# Buổi 9 - FRA - Reading 24: Financial Analysis Techniques & Reading 25: Inventories

READING 24: FINANCIAL ANALYSIS TECHNIQUES

LOS 24.b: Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios.

Question 24.1: A company has a cash conversion cycle of 80 days. If the company's average receivables turnover increases from 11 to 12, the company's cash conversion cycle:
A) decreases by approximately 3 days.
B) increases by approximately 3 days.
C) decreases by approximately 1 day.
Explanation
A is correct.
Step 1: Understand the question and identify the right formula
Cash conversion cycle (CCC) = days of sales outstanding + days of inventory on hand – number of days of payables.
Step 2: Calculate effects from changes in average receivables turnover
Days of sales outstanding = 365 / receivables turnover = 365 / 11 = 33.18; 365 / 12 = 30.42.
Step 3: Conclusion
This means the CCC decreases by 2.76 days.

Question 24.2: Books Forever, Inc., uses short-term bank debt to buy inventory. Assuming an initial current ratio that is greater than 1, and an initial quick (or acid test) ratio that is less than 1, what is the effect of these transactions on the current ratio and the quick ratio?
A) Both ratios will decrease.
B) Neither ratio will decrease.
C) Only one ratio will decrease.
Explanation
A is correct. On a horizontal common-size balance sheet, the divisor is the first-year values so they are all standardized to 1.0 by construction. Trends in the values of these items as well as the relative growth in these items are readily apparent. A vertical common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and does not standardize the initial year.

LOS 24.a: Describe tools and techniques used in financial analysis, including their uses and limitations
Question 24.3: The presentation format of balance sheet data that standardizes the first-year values to 1.0 and presents subsequent years' amounts relative to 1.0 is:
A) an indexed balance sheet.
B) a vertical common-size balance sheet.
C) a horizontal common-size balance sheet.
Explanation
C is correct. On a horizontal common-size balance sheet, the divisor is the first-year values so they are all standardized to 1.0 by construction. Trends in the values of these items as well as the relative growth in these items are readily apparent. A vertical common-size balance sheet expresses all balance sheet accounts as a percentage of total assets and does not standardize the initial year.
Schweser note:
Another way to present financial statement data that is quite useful when analyzing trends over time is a horizontal common-size balance sheet or income statement. The divisor here is the first-year values, so they are all standardized to 1.0 by construction

LOS 24.d: Demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components.
Question 24.4: The following data pertains to a company's common-size financial statements.
Current assets                          40%
Total debt                                  40%
Net income                               16%
Total assets                          \$2,000
Sales                                    \$1,500
Total asset turnover ratio         0.75
The firm has no preferred stock in its capital structure.
The company's after-tax return on common equity is closest to:
A) 15%.
B) 20%.
C) 25%.
Explanation
ROE = net income/equity = 0.16 x 1500/(1-0.4) x 2000 = 0.20

Question 24.5: Al Pike, CFA, is analyzing Red Company by projecting pro forma financial statements. Pike expects Red to generate sales of \$3 billion and a return on equity of 15% in the next year. Pike forecasts that Red's total assets will be \$5 billion and that the company will maintain its financial leverage ratio of 2.5. Based on these forecasts, Pike should project Red's net income to be:
A) \$100 million.
B) \$300 million.
C) \$500 million.
Explanation
B is correct
Step 1: Use Dupont technique to intepret ROE:
ROE = (net income / revenues) × (revenues / total assets) × (total assets / total equity).
=> 0.15 = (net income/ \$3 billion) × (\$3 billion / \$5 billion) × 2.5
=> net income/ \$3 billion = 0.1
Step 2: Calculate net income
Net income = \$3 billion x 0.1 = \$300 million

LOS 24.e: Calculate and interpret ratios used in equity analysis and credit analysis.
Question 24.6: An analysis of the industry reveals that firms have been paying out 45% of their earnings in dividends, asset turnover = 1.2; asset-to-equity (A/E) = 1.1 and profit margins are 8%. What is the industry's projected growth rate?
A) 4.95%.
B) 5.81%.
C) 4.55%.
Explanation
B is correct.
Step 1: Understand the question and find the right formula
g = Retention rate x ROE
retention rate = 1 - 45% = 55%
Step 2: Use Dupont technique to calculate ROE
ROE = profit margin × asset turnover × A/E = 0.08 × 1.2 × 1.1 = 0.1056
Step 3: Calculate growth rate
g = Retention rate x ROE = 0.55 x 0.1056 = 0.0581

LOS 24.g: Describe how ratio analysis and other techniques can be used to model and forecast earnings.

Question 24.7: A company must report separate financial information for any segment of their business which:
A) is located in a country other than the firm’s home country.
B) is more than 20% of a firm’s revenues.
C) accounts for more than 10% of the firm’s assets and has risk and return characteristics distinguishable from the company’s other lines of business.
Explanation
C is correct. Financial statement items must be reported separately for any segment of a rm's business that is greater than 10% of revenue or assets and has risk and return characteristics that are distinguishable from those of the company's other lines of business. Requirements for reporting of geographic segments have the same size threshold and the segment must operate in a business environment that is different from that of the firm's other segments.

LOS 25.a: distinguish between costs included in inventories and costs recognised as expenses in the period in which they are incurred.
Question 25.1:
Diabelli Inc. is a manufacturing company that is operating at normal capacity levels. Which of the following inventory costs is most likely to be recognized as an expense on Diabelli's financial statements when the inventory is sold?

B) Selling cost.
C) Allocation of fixed production overhead

Explanation
C is correct. Assuming normal capacity levels, allocation of fixed production overhead is a product cost that is capitalized as part of inventory. Thus, this cost will not be recognized as an expense until the inventory is sold (it becomes part of COGS for that period). Administrative overhead and selling costs are period costs that must be expensed in the period incurred.

Schweser note:
The costs included in inventory are similar under IFRS and U.S. GAAP. These costs, known
as product costs, are capitalized in the Inventories account on the balance sheet and include:
1. Purchase cost less trade discounts and rebates.
2. Conversion (manufacturing) costs including labor and overhead.
3. Other costs necessary to bring the inventory to its present location and condition.
Not all inventory costs are capitalized; some costs are expensed in the period incurred. These
costs, known as period costs, include:
1. Abnormal waste of materials, labor, or overhead.
2. Storage costs (unless required as part of production).
4. Selling costs

LOS 25.b: Describe different inventory valuation methods (cost formulas).
Question 25.2: During a period of falling costs of manufacturing, which of the following inventory cost formulas would result in the greatest reported net income?
A) LIFO.
B) FIFO.
C) Average cost
Explanation
A is correct. With LIFO, more recent, lower costs would be used for COGS. A reduction in COGS will increase gross profits and net income, other things equal.

LOS 25.c: Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems.
Question 25.3: A firm uses the first-in first-out (FIFO) cost flow assumption. Compared to gross profit with a periodic inventory system, the firm's gross profit with a perpetual inventory system would be:
A) lower.
B) higher.
C) the same.
Explanation
C is correct. For a firm using FIFO, gross profit is the same whether the firm uses a periodic or perpetual inventory system. For a firm using LIFO or average cost, gross profit can be different depending on the choice of inventory system.
Schweser note:
In a periodic inventory system, inventory values and COGS are determined at the end of the accounting period.
In a perpetual inventory system, inventory values and COGS are updated continuously.
Inventory purchased and sold is recorded directly in inventory when the transactions occur.
Thus, a Purchases account is not necessary

LOS 25.d: Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods
Question 25.4: From the point of view of a financial analyst, when evaluating companies that use different inventory cost assumptions, in a period of:
A) stable prices, LIFO inventory is preferred to FIFO inventory.
B) decreasing prices, FIFO inventory is preferred to LIFO inventory.
C) increasing prices, FIFO cost of sales is preferred to LIFO cost of sales.
Explanation
B is correct. The most useful estimates of inventory and cost of sales are those that best approximate current cost. Whether prices are increasing or decreasing, FIFO provides a better estimate of inventory values, and LIFO provides a better estimate of cost of sales. If prices are stable, there is no difference between LIFO and FIFO estimates of inventory or cost of sales.
Schweser note:
During deflationary periods and stable or increasing inventory quantities, the cost flow effects
of using LIFO and FIFO will be reversed; that is, LIFO COGS will be lower and LIFO
ending inventory will be higher. This makes sense because the most recent lower-cost
purchases are assumed to be sold first under LIFO, and the units in ending inventory are
assumed to be the earliest purchases with higher costs.

LOS 25.f: Convert a company’s reported financial statements from LIFO to FIFO for purposes of comparison
Question 25.5: A company using LIFO reports the following:
Cost of goods sold was                                                               \$27,000.
Beginning inventory was \$6,500, and ending inventory was        \$6,200.
The beginning LIFO reserve was                                                  \$1,200.
The ending LIFO reserve was                                                       \$1,400.
The best estimate of the company's cost of goods sold on a FIFO basis would be:
A) \$21,300.
B) \$26,800.
C) \$27,500.
Explanation
B is correct.
Step 1: Understand the question and find the right formula
COGS FIFO = COGS LIFO − (ending LIFO reserve − beginning LIFO reserve)
Step 2: Calculate COGS FIFO
COGS FIFO = 27,000 − (1,400 − 1,200) = \$26,800.

Question 25.6: A firm ended the last period with inventory of \$4.0 million and a LIFO reserve of \$175,000. During the year, it made purchases of \$2.0 million and reported sales of \$5.5 million with a gross margin of 0.32. At the end of the year, it reported a LIFO reserve of \$75,000. What is the value of the firm's cost of goods sold on a FIFO basis?
A) \$3,640,000.
B) \$3,740,000.
C) \$3,840,000.
Explanation
C is correct.
Step 1: Understand the question and find the right formula
FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve)
Step 2: Calculate LIFO COGS
LIFO COGS = \$5.5 million × (1 − 0.32) = \$3.74 million
Step 3: Calculate FIFO COGS
FIFO COGS = \$3,740,000 − (\$75,000 − \$175,000) = \$3,840,000

LOS 25.g: Describe the measurement of inventory at the lower of cost and net realisable value
Question 25.7: Rowlin Corporation, which reports under IFRS, wrote down its inventory of electronic parts last period from its original cost of €28,000 to net realizable value of €25,000. This period, inventory at net realizable value has increased to €30,000. Rowlin should revalue this inventory to:
A) €28,000, and report a gain of €3,000 on the income statement.
B) €30,000, and report a gain of €3,000 on the income statement.
C) €30,000, and report a gain of €5,000 on the income statement.
Explanation
A is correct. Under IFRS, inventory values are revalued upward only to the extent they were previously written down. In this case, that is from €25,000 back up to the original value of €28,000. The increase is reported as gain for the period.
Schweser note:
Net realizable value (NRV) is equal to the expected sales price less the estimated selling costs and completion costs. If net realizable value is less than the balance sheet value of inventory, the inventory is “written down” to net realizable value and the loss is recognized in the income statement. If there is a subsequent recovery in value, the inventory can be “written up” and the gain is recognized in the income statement by reducing COGS by the amount of the recovery.

LOS 25.k: Calculate and compare ratios of companies, including companies that use different inventory methods & LOS 25.l: Analyze and compare the financial statements of companies, including companies that use different inventory methods
Question 25.8: In periods of rising prices and stable or increasing inventory quantities, compared with companies that use LIFO inventory accounting, companies that use the FIFO method will have:
A) higher COGS and lower taxes.
B) higher net income and higher taxes.
C) lower inventory balances and lower working capital.
Explanation
B is correct. FIFO companies have higher net income, lower COGS, higher inventory, and higher taxes.

LOS 25.j: Explain issues that analysts should consider when examining a company’s inventory disclosures and other sources of information
Question 25.9: Data for a manufacturing industry indicate that inventories of work in progress are increasing faster than sales. This is most likely to indicate that:
A) the business cycle is at a peak.
B) inventory is becoming obsolete.
C) firms expect demand to increase
Explanation
C is correct. An increase in work-in-progress inventory relative to sales is likely to result from firms increasing production because they expect an increase in demand. An increase in finished goods inventories relative to sales would be more likely to indicate a decrease in demand that may be caused by obsolete inventory or a business cycle peak.

LOS 25.i: Describe the financial statement presentation of and disclosures relating to
inventories.
Question 25.10: A company that reports under U.S. GAAP and changes its inventory cost assumption from weighted average cost to last-in first-out is required to apply this change in accounting principle:
A) retrospectively, and disclose the new cost flow method being used.
B) prospectively, and explain the reasons for the change in the financial statement disclosures.
C) retrospectively, and explain the reasons for the change in the financial statement disclosures.
Explanation
B is correct. Under U.S. GAAP, a change to LIFO from another inventory cost method is an exception to the requirement of retrospective application of changes in an accounting principle. Instead of restating prior years' data, the firm uses the carrying value of inventory at the time of the change as the first LIFO layer. U.S. GAAP requires a company that is changing its inventory cost assumption to explain, in its financial statement disclosures, why the new method is preferable to the old method.

LOS 25.h: Describe implications of valuing inventory at net realizable value for financial statements and ratios.
Question 25.11: Greene Company discloses that its net income for the most recent period was reduced by a writedown of inventory to net realizable value. What effect is the inventory writedown most likely to have on Greene's net income in future periods?
A) Increase.
B) Decrease.
C) No effect.
Explanation
A is correct. In future periods, lower-valued inventory will result in lower cost of sales and higher net income.
Schweser note:
Assuming the write-down is reported as part of the cost of sales, these effects in the period of the write-down include:
As inventory is part of current assets, an inventory write-down decreases both current and total assets.
Current ratio (CA/CL) decreases. However, the quick ratio is unaffected because
inventories are not included in the numerator of the quick ratio.
Inventory turnover (COGS/average inventory) is increased, which decreases days’ inventory on hand and the cash conversion cycle.
The decrease in total assets increases total asset turnover and increases the debt-toassets ratio.
Equity is decreased, increasing the debt-to-equity ratio.The increase in COGS reduces gross margin, operating margin, and net margin. The percentage decrease in net income can be expected to be greater than the percentage decrease assets or equity. As a result, both ROA and ROE are decreased.