IAR Financial Analysis & Reporting 3 — Questions and Answers
Question 1: Which of the following is a non-cash charge that reduces net income but does not affect operating cash flow when using the indirect method?
- Depreciation expense (Correct answer)
- Interest expense
- Income tax expense
- Cost of goods sold
Correct answer: Depreciation expense
Depreciation is added back to net income under the indirect method because it reduces income without involving any cash outflow.
Question 2: A company's quick ratio is 0.6. This most likely means the company:
- May struggle to meet short-term obligations without selling inventory (Correct answer)
- Has excessive cash on its balance sheet
- Is highly profitable relative to its peers
- Has a very low level of current liabilities
Correct answer: May struggle to meet short-term obligations without selling inventory
A quick ratio below 1.0 means liquid assets (cash, receivables) are insufficient to cover current liabilities without liquidating inventory.
Question 3: When a company uses the equity method to account for an investment, it records:
- Its proportionate share of the investee's net income as investment income (Correct answer)
- Only dividends received as revenue
- The investment at fair market value each reporting period
- The full consolidation of the investee's assets and liabilities
Correct answer: Its proportionate share of the investee's net income as investment income
Under the equity method, the investor recognizes its pro-rata share of the investee's earnings, increasing the investment account, and reduces it when dividends are received.
Question 4: Goodwill on a balance sheet arises when:
- An acquirer pays more than the fair value of identifiable net assets of an acquired company (Correct answer)
- A company internally develops a strong brand over many years
- Intangible assets are amortized below their book value
- A company records a write-down of its tangible assets
Correct answer: An acquirer pays more than the fair value of identifiable net assets of an acquired company
Goodwill is recorded in a business combination as the excess of purchase price over the fair value of identifiable assets acquired minus liabilities assumed.
Question 5: Which financial statement analysis technique expresses each line item as a percentage of a base figure within the same period?
- Common-size analysis (Correct answer)
- Trend analysis
- Ratio analysis
- DuPont decomposition
Correct answer: Common-size analysis
Common-size analysis normalizes financials (e.g., income statement items as % of revenue) to enable meaningful comparisons across companies or time periods.
Question 6: An investment adviser is reviewing a client's bond portfolio. Which measure best captures interest rate risk for a bond with embedded options?
- Effective duration (Correct answer)
- Macaulay duration
- Modified duration
- Convexity alone
Correct answer: Effective duration
Effective duration accounts for changes in cash flows due to embedded options (calls, puts) when interest rates change, making it superior for option-embedded bonds.
Question 7: Under the DuPont framework, return on equity (ROE) is decomposed into which three components?
- Net profit margin, asset turnover, and financial leverage (Correct answer)
- Gross margin, operating margin, and net margin
- Current ratio, quick ratio, and cash ratio
- Revenue growth, cost control, and dividend payout
Correct answer: Net profit margin, asset turnover, and financial leverage
The three-factor DuPont formula is ROE = Net Profit Margin × Asset Turnover × Equity Multiplier (financial leverage).
IAR Financial Analysis & Reporting 3
Which of the following is a non-cash charge that reduces net income but does not affect operating cash flow when using the indirect method?