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Study Session 8 Sample Questions Investment Tools Financial Statement Analysis Financial Ratios and Earnings per Share Analysis of Financial Statements 1.

Internal liquidity or solvency ratios indicate the ability of the firm to: A. B. C. D.

meet future short term financial obligations meet future long term financial obligations settle current debt with fixed assets settle future short term debt with fixed assets

Answer A. Internal liquidity and solvency ratios Internal liquidity or solvency ratios indicate the ability of the firm to meet future short term financial obligations. Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1b

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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The return on owner’s equity ratio indicates: A. B. C. D.

the rate of return that management has earned on the capital provided by the owner after accounting for payments to all other capital suppliers how management uses its assets and capital, measured in terms of the sales generated by various assets or capital categories the rate of return that management has earned on the capital provided by the owner after accounting for payments to all other capital suppliers the rate of return that management has earned on the capital provided by the owner before accounting for payments to all other capital suppliers

Answer B. The return on owner’s equity ratio The return on owner’s equity ratio indicates how management uses its assets and capital, measured in terms of the sales generated by various assets or capital categories. Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Three companies had the following results during the recent period. Net profit margin Total asset turnover Total assets/equity

A 0.03 2.4

B 0.05 2.2

C 0.08 1.8

2.6

2.4

2.0

The ROE for company B is equal to: A. B. C. D.

5.280 0.264 0.110 0.120

Answer B. Calculating ROE The ROE for company B is equal to 0.264 ROE = Total asset turnover x Total assets/equity x Net profit margin ROE = 2.2 x 2.4 x 0.05 = 0.264 Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Consider a jewellery store and a grocery store. How would they differ in terms of asset turnover and profit margin as well as return on total assets assuming equal business risk? A. Asset turnover Profit margin ROE

Jewelry store Low High Equal

Grocery Store High Low Equal

Jewelry store High High Equal

Grocery Store Low Low Equal

Jewelry store Low Low Equal

Grocery Store High High Equal

Jewelry store Low High High

Grocery Store High Low Low

B. Asset turnover Profit margin ROE

C. Asset turnover Profit margin ROE

D. Asset turnover Profit margin ROE

Answer A.

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Ratios and different industries Consider a jewellery store and a grocery store. They differ in terms of asset turnover and profit margin as well as return on total assets assuming equal business risk as follows: Asset turnover Profit margin ROE

Jewelry store Low High Equal

Grocery Store High Low Equal

Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c Use the following information in answering Questions 5 and 6 5.

Given the following information for three companies: Net profit margin Total asset turnover Total assets/equity Earnings/share Dividends/share

A 0.03

B 0.05

C 0.08

2.4

2.2

1.8

2.6

2.4

2.0

2.78 1.67

3.30 1.5

4.9 1.2

The growth rate for company A is: A. B. C. D.

18.7% 27.8% 6.7% 7.5%

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Answer D. Calculating growth rate The growth rate for company A is 7.5% ROE = Total asset turnover x Total assets / equity x Net profit margin ROE = 2.4 x 2.6 x 0.03 = 0.187 Growth rate = (1 - Payout ratio) x ROE 



Dividends per share  Growth rate = 1 − × ROE Earning per share   Growth rate = (1-1.67/2.78) x 0.187 = 0.075 Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

6.

The growth rate for company B is: A. B. C. D.

26.4% 24% 14.4% 22%

Answer C.

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Calculating growth rate The growth rate for company B is 14.4% ROE = Total asset turnover x Total assets/equity x Net profit margin ROE = 2.2 x 2.4 x 0.05 = 0.264 Growth rate = (1-1.5/3.3) x 0.264 = 0.144 Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

Use the following information in answering Questions 7 and 8 Given the following data: 20X2

19X8

1,626 114 9 9 96 39 57

2,937 228 27 0 201 111 90

123 735 369 48 477

210 873 471 0 660

INCOME STATEMENT DATA Revenues Operating income Depreciation and amortization Interest expense Pretax income Income taxes Net income after tax BALANCE SHEET DATA Fixed assets Total assets Working capital Total debt Total shareholders’ equity Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Using the DuPont formula, calculate the asset turnover for 20X2: A. B. C. D.

0.298x 4.23x 3.36x 0.98x

Answer C.

Asset turnover and the DuPont formula Using the DuPont formula, the asset turnover for 20X2 is 3.36x Asset turnover =

Sales 2,937 = = 3.36x Total assets 873

Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

8.

Using the DuPont formula, calculate the interest burden for 20X2: A. B. C. D.

1% 2% 3% 0%

Answer D.

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Interest burden and the DuPont formula Using the DuPont formula, the interest burden for 20X2 is 0% Interest burden =

Interest expense 0 = = 0% Total assets 873

Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Analysis of Financial Statements, LOS 1c

2.

Dilutive Securities and Earnings Per Share

1.

When stock dividends or stock splits occur, which of the following statements describes the effect, if any, on the weighted average number of shares outstanding? A. B. C. D.

The computation of the weighted average number of shares outstanding does not require restatement of the shares outstanding before the stock dividend or split. The computation of the weighted average number of shares outstanding requires restatement of the shares outstanding after the stock dividend or split. The computation of the weighted average number of shares outstanding requires restatement of the shares outstanding before the stock dividend but after the stock split. The computation of the weighted average number of shares outstanding requires restatement of the shares outstanding before the stock dividend or split.

Answer D.

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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The effect on the weighted average number of shares outstanding with stock dividends and stock splits When stock dividends or stock splits occur, the computation of the weighted average number of shares outstanding requires restatement of the shares outstanding before the stock dividend or split. Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2d

2.

Consider the following information relating to Bex Company, whose yearend is December 31. Income before extraordinary item Extraordinary gain, net of tax Preference dividends declared $4 on 100,000 shares

2,320,000 960,000

The changes in common stock during 20X2 is as follows: Dates

Share changes

January 1 May 1

Beginning balance Purchased 120,000 treasury shares

July 1

1,200,000 additional shares (3 for 1 stock split)

December 31 December 31

Shares outstanding

Issued 200,000 shares for cash Ending balance

Study Session 8 Sample Questions

720,000 120,000 600,000 1,200,000 1,800,000 200,000 2000,000

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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The earnings per share for income before extraordinary items for Bex Company for the year ended December 31 is: A. B. C. D.

$1.208 $1.50 $0.50 $1.00

Answer D.

Calculating earnings per share The earnings per share for income before extraordinary items for Bex Company for the year ended December 31 is $1.00. Weighted shares: Dates outstanding

Shares outstanding (A) Jan.1 – May 720,000 1 May 1 – 600,000 Dec. 31 Weighted

Restatement Fraction of year (C) (B) 3

4/12

Weighted shares (A x B x C) 720,000

3

8/12

1,200,000 1,920,000

Income available to common stockholders Income before extraordinary item Pref div (100 000 x 4) Income Extraordinary gain, net of tax Income available to common stockholders

Study Session 8 Sample Questions

2,320,000 400,000 1,920,000 960,000 2,880,000

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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EPS calculation Income (A) Income before 1,920,000 extraordinary item Extraordinary 960,000 item Income available 2,880,000

Weighted shares (B) 1,920,000

EPS (C)

1,920,000

0.5

1.920,000

1.5

1.00

Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2d

Use the following information in answering Questions 3 and 4 Consider the following information relating to Brittany Corporation. Net income for the year Weighted average shares outstanding

420,000 200,000

The company has two convertible debenture bond issues outstanding as follows: 6% issue sold at 100 (total $2,000,000) in a prior year and convertible into 40,000 common shares. 10% issue sold at 100 (total $2,000,000) on 1 April of the current year and convertible into 64,000 common shares. The tax rate is 40%. The year-end is December 31.

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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The basic earnings per share for the year-ended December 31 is: A. B. C. D.

$2.02 $2.46 $2.10 $2.55

Answer C.

Calculating basic earnings per share and convertibles The basic earnings per share for the year-ended December 31 is $2.10 Net income for the year Add: adjustment for interest (net of tax) 6% debentures (2,000,000 x 6%) x (0.6) 10% debentures (2,000,000 x 10% x 9/12 x 0.6) Adjusted net income Weighted average number of shares outstanding Add: Shares assumed to be issued: 6% debentures 10% debentures (9/12 x 64,000) Weighted average number of shares adjusted for dilutive securities

420,000 72,000 90,000 582,000 200,000 40,000 48,000 288,000

Basic earnings per share = 420,000/200,000 = $2.10 Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2f

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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The diluted earnings per share for the year-ended December 31 is: A. B. C. D.

$2.10 $2.46 $2.55 $2.02

Answer D.

Calculating diluted earnings per share with convertibles The diluted earnings per share for the year-ended December 31 is $2.02 Net income for the year Add: adjustment for interest (net of tax) 6% debentures (2,000,000 x 6%) x (0.6) 10% debentures (2,000,000 x 10% x 9/12 x 0.6) Adjusted net income Weighted average number of shares outstanding Add: Shares assumed to be issued: 6% debentures 10% debentures (9/12 x 64,000) Weighted average number of shares adjusted for dilutive securities

420,000 72,000 90,000 582,000 200,000 40,000 48,000 288,000

Diluted earnings per share = 582,000/288,000 = $2.02 Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2g

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Under what condition(s) is/are convertible securities considered to be dilutive securities? A. B. C. D.

whenever interest per share obtainable on conversion is more than the EPS amount computed without assuming conversion whenever interest per share obtainable on conversion is less than the EPS amount computed assuming conversion whenever interest per share obtainable on conversion is less than the EPS amount computed without assuming conversion whenever interest per share obtainable on conversion is more than the EPS amount computed assuming conversion

Answer C.

Dilutive securities and convertible securities Convertible securities are considered to be dilutive securities whenever interest per share obtainable on conversion is less than the EPS amount computed without assuming conversion. Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2e

6.

Potential common stock can be described as: A. B. C. D.

common stock in form not common stock in form but with voting powers of common stock stock that has the potential to be common stock not common stock in form but enabling holders to obtain common stock upon exercise or conversion

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Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share

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Answer D.

Potential common stock Potential common stock can be described as not common stock in form but they enable holders to obtain common stock upon exercise or conversion. Reference Investment Analysis and Portfolio Management, 6th edition, Frank K. Reilly and Keith C. Brown (Dryden, 2000) Study Session 8 2003, Dilutive Securities and Earnings per Share, LOS 2a

Study Session 8 Sample Questions

Investment Tools, Financial Statement Analysis Financial Ratios and Earnings per Share