FAC Financial Statement Analysis 3 — Questions and Answers
Question 1: Which of the following is an example of a non-cash item that must be added back to net income in the indirect method cash flow statement?
- Increase in accounts payable
- Depreciation expense (Correct answer)
- Decrease in inventory
- Cash dividends paid
Correct answer: Depreciation expense
Depreciation is a non-cash charge deducted on the income statement, so it is added back to net income when reconciling to operating cash flow.
Question 2: A company's times interest earned (interest coverage) ratio declined from 8x to 3x over two years. This trend most likely signals:
- Improved debt management
- Deteriorating ability to service interest obligations from operating earnings (Correct answer)
- A reduction in the company's interest expense
- Higher profitability relative to assets
Correct answer: Deteriorating ability to service interest obligations from operating earnings
A falling interest coverage ratio means EBIT is shrinking relative to interest expense, indicating greater risk of being unable to meet debt service obligations.
Question 3: Which financial metric is most useful for comparing operating profitability across companies with different capital structures?
- Net profit margin
- Return on equity
- EBITDA margin (Correct answer)
- Earnings per share
Correct answer: EBITDA margin
EBITDA margin strips out interest (capital structure) and taxes, making it useful for comparing operating performance across firms with varying leverage.
Question 4: A high accounts payable turnover ratio compared to industry peers most likely indicates a company:
- Is taking longer to pay its suppliers
- Is paying its suppliers more quickly than peers (Correct answer)
- Has excessive inventory on hand
- Is collecting receivables slowly
Correct answer: Is paying its suppliers more quickly than peers
A high payables turnover ratio means the company pays suppliers frequently (quickly), which may reduce its days payable outstanding.
Question 5: Which section of the cash flow statement would reflect the proceeds from selling a building?
- Operating activities
- Investing activities (Correct answer)
- Financing activities
- Supplemental disclosures
Correct answer: Investing activities
Proceeds from selling long-term assets such as buildings are classified as investing cash inflows.
Question 6: If a firm's debt-to-equity ratio is 1.5, how much debt does it carry for every dollar of equity?
- $0.67
- $1.00
- $1.50 (Correct answer)
- $2.50
Correct answer: $1.50
A debt-to-equity ratio of 1.5 means $1.50 of debt for every $1.00 of equity.
Question 7: Vertical analysis of a balance sheet expresses each asset and liability as a percentage of:
- Net revenues
- Shareholders' equity
- Total assets (Correct answer)
- Long-term debt
Correct answer: Total assets
In vertical analysis of the balance sheet, each item is expressed as a percentage of total assets, facilitating cross-company and cross-period comparison.
FAC Financial Statement Analysis 3
Which of the following is an example of a non-cash item that must be added back to net income in the indirect method cash flow statement?