Ch. 12 Financial Statement Analysis

Question 1

Vertical analysis

Answer 1

Expresses each item in a financial statement as a percentage of the same base amount such as a percentage of sales in the income statement or as a percentage of total assets in the balance sheet.

Question 2

Horizontal analysis

Answer 2

Analyzes trends in financial statement data for a single company over time.

Question 3

Liquidity

Answer 3

Refers to a company’s ability to pay its current liabilities.
-The accounts used to calculate liquidity ratios are located in the current assets and current liabilities sections of the balance sheet.

Question 4

Solvency

Answer 4

Refers to a company’s ability to pay its long-term liabilities.

Question 5

Receivables turnover ratio

Answer 5

Net credit sales divided by average accounts receivable; the number of times during a year that the average accounts receivable balance is collected (“turns over”).

Question 6

Average collection period

Answer 6

Approximate number of days the average accounts receivable balance is outstanding. It equals 365 divided by the receivables turnover ratio.

Question 7

Inventory turnover ratio

Answer 7

Cost of goods sold divided by average inventory; the number of times the firm sells its average inventory balance during a reporting period.

Question 8

Average days in inventory

Answer 8

Approximate number of days the average inventory is held. It equals 365 days divided by the inventory turnover ratio.

Question 9

Current ratio

Answer 9

Current assets divided by current liabilities; measures the availability of current assets to pay current liabilities.

Question 10

Acid-test ratio

Answer 10

Cash, current investments, and accounts receivable divided by current liabilities; measures the availability of liquid current assets to pay current liabilities.

Question 11

Debt to equity ratio

Answer 11

Total liabilities divided by stockholders’ equity; measures a company’s solvency risk.

Question 12

Times interest earned ratio

Answer 12

Ratio that compares interest expense with income available to pay those charges.

Question 13

Profitability ratios

Answer 13

Measure the earnings or operating effectiveness of a company.

Question 14

Gross profit ratio

Answer 14

Gross profit divided by net sales; measures the amount by which the sale price of inventory exceeds its cost per dollar of sales.

Question 15

Return on assets

Answer 15

Net income divided by average total assets; measures the amount of net income generated for each dollar invested in assets.

Question 16

Profit Margin

Answer 16

Net income divided by net sales; indicates the earnings per dollar of sales.

Question 17

Asset Turnover

Answer 17

Net sales divided by average total assets, which measures the sales per dollar of assets invested.

Question 18

Return on equity

Answer 18

Net income divided by average stockholders’ equity; measures the income generated per dollar of equity.

Question 19

Price-earnings (PE) ratio

Answer 19

Compares a company’s share price with its earnings per share

Question 20

Growth stocks

Answer 20

Stocks that have high expectations of future earnings growth and therefore usually trade at higher PE ratios.
-Said to be great stocks at a good price

Question 21

Value stocks

Answer 21

Stocks that have lower share prices in relationship to their fundamental ratios and therefore trade at lower (bargain) PE ratios.
-Said to be good stocks at a great price.

Question 22

Discontinued operation

Answer 22

The sale or disposal of a significant component of a company’s operations.

• ie: ABC company reported a $515 million loss on discontinued operations on the sale of its hard-disk drive business to XYZ company.
• Sometimes a company will dispose of one of its business activities by ending operations and selling the individual assets.
• We report any profits or losses on discontinued operations in the current year, separately from profits and losses on the portion of the business that will continue.

Question 23

Extraordinary item

Answer 23

An event that is (1) unusual in nature and (2) infrequent in occurrence.

• Because of the unusual nature of these items, we don’t want to combine their effects on net income with those of normal operations.
• A company must consider the definition of extraordinary in the context of the environment in which it operates.
• We report extraordinary items separately, net of taxes, near the bottom of the income statement just below discontinued operations.

Question 24

Quality of earnings

Answer 24

Refers to the ability of reported earnings to reflect the company’s true earnings, as well as the usefulness of reported earnings to predict future earnings.

Question 25

Conservative accounting practices

Answer 25

Practices that result in reporting lower income, lower assets, and higher liabilities.

• Larger estimation of the allowance for uncollectible accounts
• write-down of overvalued inventory
• Use of a shorter useful life for depreciation
• Recording of a contingent litigation loss

Question 26

Aggressive accounting practices

Answer 26

Practices that result in reporting higher income, higher assets, and lower liabilities.

• Lower estimation of the allowance for uncollectible accounts
• Waiting to report an inventory write-down
• Choosing a longer useful life for depreciation
• Waiting to record a litigation loss.

Question 27

Financial Leverage

Answer 27

The amount of debt each company carries
-Remember, too, that debt can be good for the company as long as the return on investment exceeds the interest cost of borrowing.

Question 28

One-time income items

Answer 28

items that are part of net income in the current year that are not expected to persist
-includes: discontinued operations and extraordinary items.