CCM Financial Statement Analysis 3 — Questions and Answers
Question 1: A manufacturer's gross profit margin declined from 42% to 31% over three years while revenue grew. What is the most probable cause?
- Selling, general, and administrative expenses increased
- Cost of goods sold rose faster than revenue, possibly due to input cost inflation or pricing pressure (Correct answer)
- Interest expense increased due to new debt
- Accounts receivable balances decreased
Correct answer: Cost of goods sold rose faster than revenue, possibly due to input cost inflation or pricing pressure
A declining gross margin with growing revenue typically signals that COGS is rising faster than prices, often from raw material cost increases or competitive pricing pressure.
Question 2: When comparing two companies in the same industry, Company A has a fixed asset turnover of 8.2 and Company B has 3.1. What does this suggest?
- Company B uses its fixed assets more productively
- Company A generates significantly more revenue per dollar of fixed assets (Correct answer)
- Company A has newer, more expensive equipment
- Company B has lower depreciation charges
Correct answer: Company A generates significantly more revenue per dollar of fixed assets
A higher fixed asset turnover means Company A generates more revenue for each dollar invested in fixed assets, indicating greater operational efficiency.
Question 3: A credit manager is reviewing a borrower's financial statements and finds that capital expenditures exceed depreciation every year for five consecutive years. What does this pattern most likely indicate?
- The company is shrinking its asset base
- The company is consistently investing in growth by expanding its fixed asset base (Correct answer)
- Depreciation methods are inconsistent
- The company has excessive free cash flow
Correct answer: The company is consistently investing in growth by expanding its fixed asset base
When capex consistently exceeds depreciation, the company is net-investing in fixed assets, suggesting expansion or modernization of its productive capacity.
Question 4: Which of the following is the correct formula for calculating the debt service coverage ratio (DSCR)?
- Net income ÷ total debt
- EBITDA ÷ (principal payments + interest payments) (Correct answer)
- Total liabilities ÷ total equity
- Operating income ÷ revenue
Correct answer: EBITDA ÷ (principal payments + interest payments)
DSCR is calculated as EBITDA (or net operating income) divided by total debt service (principal + interest), showing whether earnings can cover debt obligations.
Question 5: A company's income statement shows a net loss, but the cash flow statement shows positive operating cash flow. Which scenario best explains this?
- The company is fraudulently reporting income
- Large non-cash charges such as depreciation and amortization exceed the net loss (Correct answer)
- Revenue is being recognized too early
- Accounts payable decreased significantly
Correct answer: Large non-cash charges such as depreciation and amortization exceed the net loss
High non-cash charges (depreciation, amortization, impairments) can result in a book net loss while actual cash from operations remains positive.
Question 6: In vertical (common-size) analysis of an income statement, each line item is expressed as a percentage of:
- Total assets
- Net income
- Net revenue or net sales (Correct answer)
- Total equity
Correct answer: Net revenue or net sales
In vertical analysis of an income statement, all line items are divided by net sales, allowing comparison of cost and profitability structure across periods or companies.
Question 7: A retailer's inventory days increased from 45 to 90 days. From a credit risk perspective, this is concerning primarily because:
- The company is selling inventory faster than before
- Slow-moving inventory ties up cash and may need to be written down, reducing asset quality (Correct answer)
- Higher inventory levels always reflect stronger sales growth
- The company's accounts payable will automatically decrease
Correct answer: Slow-moving inventory ties up cash and may need to be written down, reducing asset quality
Doubling inventory days suggests inventory is moving slowly, which can lead to write-downs, reduced liquidity, and overstated asset values on the balance sheet.
CCM Financial Statement Analysis 3
A manufacturer's gross profit margin declined from 42% to 31% over three years while revenue grew.
What is the most probable cause?