FIA Financial Statement Interpretation 4 — Questions and Answers
Question 1: Which of the following is classified as a non-cash item that must be added back to net income under the indirect method?
- Increase in inventory
- Depreciation expense (Correct answer)
- Decrease in accounts payable
- Cash dividend paid
Correct answer: Depreciation expense
Depreciation is a non-cash charge deducted in computing net income, so it must be added back when reconciling to operating cash flow.
Question 2: A company's gross margin is 40% and its net profit margin is 5%. The large difference is most likely attributable to:
- Very low cost of goods sold
- High operating expenses, interest, or taxes below the gross profit line (Correct answer)
- Excessive revenue recognition
- Low accounts receivable balances
Correct answer: High operating expenses, interest, or taxes below the gross profit line
The gap between gross margin and net margin reflects operating expenses, interest expense, and income taxes that reduce gross profit to net income.
Question 3: A contingent liability should be recorded on the balance sheet when it is:
- Possible and the amount can be reasonably estimated
- Probable and the amount can be reasonably estimated (Correct answer)
- Remote but disclosed in the notes
- Certain but payment date is unknown
Correct answer: Probable and the amount can be reasonably estimated
Under U.S. GAAP, a contingent liability is recognized when the loss is probable and the amount can be reasonably estimated.
Question 4: Book value per share is calculated as:
- Net income divided by shares outstanding
- Total equity divided by shares outstanding (Correct answer)
- Market capitalization divided by net income
- Total assets divided by shares outstanding
Correct answer: Total equity divided by shares outstanding
Book value per share equals total stockholders' equity divided by the number of common shares outstanding.
Question 5: A high price-to-book (P/B) ratio generally suggests that:
- The market values the company's assets below their accounting value
- Investors expect returns above the cost of equity or anticipate future growth (Correct answer)
- The company has significant tangible assets relative to price
- The company is undervalued by the market
Correct answer: Investors expect returns above the cost of equity or anticipate future growth
A high P/B ratio means investors are willing to pay more than book value, typically because they expect high future profitability or growth.
Question 6: When a company records a write-down of inventory, the immediate effect on the financial statements is:
- Decreased assets and decreased net income (Correct answer)
- Increased assets and increased liabilities
- Decreased liabilities and increased equity
- No effect on net income
Correct answer: Decreased assets and decreased net income
An inventory write-down reduces the inventory asset on the balance sheet and increases cost of goods sold (or loss), reducing net income.
Question 7: What does the cash conversion cycle (CCC) measure?
- The time it takes to convert debt to equity
- The number of days to convert inventory and receivables into cash after paying suppliers (Correct answer)
- The average collection period for long-term assets
- The speed at which a firm repays its bank loans
Correct answer: The number of days to convert inventory and receivables into cash after paying suppliers
The CCC measures the days from paying for inventory to collecting cash from customers: DIO + DSO – DPO.
FIA Financial Statement Interpretation 4
Which of the following is classified as a non-cash item that must be added back to net income under the indirect method?