FIA Financial Statement Interpretation 2 — Questions and Answers
Question 1: A company's current ratio decreased from 2.5 to 1.2 over one year while its quick ratio remained stable at 1.1. What does this most likely indicate?
- Significant build-up of inventory (Correct answer)
- Improvement in short-term liquidity
- Decrease in accounts payable
- Reduction in long-term debt
Correct answer: Significant build-up of inventory
When the current ratio falls sharply but the quick ratio (which excludes inventory) stays stable, the gap indicates a significant increase in inventory holdings.
Question 2: Which section of the cash flow statement would reflect the proceeds from selling a manufacturing plant?
- Operating activities
- Investing activities (Correct answer)
- Financing activities
- Non-cash supplemental disclosures
Correct answer: Investing activities
Proceeds from the sale of long-term assets such as property, plant, and equipment are reported under investing activities.
Question 3: A firm reports net income of $500,000 but operating cash flow of only $50,000. Which scenario best explains this discrepancy?
- The firm paid large dividends to shareholders
- The firm has high non-cash revenues and rising receivables (Correct answer)
- The firm repurchased significant amounts of stock
- The firm issued new long-term bonds
Correct answer: The firm has high non-cash revenues and rising receivables
High non-cash revenues (e.g., recognized but uncollected) and rising receivables cause net income to exceed cash from operations.
Question 4: Under the indirect method of preparing the cash flow statement, an increase in accounts payable is:
- Subtracted from net income
- Added to net income (Correct answer)
- Reported under investing activities
- Reported under financing activities
Correct answer: Added to net income
An increase in accounts payable means the company delayed cash payments, preserving cash, so it is added back to net income in operating activities.
Question 5: Return on Equity (ROE) can be decomposed using the DuPont formula into which three components?
- Gross margin × asset turnover × leverage
- Net profit margin × asset turnover × equity multiplier (Correct answer)
- Operating margin × inventory turnover × debt ratio
- EBIT margin × total asset ratio × interest coverage
Correct answer: Net profit margin × asset turnover × equity multiplier
The DuPont decomposition breaks ROE into net profit margin (profitability), asset turnover (efficiency), and the equity multiplier (financial leverage).
Question 6: A company's debt-to-equity ratio rises from 0.4 to 1.8 in one year with no change in equity. What is the most direct implication?
- The company significantly increased its borrowing (Correct answer)
- The company repurchased substantial equity
- Net income increased sharply
- Operating expenses decreased
Correct answer: The company significantly increased its borrowing
A large increase in the debt-to-equity ratio with stable equity means total debt rose substantially, indicating significant new borrowing.
Question 7: Which financial statement best reveals whether a profitable company can meet its upcoming debt obligations?
- Income statement
- Balance sheet
- Statement of cash flows (Correct answer)
- Statement of changes in equity
Correct answer: Statement of cash flows
The statement of cash flows shows actual liquidity and cash generation, which determines the ability to service debt regardless of reported profit.
FIA Financial Statement Interpretation 2
A company's current ratio decreased from 2.5 to 1.2 over one year while its quick ratio remained stable at 1.1.
What does this most likely indicate?