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Reading 28: Integration of Financial Statement Analysis Techn

Session 7: Financial Reporting and Analysis: Earnings Quality Issues and Financial Ratio Analysis
Reading 28: Integration of Financial Statement Analysis Techniques

LOS e: Analyze and interpret the effects of balance sheet modifications, earnings normalization, and cash-flow-statement-related modifications on a company's financial statements, financial ratios, and overall financial condition.

 

 

An analyst finds return-on-equity (ROE) a good measure of management performance and wants to compare two firms: Firm A and Firm B. Firm A reports net income of $3.2 million and has a ROE of 18. Firm B reports income of $16 million and has an ROE of 16.

A review of the notes to the financial statements for Firm A, shows that the earnings include a loss from smelting operations of $400,000 and that the firm has exited this business. In addition, the firm sold the smelting equipment and had a gain on the sale of $300,000.

A similar review of the notes for Firm B discloses that the $16 million in net income includes $2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for both firms is 36%, and that the notes describe pre-tax amounts. Which of the following is closest to the “normalized” ROE for Firm A and for Firm B, respectively?

A)
17.1 and 16.9.
B)
16.0 and 18.0.
C)
18.4 and 14.3.


 

The ROE for Firm A is adjusted for the $400,000 loss on discontinued operations and the $300,000 non-recurring gain. The ROE for Firm B is adjusted to remove the effects of the $2.6 million one-time gain.

The first step in this problem is to solve for equity using ROE. Then, “normalize” net income by adjusting for discontinued operations and non-recurring items. Then, solve for “normalized” ROE.

Firm A:
18% = 3,200,000 / EquityA
EquityA = 17,777,778 (rounding)
Normalized Net IncomeA = 3,200,000 + (1 – 0.36)(400,000 – 300,000)
Normalized ROEA = 3,264,000 / 17,777,778 = 18.360%

Firm B:
16% = 16,000,000 / EquityB
EquityB = 100,000,000
Normalized Net IncomeB = 16,000,000 + (1 – 0.36)(–2,600,000)
Normalized ROEB = 14,336,000 / 100,000,000 = 14.336%

18.360 and 14.336 are closest to 18.4 and 14.3

An investor relations spokesperson for the Square Door Corporation was quoted as saying that Square Door shares were a bargain, selling at a price-to-earnings (P/E) ratio of 12, relative to the S& 500 average P/E of 15.3. The financial statements reported net earnings of $126 million, or $4.00 per share. The notes to the financial statements included a statement that income for the year included a $31.5 million (after-tax) gain from the reclassification of certain assets from its investment portfolio to its trading portfolio. What would be the normalized P/E?

A)
15.
B)
13.
C)
16.


Since the P/E ratio was 12 and EPS was $4, the price of the stock was $48 (12 × 4).  After removing the nonrecurring gain, earnings will be $94.5 million (126 ? 31.5).  We know the number of shares is 31.5 million (126 Million ÷ 4).  So the new EPS number is 3 (94.5 million ÷ 31.5 million) and new P/E ratio is 16 (48 ÷ 3).

TOP

Which of the following statements is CORRECT when inventory prices are falling?

A)
LIFO results in higher COGS, lower earnings, higher taxes, and higher cash flows.
B)
LIFO results in lower COGS, higher earnings, higher taxes, and lower cash flows.
C)
LIFO results in lower COGS, lower earnings, lower taxes, and higher cash flows.


Remember, prices are falling.

TOP

MKF Consolidated reports $500 million in goodwill on its balance sheet. The market consensus indicates that the value of MKF’s intangible assets is $300 million. How should an analyst adjust MKF’s balance sheet? Reduce goodwill and:

A)
increase liabilities by $200 million.
B)
equity by $200 million.
C)
equity by $500 million.


If goodwill has no economic value apart from the firm, it should be eliminated from the balance sheet. If the value of the intangibles can be reliably estimated they can be substituted for accounting goodwill.

TOP

A firm has reported net income of $136 million, but the notes to financial statements includes a statement that the results “include a $27 million charge for non-insured earthquake damage” and a “gain on the sale of certain assets during restructuring of $16 million.” If we assume that both of these items are given on a pre-tax basis and the effective tax rate is 36%, what would be the “normal operating income?”

A)
$143.04 million.
B)
$94.08 million.
C)
$147.00 million.


To normalize earnings you would increase it by the non-recurring charge of $27 million and decrease it by the non-recurring gain, both tax adjusted.

$136 + (27 - 16)(1 - 0.36) = $143.04.

TOP

ABC Tie Company reports income for the year 2009 as $450,000. The notes to its financial statements state that the firm uses the last in, first out (LIFO) convention to value its inventories, and that had it used first in, first out (FIFO) instead, inventories would have been $62,000 greater for the year 2008 and $78,000 greater for the year 2009. If earnings were restated using FIFO to determine the cost of goods sold (COGS), what would the net income be for the year 2009? Assume a tax rate of 36%. Net income would have been:

A)
$460,240.
B)
$455,760.
C)
$439,760.


The reduction in COGS would result in an increase in net income (62,000 ? 78,000) × (1 ? 0.36).

TOP

Endrun Company reported net income of $4.7 million in 1999, and $4.3 million in 2000. In reviewing the annual report an analyst notices that the Endrun took a charge of $2.4 million in 1999 for the costs of relocating its main office, and in 2000 booked a gain of $900,000 on the sale of its previous office building. What would “normalized earnings” be for 1999 and 2000 if we assume a tax rate of 36% for both years?

A)
$7.1 million and $5.2 million.
B)
$3.99 million and $2.54 million.
C)
$6.236 million and $3.724 million.


You will increase 1999 earnings by the tax-adjusted value of the 2.4 million one-time charge (2.4 × (1 - 0.36) = +1.536), and you would decrease Y2000 earnings by the tax-adjusted amount of the $0.9 million one-time gain (0.9 × (1 - 0.36) = -0.576).

TOP

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