Series 86: Data Verification and Analysis

Series 86 Data Verification and Analysis questions help you isolate one part of the FINRA outline before returning to a mixed practice test. The questions below are original Securities Prep practice items aligned to this topic and are not copied from any exam sponsor.

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Sample questions

Question 1

You are updating a software company model after its 10-Q. Management emphasizes “adjusted operating income” that excludes stock-based compensation (SBC). Your current model uses the company’s adjusted operating margin and applies a forward P/E to forecast EPS.

Exhibit (USD, quarter):

• GAAP operating income: $120
• SBC expense (in SG&A): $45
• “Adjusted operating income” (company): $165
• Weighted-average shares: 100 basic, 108 diluted

What is the best next step to ensure your profitability metrics and per-share economics are not overstated?

• A. Add SBC back to operating income for comparability, but keep the share count unchanged to isolate operating performance
• B. Select a peer forward P/E multiple first, then decide whether to adjust SBC based on how peers present non-GAAP results
• C. Update operating expenses to include SBC for margin/EPS, and update diluted shares for expected SBC-driven dilution
• D. Keep using adjusted operating margin because SBC is non-cash and does not affect valuation multiples

Best answer: C

Explanation: SBC is an economic cost that depresses GAAP profitability and typically increases diluted shares, so both the income statement and share count need to be modeled consistently.

SBC reduces reported profitability because it is recorded as compensation expense, and it can also dilute shareholders through incremental shares. If you rely on an adjusted margin that excludes SBC and do not refresh diluted shares, you can overstate operating metrics and EPS at the same time. The appropriate next step is to model SBC consistently in the income statement and reflect its dilution in per-share forecasts.

SBC is typically non-cash in the period granted, but under GAAP it is still a compensation expense that lowers operating income and net income, affecting margins and EPS. In addition, SBC often results in future share issuance (or fewer shares repurchased), increasing diluted shares and reducing per-share economics.

A sound workflow is:

• Reconcile the company’s non-GAAP profit measure to GAAP.
• Include SBC in operating expenses when computing profitability metrics used for P/E- and margin-based analysis.
• Separately, reflect SBC’s impact on per-share figures by updating diluted share assumptions (and keeping valuation inputs consistent with the earnings definition used).

Treating SBC as “irrelevant” because it is non-cash can overstate both profitability and per-share value.

• Ignoring SBC in margins can overstate operating income and EPS because GAAP includes SBC as an expense.
• Add-back without dilution misses that SBC can increase diluted shares, overstating per-share economics.
• Pick multiple first is a premature sequencing step; the model’s earnings definition must be set before applying multiples.

Question 2

You cover a mid-cap U.S. apparel retailer in a slowing consumer demand environment where markdown risk is rising. Management’s earnings release and investor deck state inventory is “down 8% YoY,” but the most recent filed 10-Q balance sheet shows inventory up 6% YoY; the deck footnote says its metric is “excluding goods in transit and net of reserves.” You need a defensible ending-inventory input for next quarter’s working-capital forecast in a DCF, and you cannot assume the deck’s definition matches GAAP. What is the best research action to validate the inventory data point before updating your model?

• A. Reconcile 10-Q inventory to deck definition; verify with third-party shipment data
• B. Use the investor deck metric because it reflects operational inventory
• C. Override reported inventory with third-party import data for the forecast
• D. Forecast inventory from historical days-in-inventory and ignore the discrepancy

Best answer: A

Explanation: Start with GAAP inventory from the 10-Q, bridge to management’s stated definition using disclosures, and corroborate with an independent source.

The right approach is to triangulate and reconcile the same metric across sources rather than picking one number. Use the 10-Q as the anchor (audited/GAAP framework), then bridge to management’s non-GAAP definition using disclosed components like reserves and in-transit goods, and corroborate reasonableness with an independent third-party indicator.

When a key driver (like inventory) conflicts across an earnings release/deck and a filed 10-Q, the analyst’s job is to validate by reconciling definitions and timing. Anchor on the 10-Q GAAP balance sheet figure, then use MD&A and footnotes to identify items that management may be excluding (for example, goods in transit classification and inventory reserves/markdown allowances). Build a bridge from GAAP to the deck metric so you can (1) explain why the numbers differ and (2) choose the appropriate definition for modeling working capital. Finally, cross-check the reconciled result against independent evidence (such as third-party shipment/import data or channel checks) to assess whether the company’s framing is directionally consistent with observable flows.

• Deck-only reliance fails because it accepts a non-GAAP definition without a GAAP bridge.
• Ratio-based inference can’t resolve a definitional/timing mismatch and may perpetuate the wrong level.
• Third-party override is weak because it doesn’t reconcile to the company’s accounting disclosures and may measure a different point in the flow.

Question 3

Which statement best describes the effective tax rate (ETR) for a company and a common driver of a year-over-year change in ETR?

• A. ETR equals income tax expense divided by pretax income; it can change with shifts in geographic mix between higher- and lower-tax jurisdictions.
• B. ETR equals cash taxes paid divided by pretax income; it can change when deferred taxes reverse.
• C. ETR equals income tax expense divided by net income; it can change with changes in EBITDA margin.
• D. ETR equals statutory tax rate multiplied by pretax income; it can change when revenue recognition timing changes.

Best answer: A

Explanation: ETR is computed as tax expense over pretax income, and mix of earnings across taxing regimes is a common driver of ETR changes.

The effective tax rate is calculated as total income tax expense (current plus deferred) divided by pretax income. Because it reflects where profits are earned and what items are taxable or deductible, it can move even if the statutory rate is unchanged. A common driver is a change in the geographic mix of earnings across jurisdictions with different tax rates.

Effective tax rate (ETR) is a financial-statement measure of the tax burden on reported earnings, computed as total income tax expense divided by pretax income. Because the numerator includes both current and deferred tax expense, ETR can diverge from cash taxes paid and from the statutory rate.

High-level drivers of ETR changes include:

• Shifts in geographic/segment profit mix across different tax regimes
• Changes in permanent differences (e.g., nondeductible expenses, tax credits)
• Discrete tax items (e.g., valuation allowance changes, audit settlements)

Key takeaway: ETR is an accrual-based rate on pretax book income, not a cash-tax ratio or a margin metric.

• Cash taxes vs. tax expense confuses ETR with cash taxes paid, which can differ due to deferrals and timing.
• Wrong denominator using net income double-counts tax effects because net income is after tax.
• Statutory rate misuse treats ETR as a fixed statutory calculation, ignoring mix and book-tax differences.

Question 4

You are reviewing a company’s working capital efficiency. Two analysts offer different explanations for the year-over-year change in cash conversion cycle (CCC).

Exhibit: Operating working capital days

Analyst 1 says CCC improved mainly due to inventory and payables management. Analyst 2 says CCC improved mainly due to faster collections.

Which conclusion best fits the exhibit?

• A. CCC improved mainly because DSO increased
• B. Analyst 2: lower DSO drove the CCC improvement
• C. Analyst 1: lower DIO and higher DPO drove the CCC improvement
• D. CCC did not improve; it deteriorated year over year

Best answer: C

Explanation: DSO worsened, while DIO fell and DPO rose, which shortens CCC and supports Analyst 1.

CCC is calculated as DSO + DIO − DPO. From FY2024 to FY2025, DSO rose (worse), DIO fell (better), and DPO rose (better). The net effect is a shorter CCC, so the improvement is explained by faster inventory conversion and slower cash paid to suppliers, not faster collections.

The cash conversion cycle links operating working capital to cash flow timing:

• CCC measures how long cash is tied up in operations: receivables days (DSO) plus inventory days (DIO) minus payables days (DPO).
• A lower CCC generally indicates less cash tied up (a working-capital tailwind), while a higher CCC indicates more cash tied up.

Using the exhibit, DSO increases from 38 to 40 days (collections slow), DIO decreases from 52 to 40 days (inventory converts faster), and DPO increases from 35 to 38 days (the firm takes longer to pay suppliers). The decrease in DIO and increase in DPO both reduce CCC and are consistent with inventory being a source of cash and payables providing financing. The rise in DSO is the opposite of “faster collections.”

• Faster collections is inconsistent with DSO rising from 38 to 40 days.
• DSO increase helps CCC is backward because higher DSO lengthens CCC.
• No improvement ignores that the combined changes shorten CCC (DIO down and DPO up outweigh DSO up).

Question 5

A public manufacturer guides to the following 2026 capital spending (USD):

• Replace aging boilers to keep current output and meet safety standards: $40 million
• Build a new production line expected to increase capacity ~20% and support incremental revenue: $60 million

Which statement about maintenance versus growth capex is INCORRECT for an analyst’s forecast and valuation work?

• A. DCF free cash flow should exclude growth capex because it is discretionary.
• B. Forecasts assuming added capacity must include related growth capex cash outflows.
• C. Terminal value should reflect ongoing maintenance capex to sustain sales.
• D. Boiler replacement is maintenance capex; new line is growth capex.

Best answer: A

Explanation: If the forecast (and valuation) assumes growth, the associated growth capex must be included in projected cash outflows.

Maintenance capex is spending required to sustain the current revenue/operating base, while growth capex is spending intended to expand capacity and drive incremental revenue. In a DCF, free cash flow must reflect the cash outflows needed to achieve the forecast path. Excluding growth capex while still forecasting growth would overstate free cash flow and value.

The core distinction is economic purpose: maintenance capex preserves the existing asset base and keeps current output/revenue achievable, while growth capex increases future earning power (e.g., new capacity, new sites, major expansion). In forecasting, analysts often separate the two to (1) understand what cash is required just to “stand still” and (2) model discretionary investments that create incremental revenue. However, valuation must be internally consistent: if the forecast includes incremental volumes/revenue from an expansion, then the model’s cash flows must include the corresponding growth capex during the build period. For a steady-state terminal value, using a maintenance capex level consistent with sustaining the terminal run-rate is typical; excluding growth capex is only consistent if the terminal assumptions reflect no incremental growth investment.

• Classification by purpose is appropriate because replacing worn equipment to sustain output is maintenance, while adding capacity is growth.
• Terminal value linkage is appropriate because steady-state cash flows should include the capex needed to maintain the terminal run-rate.
• Consistency with forecast is appropriate because you cannot assume incremental capacity/revenue without also reflecting the cash required to build it.

Question 6

Which statement is most accurate about stock-based compensation (SBC) and its impact on profitability metrics and per-share economics?

• A. Adding back SBC to EBITDA eliminates any need to adjust diluted shares in per-share valuation.
• B. SBC lowers GAAP operating profit, is added back in operating cash flow, and its cost shows up economically through dilution in per-share metrics.
• C. SBC reduces operating cash flow because it represents an ongoing cash outlay to employees.
• D. Because SBC is non-cash, it should be excluded from operating margin and EPS calculations.

Best answer: B

Explanation: SBC is a non-cash expense that reduces GAAP earnings but is added back in cash flow, while the economic cost is dilution affecting EPS/value per share.

Under GAAP, SBC is an operating expense that reduces operating income and margins. Because it is non-cash, it is typically added back in the operating cash flow reconciliation. However, SBC is not “free”: it generally increases shares outstanding over time, so per-share economics must reflect dilution (for example, using diluted shares or modeling buybacks needed to offset issuance).

The core idea is that SBC affects profitability metrics and per-share value through two different channels. On the income statement, SBC is recognized as compensation expense, so it reduces GAAP operating income, net income, and margins. On the cash flow statement, SBC is a non-cash charge, so it is typically added back in the reconciliation from net income to cash from operations (raising reported CFO versus GAAP earnings).

For per-share analysis, the economic cost of SBC is primarily dilution: equity awards increase the diluted share count (and may require repurchases to offset). Therefore, even if an analyst uses an “adjusted” profit metric that adds back SBC, per-share metrics and equity valuation still need a realistic diluted share assumption to avoid overstating EPS and value per share.

• Exclude from margins/EPS fails because GAAP operating metrics include SBC as an operating expense.
• Cash outlay view fails because SBC is generally non-cash at grant/vesting and is added back in CFO.
• EBITDA add-back replaces dilution fails because adding back an expense does not prevent share count from rising.

Question 7

A company reports a GAAP restructuring charge of $120 million this year (included in SG&A). Management discloses expected recurring SG&A savings of $70 million per year starting next year, and expects $90 million of cash restructuring payments over the next 12 months.

An analyst builds a DCF and (1) adds back the $120 million charge to LTM EBITDA as “non-recurring,” (2) reduces forecast SG&A by $70 million per year, and (3) does not model the $90 million cash restructuring payments. What is the most likely outcome of this modeling choice?

• A. The model will likely understate value by understating future margins
• B. Enterprise value is unaffected because restructuring is below EBITDA
• C. The DCF will likely understate value by double-counting restructuring costs
• D. The DCF will likely overstate value by overstating near-term FCF

Best answer: D

Explanation: The model benefits from normalized earnings and recurring savings but omits the cash outflows required to achieve them, inflating free cash flow and valuation.

Restructuring charges are often non-recurring in reported earnings, but they commonly require real cash outflows (severance, lease exits, facility closures). Adding back the charge and also forecasting the recurring savings is reasonable only if the associated restructuring cash payments are reflected in the cash flow forecast. Omitting those payments inflates near-term free cash flow and biases the DCF upward.

The core distinction is between (a) one-time accounting charges that should not be treated as ongoing expenses in normalized earnings and (b) the cash costs required to execute the restructuring and unlock any sustainable savings. In a DCF, you can normalize EBITDA by excluding a non-recurring charge and separately incorporate recurring cost savings in future margins, but you must also reflect the restructuring cash payments (often in operating cash flow or as a separate cash item) during the period they occur. Here, the model captures the benefit twice (higher base-year EBITDA and lower future SG&A) while ignoring the $90 million cash outflow needed to achieve the savings, overstating near-term FCF and inflating present value. A common safeguard is reconciling adjusted EBITDA changes to cash flow to ensure “non-recurring” items are not simply disappearing from the forecast.

• Double-counting confusion would apply if the charge were kept in expenses and cash payments were also deducted, but the charge was added back here.
• Below-EBITDA misconception fails because the charge is stated as included in SG&A, which affects EBITDA.
• Margin direction error fails because reducing SG&A by $70 million increases (not decreases) future margins.

Question 8

An analyst is modeling a consumer products company whose sales spike predictably every year in the fourth quarter. Before estimating the underlying growth trend, the analyst first removes the recurring within-year pattern by estimating seasonal factors from several years of quarterly data and adjusting each quarter by those factors.

Which technique is the analyst using?

• A. Smoothing results by using trailing twelve-month (TTM) revenue
• B. Seasonal adjustment (deseasonalizing the quarterly series)
• C. Normalizing earnings by using mid-cycle margins
• D. Sizing profitability by converting the income statement to common-size percentages

Best answer: B

Explanation: Estimating seasonal factors and adjusting each quarter to isolate the underlying trend is deseasonalization.

The described process is designed to separate predictable calendar-driven effects from true growth. Estimating seasonal factors from multiple years and adjusting each quarter removes seasonality so a trend (and any cyclicality) can be analyzed on a comparable basis.

Seasonality is a recurring, calendar-driven pattern within a year (for example, a Q4 holiday spike) that can mask the underlying trend in a quarterly time series. Seasonal adjustment (deseasonalization) estimates the typical seasonal lift or drag for each quarter using several years of history and then removes that pattern from reported results. After deseasonalizing, the analyst can fit a trend line or evaluate growth rates that are not distorted by quarter-to-quarter seasonal swings. This is different from normalizing for cyclicality, which aims to adjust for broader economic or industry cycles across years rather than predictable within-year timing effects.

• Mid-cycle normalization addresses cyclical peaks/troughs, not predictable quarter-of-year patterns.
• TTM smoothing reduces seasonality’s visibility but does not explicitly remove the seasonal component.
• Common-size statements help compare cost structure/margins, not separate seasonality from trend.

Question 9

You are updating a 1-year forecast for a consumer hardware company with two product lines. Management expects a shift toward the higher-end product due to new features, but notes continued competitive discounting in the entry product.

Exhibit (last fiscal year):

• Standard: 70% of units; ASP $300; gross margin 25%
• Pro: 30% of units; ASP $600; gross margin 40%

Which forecasting approach best aligns with durable research standards when assessing how product mix and differentiation affect pricing flexibility and gross margin?

• A. Apply a single blended ASP change to total revenue
• B. Model each line’s volume, ASP, and margin; sensitivity by mix
• C. Anchor to management’s gross margin target and back-solve ASPs
• D. Remove discounting from Standard margin to reflect “normalized” pricing

Best answer: B

Explanation: Separating drivers by product line supports evidence-based mix/pricing assumptions and makes margin impacts transparent via sensitivities.

The cleanest way to link differentiation and mix to margin is to model each product line separately with explicit assumptions for units, pricing, and costs. This preserves comparability (no ad hoc “normalizations”), makes the mix effect observable, and allows transparent uncertainty through sensitivities around mix and price realization.

When product differentiation drives pricing flexibility, the forecast should reflect that flexibility where it actually exists: at the product (or segment) level. A blended top-line or margin assumption can hide the mechanism (mix shift vs. price vs. cost) and can unintentionally double-count benefits. A durable, evidence-based approach is to build revenue and gross profit by line using explicit drivers (units, ASP, unit costs/gross margin), tie those drivers to observable support (history, competitor positioning, channel checks, announced features), and then show uncertainty with a small sensitivity around (1) mix shift and (2) price realization/discounting—especially for the less-differentiated product facing competition. The key takeaway is that mix and differentiation should change the model through explicit line-item drivers, not through opaque blended assumptions or one-off adjustments.

• Blended ASP change obscures whether margin change comes from mix vs. pricing and reduces comparability.
• Back-solving from a target can embed an unverified outcome and hide weak pricing-power evidence.
• Removing discounting as “normalized” is an inconsistent adjustment unless it is clearly non-recurring and applied comparably across periods.

Question 10

A packaging manufacturer reports one primary bottling line. Management says unit shipment growth next year will be limited by capacity until an expansion comes online.

Exhibit: Capacity and expansion

Assume utilization can increase to 100% with no other constraints and the expansion contributes only for the second half of next year.

Based on the exhibit, what is the approximate maximum percentage increase in next year’s unit shipments versus the current run-rate?

• A. About 25%
• B. About 30%
• C. About 10%
• D. About 20%

Best answer: D

Explanation: Max next-year shipments are 13.0M units (12.0M + 1.0M half-year add), versus a 10.8M current run-rate, implying roughly 20% growth.

Current shipments at a 90% run-rate are 10.8 million units (12.0 million 90%). Next year, the most the company can ship is full utilization of current capacity plus half-year contribution from the expansion: 12.0 million + (2.0 million 0.5) = 13.0 million units. The implied maximum growth is (13.0/10.8) 1 " 20%.

Capacity utilization converts “installed capacity” into an implied shipment run-rate, and timing of expansions determines how much incremental capacity is actually available in the forecast period. Here, current run-rate shipments are 12.0 million 90% = 10.8 million units. The expansion adds 2.0 million units/year but only for half of next year, so it contributes 1.0 million units in that year. If the firm can run at 100% utilization, maximum next-year shipments are 12.0 + 1.0 = 13.0 million units.

A common error is treating a mid-year expansion as if it contributes a full year of output.

• Wrong base level uses 12.0 million capacity instead of the 10.8 million current run-rate.
• Full-year expansion incorrectly counts the 2.0 million add for all 12 months.
• Mixing timing and utilization effectively double-counts improvement (or assumes more than 100% utilization) to reach a higher growth rate.

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