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← Unit 4: Financial Analysis and Decision Making

BAT4M · Unit 4 test review

Financial Analysis and Decision Making: Test Review

Everything for the Unit 4 test on one page: the key facts from all 6 lessons, the mistakes that cost the most marks, and a practice test that points you back to the lessons you need.

Key facts

Financing a Business: Debt versus Equity

  • Debt must be repaid with interest; interest is generally tax-deductible; lenders get no ownership or vote.
  • Equity (common or preferred shares) is never repaid and dividends are optional, but new shares dilute existing owners.
  • Semi-annual bond interest face value contract rate .
  • Return on equity
  • Leverage raises ROE when the return on assets exceeds the interest rate, and lowers it when the return on assets is below the interest rate.
  • Alternative sources: angel investors, venture capital, BDC, government loans and grants, crowdfunding, leasing, retained earnings.

Reading an Annual Report

  • An annual report contains the highlights, letter to shareholders, MD&A, management's responsibility statement, auditor's report, the four financial statements, notes and governance information.
  • The MD&A explains results, liquidity, risks and outlook in management's words and includes forward-looking estimates.
  • An unmodified (clean) opinion means the statements present fairly in all material respects; it is not a verdict on profitability or investment value.
  • The notes disclose accounting policies, debt terms, commitments, contingencies and subsequent events that the statements alone do not show.
  • Judge strength with liquidity, solvency, profitability, cash flow and trends, always against a comparable company or industry average.

Horizontal and Vertical Analysis

  • Dollar change current year base year.
  • Percent change ; divide by the base (earlier) year.
  • Trend percentage the base year is 100%.
  • Common-size income statement: every item as a percent of net sales.
  • Common-size balance sheet: every item as a percent of total assets (which equals total liabilities and equity).
  • Horizontal analysis compares years; vertical analysis compares items within one year and lets you compare companies of different sizes.

Liquidity, Efficiency and Solvency Ratios

  • Current ratio quick ratio where quick assets are cash, short-term investments and receivables.
  • Receivables turnover days' sales in receivables .
  • Inventory turnover ; days in inventory .
  • Debt-to-equity debt ratio
  • Times interest earned
  • Judge every ratio against prior years, the industry and any loan covenants.

Profitability and Market Ratios

  • Gross profit margin ; net profit margin .
  • Return on assets return on equity
  • EPS
  • Book value per common share
  • P/E ; dividend yield
  • Ratios depend on accounting choices, historical cost and one-day snapshots, so compare carefully and read the notes.

The Cash Flow Statement

  • Net income is not cash: accruals, amortization and capital purchases make them differ.
  • Indirect method: net income amortization losses gains increases in current assets decreases in current assets increases in current liabilities decreases in current liabilities.
  • Investing activities: buying and selling long-term assets and investments. Financing: borrowing, repaying, issuing shares, paying dividends.
  • Operating investing financing net change in cash, which must equal ending cash minus beginning cash on the balance sheet.
  • Positive operating and negative investing cash flow usually signals a healthy, growing company.

Where marks get lost

  • Using the full annual rate for a semi-annual interest payment: 6% bonds pay 3% of face value every six months, not 6%. (Financing a Business: Debt versus Equity)
  • Calling bondholders owners. A bond is a loan; bondholders are creditors with no vote. (Financing a Business: Debt versus Equity)
  • Saying debt is always cheaper or always better. Debt's lower after-tax cost comes with fixed payments that can sink a business in a bad year. (Financing a Business: Debt versus Equity)
  • Thinking that issuing shares reduces an existing owner's number of shares. Dilution lowers the owner's percentage, not the number of shares held. (Financing a Business: Debt versus Equity)
  • Treating a government grant as a loan. A grant that meets its conditions is not repaid, so it is not a liability. (Financing a Business: Debt versus Equity)
  • Treating a clean audit opinion as proof that the company is healthy or a good investment. It only says the statements are fairly presented. (Reading an Annual Report)
  • Relying on the letter to shareholders or the highlights page alone. Both are written by management to present the company favourably. (Reading an Annual Report)
  • Skipping the notes, where debt maturities, lawsuits and changes in accounting methods are disclosed. (Reading an Annual Report)
  • Comparing companies in different industries (a grocery chain and a software firm) as if their ratios should match. (Reading an Annual Report)
  • Reading forward-looking statements in the MD&A as facts rather than management's estimates. (Reading an Annual Report)
  • Dividing the change by the current year instead of the base year. A rise from $700,000 to $800,000 is 14.3%, not 12.5%. (Horizontal and Vertical Analysis)
  • Using total assets as the base for an income statement, or net sales for a balance sheet. (Horizontal and Vertical Analysis)
  • Calculating a percent change from a base of zero or a negative number. Write n/m (not meaningful) instead. (Horizontal and Vertical Analysis)
  • Assuming a large percent change is important. A 50% rise on a $2,000 item matters less than a 5% rise on a $500,000 item; look at the dollar change too. (Horizontal and Vertical Analysis)
  • Forcing rounded common-size percentages to total exactly 100.0%. Small rounding differences are normal and acceptable. (Horizontal and Vertical Analysis)
  • Including inventory or prepaid expenses in the numerator of the quick ratio. (Liquidity, Efficiency and Solvency Ratios)
  • Using ending receivables or ending inventory instead of the average of the beginning and ending balances. (Liquidity, Efficiency and Solvency Ratios)
  • Using net sales instead of cost of goods sold for inventory turnover. Inventory is recorded at cost, so compare it with a cost figure. (Liquidity, Efficiency and Solvency Ratios)
  • Using net income instead of income before interest and tax for times interest earned. Interest and tax must be added back. (Liquidity, Efficiency and Solvency Ratios)
  • Calling a high current ratio automatically good. Very high values can mean idle cash or slow-moving inventory. (Liquidity, Efficiency and Solvency Ratios)
  • Forgetting to subtract preferred dividends from net income when calculating EPS. (Profitability and Market Ratios)
  • Using year-end shares instead of the weighted average for EPS when shares were issued during the year. (Profitability and Market Ratios)
  • Using a weighted average, instead of shares outstanding at year end, for book value per share. (Profitability and Market Ratios)
  • Using ending total assets instead of average total assets for return on assets. (Profitability and Market Ratios)
  • Treating a high P/E as proof a share is overpriced, or a low one as proof it is a bargain, without looking at growth and risk. (Profitability and Market Ratios)
  • Reversing the working-capital signs: an increase in a current asset is subtracted, not added. (The Cash Flow Statement)
  • Including the change in cash itself as one of the working-capital adjustments. (The Cash Flow Statement)
  • Reporting the gain on a sale as the investing inflow instead of the full cash proceeds, or forgetting to subtract the gain in operating activities, which counts it twice. (The Cash Flow Statement)
  • Putting dividends paid in operating activities under ASPE, or treating the declaration of a dividend not yet paid as a cash outflow. (The Cash Flow Statement)
  • Forgetting to check that the net change in cash reconciles to the balance sheet. (The Cash Flow Statement)

Practice test

24 questions from across the unit. Each one shows the lesson it comes from.

  1. Financing a Business: Debt versus Equity
    1
    A company issues $300,000 of 8% bonds at face value with interest paid semi-annually. How much cash is paid at each interest date? Answer to the nearest dollar.
    $
  2. Financing a Business: Debt versus Equity
    2
    Plan B in a leverage example has net income of $63,000 and shareholders' equity of $350,000. What is its return on equity? Answer as a percent to one decimal place.
    %
  3. Financing a Business: Debt versus Equity
    3
    Match each funding source to its description.
    Venture capital
    Angel investor
    Business Development Bank of Canada
    Reward-based crowdfunding
    Leasing
  4. Financing a Business: Debt versus Equity
    4
    A company borrows at 8% and pays income tax at 25%. What is its after-tax cost of borrowing? Answer as a percent to one decimal place.
    %
  5. Reading an Annual Report
    5
    Match each annual-report section to its purpose.
    Letter to shareholders
    MD&A
    Independent auditor's report
    Notes to the financial statements
    Corporate governance section
  6. Reading an Annual Report
    6
    An auditor states that it could not obtain enough evidence to form an opinion. What type of report is this?
  7. Reading an Annual Report
    7
    Company X has a higher net profit margin than Company Y, but X's cash from operating activities has been negative for two years while Y's is positive. What is the best conclusion?
  8. Reading an Annual Report
    8
    Which pair of companies is the most meaningful to compare using annual reports?
  9. Horizontal and Vertical Analysis
    9
    Accounts receivable rose from $64,000 to $72,000. What is the percent change? Answer to one decimal place.
    %
  10. Horizontal and Vertical Analysis
    10
    Sales were $400,000 in the base year and $482,000 four years later. What is the trend percentage for the later year? Answer to one decimal place.
    %
  11. Horizontal and Vertical Analysis
    11
    Sales increased 8% while cost of goods sold increased 12%. What happened to the gross profit margin?
  12. Horizontal and Vertical Analysis
    12
    Prepaid expenses fell from $12,000 to $10,000. What is the percent change? Enter a decrease as a negative number, to one decimal place.
    %
  13. Liquidity, Efficiency and Solvency Ratios
    13
    A company has cash of $18,000, short-term investments of $7,000, accounts receivable of $35,000, inventory of $60,000 and current liabilities of $50,000. What is its quick ratio? Answer to two decimal places.
  14. Liquidity, Efficiency and Solvency Ratios
    14
    Cost of goods sold is $396,000. Inventory was $80,000 at the start of the year and $100,000 at the end. What is the inventory turnover? Answer to two decimal places.
    times
  15. Liquidity, Efficiency and Solvency Ratios
    15
    A company's days in inventory rose from 60 to 95 over two years while the industry stayed near 62. What is the most likely concern?
  16. Liquidity, Efficiency and Solvency Ratios
    16
    Current assets are $315,000 and current liabilities are $180,000. What is the current ratio? Answer to two decimal places.
  17. Profitability and Market Ratios
    17
    Net income is $180,000, preferred dividends are $30,000 and the weighted average number of common shares is 60,000. What is EPS? Answer to the nearest cent.
    $
  18. Profitability and Market Ratios
    18
    Total shareholders' equity is $900,000, including $150,000 of preferred shares. There are 50,000 common shares outstanding. What is book value per common share? Answer to the nearest cent.
    $
  19. Profitability and Market Ratios
    19
    Net sales are $1,250,000 and net income is $87,500. What is the net profit margin? Answer as a percent to one decimal place.
    %
  20. Profitability and Market Ratios
    20
    Match each question to the ratio that answers it.
    How much profit does each dollar of sales keep after all expenses?
    How well does management use all the company's assets?
    How much profit belongs to each common share?
    How much are investors paying for each dollar of earnings?
    What cash return do dividends give on the share price?
  21. The Cash Flow Statement
    21
    Net income is $48,000; amortization is $12,000; accounts receivable increased $6,000; accounts payable increased $4,000. What is cash provided by operating activities? Answer to the nearest dollar.
    $
  22. The Cash Flow Statement
    22
    Equipment with a book value of $14,000 was sold at a $2,500 loss. How much cash is reported as an investing inflow? Answer to the nearest dollar.
    $
  23. The Cash Flow Statement
    23
    A company shows negative operating cash flow, negative investing cash flow and large positive financing cash flow. What does this pattern most often indicate?
  24. The Cash Flow Statement
    24
    In a spreadsheet, you want every common-size income statement formula in column D to divide by net sales in cell B5. Which reference should the formulas use for B5?

Endless drill

Fresh numbers every time, for the calculation questions in this unit.

Endless drillnew numbers every time

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