FIA Financial Statement Interpretation 3 — Questions and Answers
Question 1: A company uses LIFO inventory accounting during a period of rising prices. Compared to FIFO, its reported gross profit will be:
- Higher, because older lower-cost inventory is expensed
- Lower, because newer higher-cost inventory is expensed first (Correct answer)
- The same, because total inventory costs are identical
- Higher, because inventory turnover increases under LIFO
Correct answer: Lower, because newer higher-cost inventory is expensed first
Under LIFO during rising prices, the most recently purchased (higher-cost) items are expensed first, raising COGS and reducing gross profit relative to FIFO.
Question 2: What does a negative working capital typically signal about a company?
- The company has more long-term assets than liabilities
- Current liabilities exceed current assets, suggesting potential liquidity stress (Correct answer)
- The company is highly profitable
- The company has no debt obligations
Correct answer: Current liabilities exceed current assets, suggesting potential liquidity stress
Negative working capital means current liabilities exceed current assets, which can indicate difficulty meeting short-term obligations.
Question 3: An analyst notices that a company's revenue grew 20% while accounts receivable grew 40%. What risk does this signal?
- Improved collections efficiency
- Potential revenue recognition issues or loosening credit standards (Correct answer)
- Decreased cost of goods sold
- Strong customer demand with rapid payment
Correct answer: Potential revenue recognition issues or loosening credit standards
Receivables growing faster than revenue may indicate that sales include uncollectible amounts or that credit terms have been loosened to inflate reported revenue.
Question 4: Which ratio measures how efficiently a company uses its assets to generate sales?
- Return on equity
- Asset turnover ratio (Correct answer)
- Current ratio
- Interest coverage ratio
Correct answer: Asset turnover ratio
The asset turnover ratio (Revenue ÷ Total Assets) measures how effectively a company generates revenue from its asset base.
Question 5: Under U.S. GAAP, research costs are generally:
- Capitalized and amortized over their useful life
- Expensed as incurred (Correct answer)
- Recognized as intangible assets on the balance sheet
- Deferred until the related product is sold
Correct answer: Expensed as incurred
U.S. GAAP requires research costs to be expensed as incurred because future benefits are too uncertain to capitalize.
Question 6: A firm's times interest earned (interest coverage) ratio falls from 8x to 1.5x. What does this indicate?
- The firm's ability to service interest has significantly deteriorated (Correct answer)
- The firm reduced its long-term debt substantially
- Operating income improved relative to interest expense
- The firm issued new equity to retire debt
Correct answer: The firm's ability to service interest has significantly deteriorated
A sharp drop in the interest coverage ratio signals that earnings before interest and taxes are barely covering interest expense, raising default risk.
Question 7: In vertical (common-size) analysis of an income statement, each line item is expressed as a percentage of:
- Total assets
- Net income
- Net revenues or sales (Correct answer)
- Shareholders' equity
Correct answer: Net revenues or sales
In a common-size income statement, each line item is divided by net revenues (net sales) to show its proportional contribution.
FIA Financial Statement Interpretation 3
A company uses LIFO inventory accounting during a period of rising prices.
Compared to FIFO, its reported gross profit will be: