D366 Financial Statement Analysis - Set 5 - Part 1

Correct Answer: An investing activity

Purchasing equipment is an investing activity because it involves acquiring a long-term asset. Investing activities include buying and selling property, plant, equipment, and investments.

Correct Answer: Net income

The indirect method begins with net income and adjusts it for non-cash items and changes in working capital to arrive at cash flow from operating activities.

Correct Answer: Depreciation and amortization

Depreciation and amortization are non-cash expenses that reduced net income but did not use cash, so they are added back to net income when computing operating cash flow under the indirect method.

Correct Answer: Capital expenditures

Free cash flow equals cash flow from operations minus capital expenditures. It represents the cash available to repay debt, pay dividends, or reinvest after maintaining the asset base.

Correct Answer: Total revenue (sales)

In a common-size income statement, each item is shown as a percentage of total revenue, allowing comparison of cost and profit structures across periods or between companies of different sizes.

Correct Answer: Total assets

In a common-size balance sheet, each line is expressed as a percentage of total assets, making it easier to compare the composition of assets, liabilities, and equity across firms or over time.

Correct Answer: Comparing amounts across multiple periods

Horizontal analysis compares financial statement figures across two or more periods, often showing dollar and percentage changes, to identify trends and growth patterns over time.

Correct Answer: Higher cost of goods sold and lower reported profit

When prices rise, LIFO assigns the most recent, higher costs to cost of goods sold, increasing COGS and lowering reported profit and taxable income, while leaving older, lower costs in ending inventory.

Correct Answer: An equal amount of depreciation to each period of the asset's life

Straight-line depreciation spreads the depreciable cost evenly over the asset's useful life, charging the same amount of depreciation expense each period.

Correct Answer: More depreciation expense in the early years of an asset's life

Double-declining balance is an accelerated method that records higher depreciation in the early years and less later, reflecting assets that lose more value or are more productive when new.

Correct Answer: Market price per share divided by earnings per share

The P/E ratio equals the market price per share divided by earnings per share. It indicates how much investors are willing to pay for each dollar of earnings and reflects growth expectations.

Correct Answer: Investing in long-term assets for future growth

Negative investing cash flow usually means the company is spending cash to acquire long-term assets, such as property or equipment, which is often a sign of expansion and future growth rather than a problem.

Correct Answer: Book value of equity

The price-to-book ratio equals market price per share divided by book value per share. It compares the market's valuation of a company to its accounting net worth (equity).

Correct Answer: Supported by strong operating cash flows

High-quality earnings are backed by strong, sustainable operating cash flows rather than one-time gains or aggressive accounting. A persistent gap where income exceeds cash flow can signal lower earnings quality.

Correct Answer: A financing activity

Issuing common stock raises capital from owners and is a financing activity. Financing activities include transactions with lenders and shareholders, such as issuing stock or debt and paying dividends.

Correct Answer: Different accounting methods can make comparisons across firms less reliable

Ratio analysis can be distorted when companies use different accounting methods (for example, LIFO versus FIFO), making cross-company comparisons less reliable without adjustments. Ratios also reflect the past, not guarantees of the future.

Correct Answer: Dividends divided by net income

The dividend payout ratio equals dividends divided by net income, showing the proportion of earnings distributed to shareholders. The remainder is retained for reinvestment in the business.

Correct Answer: Acquiring an asset by issuing stock or debt directly to the seller

Significant non-cash transactions, such as acquiring an asset by directly issuing stock or a note to the seller, do not appear in the main cash flow statement but must be disclosed separately because they affect future cash flows.

Correct Answer: Assess relative performance and identify areas of strength or weakness

Benchmarking compares a company's ratios to industry averages or competitors, helping analysts gauge relative performance and spot areas where the company outperforms or lags its peers.

Correct Answer: Significant non-cash expenses like depreciation

Operating cash flow above net income often reflects large non-cash charges such as depreciation being added back, which is common for capital-intensive firms and generally indicates healthy cash generation.