QFC Financial Statement Analysis 3 — Questions and Answers
Question 1: Which of the following best describes the common-size income statement approach?
- Each line item is expressed as a percentage of net revenue (Correct answer)
- Each line item is indexed to a base year value
- All items are restated to current-year dollars
- Items are ranked by materiality
Correct answer: Each line item is expressed as a percentage of net revenue
A vertical common-size income statement divides each line item by net revenue (or net sales), enabling comparisons across firms of different sizes.
Question 2: An increase in a company's days sales outstanding (DSO) from 30 to 50 days most likely indicates:
- Slower collection of receivables or relaxed credit terms (Correct answer)
- More efficient inventory management
- Faster payment of accounts payable
- Improved operating cash flow
Correct answer: Slower collection of receivables or relaxed credit terms
Rising DSO means customers are taking longer to pay, pointing to slower collections or looser credit policies.
Question 3: Under US GAAP, research costs must be:
- Expensed as incurred (Correct answer)
- Capitalized and amortized over their useful life
- Capitalized only if technological feasibility is established
- Disclosed but not recorded on the income statement
Correct answer: Expensed as incurred
US GAAP requires research costs to be expensed immediately; only certain software development costs may be capitalized after technological feasibility.
Question 4: A firm has total debt of $400M and equity of $600M. Its debt-to-equity ratio and financial leverage (equity multiplier) are, respectively:
- 0.67 and 1.67 (Correct answer)
- 1.50 and 2.50
- 0.67 and 2.67
- 1.50 and 1.67
Correct answer: 0.67 and 1.67
D/E = 400/600 = 0.67; Equity Multiplier = Total Assets/Equity = (400+600)/600 = 1.67.
Question 5: When a lessee uses a finance lease instead of an operating lease, the primary financial statement effect in early years is:
- Higher total expenses and lower net income (Correct answer)
- Lower total expenses and higher net income
- No effect on total assets
- Higher operating cash flows
Correct answer: Higher total expenses and lower net income
Finance leases front-load expense recognition (interest + depreciation > straight-line rent), leading to higher total expenses and lower early-year net income.
Question 6: The quality of earnings is considered high when:
- Earnings are primarily driven by recurring operating activities and are well-supported by cash flows (Correct answer)
- The company aggressively capitalizes expenditures to boost earnings
- Net income significantly exceeds free cash flow to equity
- The firm frequently changes accounting estimates
Correct answer: Earnings are primarily driven by recurring operating activities and are well-supported by cash flows
High-quality earnings come from sustainable core operations and are validated by strong operating cash flow alignment.
Question 7: A firm's gross margin declined from 45% to 38% over three years. This most likely indicates:
- Rising cost of goods sold relative to revenue, or pricing pressure (Correct answer)
- Improved operational efficiency
- Increase in interest expense
- Higher income tax rate
Correct answer: Rising cost of goods sold relative to revenue, or pricing pressure
A declining gross margin signals that COGS is growing faster than revenue, which reflects either cost inflation or competitive pricing pressure.
QFC Financial Statement Analysis 3
Which of the following best describes the common-size income statement approach?