QFC Financial Statement Analysis 2 — Questions and Answers
Question 1: A company reports operating cash flow of $500M and net income of $200M. The large positive difference is most likely explained by:
- High depreciation and amortization charges (Correct answer)
- Significant increase in accounts receivable
- Large gain on sale of assets
- Increase in inventory levels
Correct answer: High depreciation and amortization charges
Depreciation and amortization are non-cash charges added back in the operating section, creating a positive gap between OCF and net income.
Question 2: Under IFRS, interest paid may be classified in cash flow statements as:
- Only operating activities
- Only financing activities
- Either operating or financing activities (Correct answer)
- Either investing or financing activities
Correct answer: Either operating or financing activities
IFRS allows interest paid to be classified as either operating or financing activities, whereas US GAAP requires it to be operating.
Question 3: A firm's times interest earned (TIE) ratio is 2.5. This means EBIT covers interest expense by:
- 2.5 times (Correct answer)
- 40%
- 250 basis points above cost of debt
- 0.4 times
Correct answer: 2.5 times
TIE = EBIT / Interest Expense, so a ratio of 2.5 means EBIT is 2.5 times the annual interest obligation.
Question 4: Which inventory costing method results in the highest gross profit during a period of rising prices?
- FIFO (Correct answer)
- LIFO
- Weighted average
- Specific identification
Correct answer: FIFO
FIFO assigns older (lower-cost) inventory to COGS during rising prices, leaving higher gross profit compared to LIFO.
Question 5: An analyst is comparing two firms and adjusts Firm B from LIFO to FIFO by adding the LIFO reserve to inventory. This adjustment also requires:
- Increasing retained earnings net of tax by the LIFO reserve (Correct answer)
- Decreasing COGS by the full LIFO reserve
- Reducing the current ratio
- Adding the LIFO reserve to fixed assets
Correct answer: Increasing retained earnings net of tax by the LIFO reserve
The LIFO reserve is added to inventory (asset) and to retained earnings net of applicable taxes to maintain the accounting equation.
Question 6: The DuPont decomposition expresses return on equity as the product of net profit margin, asset turnover, and:
- Financial leverage (equity multiplier) (Correct answer)
- Operating leverage
- Interest coverage ratio
- Dividend payout ratio
Correct answer: Financial leverage (equity multiplier)
The three-factor DuPont model is ROE = Net Profit Margin × Asset Turnover × Equity Multiplier (Assets/Equity).
Question 7: A company capitalizes rather than expenses a $10M development cost. Compared to expensing, this choice will initially:
- Increase net income and total assets (Correct answer)
- Decrease net income and total assets
- Increase expenses and decrease equity
- Have no effect on cash flow from operations
Correct answer: Increase net income and total assets
Capitalizing defers the cost recognition, raising net income in the current period and increasing total assets on the balance sheet.
QFC Financial Statement Analysis 2
A company reports operating cash flow of $500M and net income of $200M.
The large positive difference is most likely explained by: