruals ratio is closest to:

2016 2015
A. 5.12% 5.41%
B. 11% 5.41%
C. 11% 6%
18.2. MegaCo’s cash flow accruals ratio is closest to:
 2016 2015
A. 5% 1.81%
B. 10.55% 12.72%
C. 9.44% 6.67%
18.3. Based on the balance sheet accruals ratio and the cash flow accruals ratio,
A. The potential for earning manipulation of MegaCo may increase
B. The potential for earning manipulation of MegaCo may decrease
C. The potential for earning manipulation of MegaCo may be unchanged

19. An analyst examining BP PLC (BP) wishes to understand the factors

driving the trend in ROE over a recent three-year period. The analyst obtains the
following data from Bloomberg and ascertains that Bloomberg has included
nonoperating income in the interest burden factor:
2004 2003 2002
ROE 20.62% 14.42% 10.17%
Tax burden 64.88% 62.52% 60.67%
Interest burden 130.54% 112.60% 130.50%
EBIT margin 6.51% 6.40% 4.84%
Asset turnover 1.55 1.38 1.19
Leverage 2.42 2.32 2.24
What might the analyst conclude?

20. Analyzing Operating Profitability. Exhibit 4.22 presents selected

operating data for three retailers for a recent year. Macy’s operates several
department store chains selling consumer products such as brand-name clothing,
cosmetics, and bedding and has a large presence in the bridal and formalwear
markets (under store names Macy’s and Bloomingdale’s). Home Depot sells a
wide range of building materials and home improvement products, which
includes lumber and tools, riding lawn mowers, lighting fixtures, and kitchen
cabinets and appliances. Supervalu operates grocery stores under numerous
brands (including Albertsons, Cub Foods, Jewel-Osco, Shaw’s, and Star
Market).
a. Compute the rate of ROA for each firm. Disaggregate the rate of ROA into
profit margin for ROA and assets turnover components. Assume that the
income tax rate is 35% for all companies.
b. Based on your knowledge of the three retail stores and their respective
industry concentrations, describe the likely reasons for the differences in the
profit margins for ROA and assets turnovers.

Table 3.2. Selected Data for three retailers

A B C
Sales 24892 71288 44564
Cost of goods sold 15009 47298 34451
Interest expense 588 624 633
Net Income (4803) 2260 (2855)
Average 4915 11202 2743
Inventory
Average fixed 10717 26855 7531
assets
Average total 24967 42744 19333
assets

21. Calculating and Interpreting Accounts Receivable Turnover Ratios.

Microsoft Corporation (Microsoft) and Oracle Corporation (Oracle) engage in
the design, manufacture, and sale of computer software. Microsoft sells and
licenses a wide range of systems and application software to businesses,
computer hardware manufacturers, and consumer retailers. Oracle sells software
for information management almost exclusively to businesses. Exhibit 4.23
presents selected data for the two firms for three recent years.

REQUIRED
a. Calculate the accounts receivable turnover ratio for Microsoft and Oracle for
Year 1, Year 2, and Year 3.
b. Suggest possible reasons for the differences in the accounts receivable
turnovers of Microsoft and Oracle during the three-year period.
c. Suggest possible reasons for the trends in the accounts receivable turnover for
the two firms over the three-year period.
22. Analyzing the Profitability of Two Restaurant Chains. Analyzing the
profitability of restaurants requires consideration of their strategies with respect
to ownership of restaurants versus franchising. Firms that own and operate their
restaurants report the assets and financing of those restaurants on their balance
sheets and the revenues and operating expenses of the restaurants on their
income statements. Firms that franchise their restaurants to others (that is,
franchisees) often own the land and buildings of franchised restaurants and
lease them to the franchisees. The income statement includes fees received from
franchisees in the form of license fees for using the franchiser’s name; rent for
facilities and equipment; and various fees for advertising, menu planning, and
food and paper products used by the franchisee. The revenues and operating
expenses of the franchised restaurants appear on the financial statements of the
franchisees.
Exhibit 4.41 presents profitability ratios and other data for Brinker
International, and Exhibit 4.42 presents similar data for McDonald’s. Brinker
operates chains of specialty sit-down restaurants in the United States under the
names of Chili’s, Romano’s Macaroni Grill, On the Border, Maggiano’s Little
Italy, and Corner Bakery Cafe. Its restaurants average approximately 7,000
square feet. Brinker owns and operates approximately 81% of its restaurants.
McDonald’s operates chains of fast-food restaurants in the United States and
other countries under the names of McDonald’s, Boston Market, Chipotle
Mexican Grill, and Donatos Pizza. Its restaurants average approximately 2,800
square feet. McDonald’s owns and operates approximately 29% of its
restaurants. It also owns approximately 25% of the restaurant land and buildings
of franchisees. The financial ratios and other data in Exhibits 4.41 and 4.42
reflect the capitalization of operating leases in property, plant, and equipment
and long-term debt
REQUIRED
a. Suggest reasons for the changes in the profitability of Brinker during the
three-year period.
b. Suggest reasons for the changes in the profitability of McDonald’s during the
three-year period.
c. Suggest reasons for differences in the profitability of Brinker and
McDonald’s during the three-year period.
23. Ratios for a Firm That Declared Bankruptcy. Delta Air Lines, Inc., is
one of the largest airlines in the United States. It has operated on the verge of
bankruptcy for several years. Exhibit 5.17 presents selected financial data for
Delta Air Lines for each of the five years ending December 31, 2000, to
December 31, 2004. Delta Air Lines filed for bankruptcy on September 14,
2005. We recommend that you create an Excel spreadsheet to compute the
values of the ratios and the Altman’s Z-score in Requirements a and b,
respectively.
REQUIRED
a. Compute the value of each the following risk ratios.
(1) Current ratio (at the end of 2000–2004)
(2) Operating cash flow to current liabilities ratio (for 2001–2004)
(3) Liabilities to assets ratio (at the end of 2000–2004)
(4) Long-term debt to long-term capital ratio (at the end of 2000–2004)
(5) Operating cash flow to total liabilities ratio (for 2001–2004)
(6) Interest coverage ratio (for 2000–2004)
b. Compute the value of Altman’s Z-score for Delta Air Lines for each year
from 2000 to 2004.
c. Using the analyses in Requirements a and b, discuss the most important
factors that signaled the likelihood of bankruptcy of Delta Air Lines in 2005.
24. Examine and Interpret the Financial Flexibility of VF Corporation.
VF Corporation is an apparel company that owns recognizable brands like
Timberland, Vans, Reef, and 7 For All Mankind. Exhibit 5.18 and 5.19 present
balance sheets and income statements, respectively, for Year 1 and Year 2.