CFA Level 1 (2009) - 3

Sdf:JC5t: financial Reponing and Analysis

l.H The MD&A is required I<l conlain informalion on lrends in sales and expel1S<.:S, <.:xpened capilal expendifll),(:s and orher events affecting liquidity, and the outlook fiH the fUlure

based on known lrends. Delails of depreciarion methods arc conrained in the fOlllnolc5

to lhe financial SlalemenlS.

2.C The p<.:rcentage-of-complelion method recognizes a proporrion of estimared projeCl profirs, which will increase ner income, rerained earnings, and equiry and aS5US relaliv<.:

10 the completed contract /11nhod. With inerea5ed equiry and aS5etS, bOlh the delHI asselS and debl/equilY ratios are c1<.:creilsed. Cash How.s ;11<.: IlnaCfecled by the l11er!llld seleued (l) account I'llI' lhe project on the financial SLllcmeIllS.

:I. B IntCfest paid i.1 an operaling cash How, and dividends paid arc a financing cash flow, so rhc firm thal pays highn dividends will haw JOWl'!' CFF. The Iirm wilh lo\\er ltllncst l'Xpcnsc will han' Ilighn L1'S.

ii.i\ Inventorv lurIlllvn involvcs sales (from the incol11e 5Ial<.:meI1l) and averagc invclllory

(1'1'0/11 the balance 5hcl'l) so il cannot be calculaled from cOJl1l11on-size SlalemelllS. Debr

(() equiry is ddn/assets divided hy equity/assets. Operating profitslsalcs can bc read directly from the cOIII/11on-size income sratement.

'i. A Ca.\h conversion cycle = c"llection period + invmlory period - payahles pni"d.

An increase in invenlory tmnover will decrease lhe inventory period ~nd shorten the cash conversion cycle. An incrc~s<.: in the payables period will ~Iso shorten the cash conversion cycle.

(). C Famous, Inc.'s sustainable growlh ratc = (retenrion rate)(ROE).

ROE = 0.20(800,000) / [(ROO,OOO/OS)(J 116)] = 160,OOO!l ,000,000 = 16%.

Alternatively:

ROF = (0.20)(0.SO)(I.Gl = 0.16 = 16(Yo

RerelHion rate = (J - Dividend Payour Rario) = 1 - {32,OOO/[(0.20)(800,000)JJ = 0.80.

Sustainable growlh = 0.80 (1 Mil) = 12.8%.

7.A Based on rhe average stock price, only the options at 18 arc in the money (and therefore

dilutive). Using the rreasury stock merhod, rhe average shares outstanding for calculating diluted EPS would increase by [(20 - 18)120] 200,000 = 20,000 shares.

8.C UFO reserves are nor amorri7ed. A decline in rhe LIrO rcserve occurs when the increasing prices that creared the reserve begin declining or whcn invenrory is liquidated (i.c., fewer unirs in inventory at rhe cnd of rhe year lhan at the beginning).

9.A With convcrrible bonds, the procceds at issuance represenr a balance sheer liability. For a bond with warrants artached, the fair market value of the warrants is recorded as equity, and rhe remainder of the proceeds is recorded as a liabilily, so liabilities to assets and liabililies to equity are both lower (improved), With interest expense the same on borh issues, there is no effect on ncr income or ROA.

ScH~Tesl: financial Repofling and Analysis

10.C If the COSl were allloni/.ed rarher lhan expensed, rhe $H IIIillion cosr of rhe franchise would be classilieJ as an invesling cash flow ralher lhan ,In operaling cash Bow, so eFO would increase (and CFl decrease). The asser created by capiralizing lhe COSl would increase assns, so the dehr·lo·assets rario would decrease.

11.B If it becoIlles probahle that a ponion of a deferred lax asser will not llC realized, 'I valuarion allowance should he esrablished. A valuarion allowance serves to reduce the value of a deferred lax assel 1'01' rhe probability Ihar ir will nOl be re'llized (lhe dirkrClllt' Iwrwcen lax payable and income lax expense will not reverse in fUlure periods).

l2. C Invesling cash !lows were IIIuch highellhan opnaring cash flows for Enron, indicaring a need for a grear deal of financing. The olher lWO choices were bOlh warning signs relaled

10 lhe Sunbeam accounring scandal.

U. C \1(!ilh a finance lease, only the illleresr portion of the lease paymenr is classified as CFO, so CFO will be grealCl' than ir would be wirh an <,<]uivalem olKrating lease. CTF will be less ror a finance lease because rhe principal portion or each lease paymull is classified as 'I financing cash oud1ow. Operaling income, EBIT, will 11<' reduced only hy lhe (equal) anllual depreciarion expense wilh a financ<' kase, so opeLlIing il1Col1le williX' 1',IC'11<,1 1'01 a finance kase rhan for an 0l'naling lease (Ic)r which the emire 1<:'1 St' payment will be an operaling expense). Al inceplion, a finance lease will increase 'lssers and liabilities bv rhe same amounr so rhere is no effecr on equity.

14. B Al asscr acquisirion, a liahiliry equal to rhe presel1l value of rhe asser disposal cosrs is created and an asser of equal value is created, so lhere is no initial cJ'fecr on equil),. The increase in the liabililY (accrerion) each year is recorded 'IS inrerest eXpl.'l1Se, so il1lt'l"esl coverage rarios are lower each year when rhere are assel disposal COSlS. Wilh aSSl.'r disposal cosrs, ncr income will be reduced each year by both the inreresr expense on lhe liabiliry and by depreciarion of the offselling assel lhat is creatl.'d.

1'i. C Impairmenr charges reduce operating income and Ilet income in Ihe pniod ofrhe charge. Taxes are not affected because any loss in asset value will reduce taxes Dill)' when lhe ,ISSe\ is disposed of and rhe loss is actually reali/.ed. The dehr lO equilY ratio increases in the period of the charge because equity is reduced.

16. B Il1leresr on loans rhar specifically fund construction of long·lived assers musr be capiralil.ed under U.S. GAAP. Assets of insignifical1l value (e.g., Illeral waSil' hasket) alt' lypically expensed even when their useful lives arc many years. R&D cosrs ;ue expen~c<1 under U.S. GAAP.

17. B There are no effects on invesling cash flows from the exercise of employee srock opriol1s. Oprion exercise resulrs in a rax deducrion that reduces raxes and increases opera ring cash flow. Since employee incentive slOck options are properly parr of compensarion

expense, cash expenditures ro repurchase shares and avoid dilution are properly classified as operating cash flows rather than as financing cash flows (their classification under accoulHil1g stanclards).

18.C \Virh falling prices, FIfO inventory accounting will result in higher COCS, lower ner income, and higher cash How because of lower taxes on rhe lower ner Income.

19.C Annual depreciation is .370,000 - 340,000 ~30,000.

Average depreciable life is gross fixed assEts/anl1ual depreciation ~

(400,000 + 370,000)/30,000 ~ 25.66 years.

Self-Test: Financial Reporting and Analysis

20. A The receipt of the tax-exempl interest income will create a pernnnc'nt difference between pretax incollle and taxable income. Since the tax-free in!ere~ increases pre-tax income, hut nOl income tax expense, the effeclive lax rale will be less lhan 40%. No deferred tax li,thility is crcl[ed because the dillcrence belween prelax and Ltxabk income willnevcr reverse .

.J I. C The analyst should treal the "sale" of receivables as a loan secure'll hy l he receivalllcs. 'Chis Illeans the receivables should he added back lO accoul1ls receivable, decreasin!!, receivables turnover. A current liJ.bility elJualto the value of the loan should be added to the balance sheel, which will increase the l(llal debl ratio. The cash received remains on the balance sheer so there is no reduction in the value of cash and markelable securities.

22. C Foreign issul'l's in U.S. markels must either submil U.S. GAAP complianl financial statemellls or separalely provide a reconcilialion of their lFRS slatements with U.S. GAAP, including relaled disclosures that will :lid financial Slatemenr users in the Uniled Slates.

25.C Unrcalizcd gains and losscs on tr:lding sccurities arc rq)()!"lcJ ill the inlollle ,1:llClllCJll undn hOlh U.S. allllll'!{S sl:lIldards. Siucc UFO is nO[ permitLl'd under ll-RS, adJusling the invenlory amoulll for a LIFO firm is a likely adjusllllelH. -1,) aCCllUlll ror dilTerences in how companies report leascs, adding the IHeSCIH v:Jiuc of futlll'c minimum operaling lease paymcl1ls lO bOlh the aSSClS and liabilities of a linn will removc lhe dfeCls of lease reponing methods from solvency and leverage ralios.

24.A By convening a cash flow slatement to the direcr method, an analyst can vic\\' CJsh expenses and receipts by calegory, which will facilitare a comparisoll of two firms' cash outlays and receipts. eFO is correct under either method and requires no adjustmellt. Neither dividends received nor dividends paid arc classified as eFl under U.S. GAAP

FORMULAS

Activity Ratios:

annual sales

receivahlcs IUrIlUVLT

average reccivahlcs

.'36')

days of sakos ()usL1l1ding=

rl'lTiv;lhlcs turnover

(ost of goods suld II1VCl](ury lurnovcr=c -

average IJ1vellwry

average net fixed assets

reven ue average working capital

Liquidity Ratios:

Book .1 .~ Financial SLllcI11CJl[ Analysis

Formulas

Solvency Ratios:

FlU

pretax marglll

revenue

average total capital

net Income

return on equIty ~

average total equity

Book 3 - Financial Statemcnt Analysis

Formulas

avnagc common CqllllY

net income availahle to common average common e<.lllIly

Free Cash now to the Finn:

FeF F = nee income + noncash charges + [inrcrest expense x (I - tax rate) 1 - fixed capital invcstmel1\ - working capital investment

j;CFF cc cash How from operations + [intcrest expense x (1 - tax ratc)1 - fixed capital Investment

Free Cash Flow to Equity:

j:Cj:E = c.lsh flow I"rom operations - fixed capital invesllnent + nct bOlTowing

Book :3 -- Financial SI'lll'nlClll Analy,is

Formulas

Coefficients of Variation:

standard dcviariol1 of sales

(:V sales

Illean sales

sLlI1dard dcviation o( Opn-llJl1g IIKUI11C

lllean opn'lllllg II1c0l11l'

st'll1dard deviation of net incol11e

CY ncr income

meal1 ncr lI1COl11e

Inventories:

ending inventory .- hcginning il1vcntory + !lurclLlsl'S -- (:OCS

CUrrCl1l cml o(invl:l1l01"\' 1,1:1j:()) ~ J.lH) ill\l'lllOl\' 1 I.IJ:() rl'SlI"\'C

COGS FIFO = COCS [\1'0 - (ending UFO reserve - beginning L1H) reserve)

LongLived Assets:

cost - salv3ge value

average age III years = accumulated depreciarion annual depreciation expense

Book.) - Financial S[.llCIllCIH AILdysis

hlrmlilas

in Icrest paid

CFO

Rl'i!l vcstmen I

cash paid For long-term :lSSl'lS

cash outflows from investing and flnancing activities

INDEX

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