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MS2 Accounting Intro Review > Chapter 18: Financial Statement Analysis > Flashcards

Chapter 18: Financial Statement Analysis Flashcards

1
Q

Liquidity

A

The measure of the ability of the firm to meet its immediate, current financial obligations

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2
Q

Solvency

A

The firm’s ability to have sufficient assets to meet its debts in the long term

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3
Q

Basics of Financial Statement Analysis

A

Characteristics: Liquidity, profitability, solvency

Comparison Basis: Intracompany, Industry averages, Intercompany

Tools of analysis: horizontal, vertical, ratio

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4
Q

Horizontal Analysis

A

AKA: Trend Analysis

Evaluating a series of financial statement data over a period of time - sees increases or decreases.

Commonly applied to the balance sheet, income statement, and statement of retained earnings

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5
Q

Vertical Analysis

A

AKA: Common-size Analysis

Technique that expresses each financial statement item as a percentage of a base amount. Enables comparisons of companies of different sizes.

Commonly applied to balance sheet and income statement

Balance sheet: Assets = 100%, Liabilities + Stockholders’ Equity = 100%

Income Statement: Net Sales = 100%

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6
Q

Ratio Analysis

A

Requires comparison for meaning: Intra-company, inter-company or industry average.

Expresses the relationship among selected items of financial data.

Liquidity ratios: measure the short-term ability of the company to may maturing obligations and meet unexpected needs for cash

Profitability Ratios: measure income or operating success of a company for a period of time

Solvency ratios: measure the ability of a company to survive over a long period of time

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7
Q

Sustainable Income

A

The most likely level of income to be obtained by the company in the future.

Excludes unusual revenues, expenses, gains and losses (ex: gains and losses on discontinued items)

These are all disclosed and reported Net of Income tax

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8
Q

Analysis-Distorting Issues

A

Irregular Items
Discontinued Operations
Extraordinary items

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9
Q

“Irregular” Items

A 
Can distort financial analysis
Reported separated out on income statement
- Discontinued Operations
- Extraordinary items
- Must be reported net of income taxes
- changes in accounting principle (must disclose in notes)
- Comprehensive Income (OC) items
- Improper Revenue Recognition
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10
Q

Discontinued Operations

A

Can distort financial analysis
- Disposal of a significant component of the business
- Income (or loss) reported in two parts:
Income (or loss) from discontinued operations
Gain (or loss) on disposal

Both reported net of tax

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11
Q

Change in accounting principle

A

Can distort financial analysis

  • occurs when the principle used in current year differs from proceeding year.
  • allowable if change is justified (operations/ situation changes)
  • only ever reported retroactively
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12
Q

Comprehensive Income

A

Can distort financial analysis
All changes in stockholders’ equity EXCEPT those resulting from investment by stockholders and distributions to stockholders
- Reported in unrealized equity
- Ex: unrealized gains and losses on available-for-sale securities

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13
Q

Quality of Earnings

A

A company that provides full and transparent information that will not confuse the users of financial statements = high quality of earnings

Reduced by the variability of application of GAAP that hampers comparability

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14
Q

Pro Forma Income

A

Usually excludes items that the company thinks are unusual and non-recurring.

(this is a flexibility in reporting that is sometimes abused)

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15
Q

Improper Recognition

A

Often occurs when there is pressure to continually increase earnings

  • improper recognition of revenue
  • improper capitalization of operating expenses
  • failure to report all liabilties
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16
Q

Extraordinary Items

A

Can distort financial analysis

Must be BOTH: of an unusual nature (some judgement call in this) and occur infrequently

Reported net of tax

ex: expropriated property or rare weather/ geological events

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17
Q

Benford’s Law

A

In a random collection of numbers the frequency of lower digits (1,2,3) should be much higher than the higher digits (7,8,9)

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18
Q

Discontinued Operations on Income Statement

A

Reported on income statement after income from continuing operations

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19
Q

Extraordinary items on income Statement

A

Reported on income statement after income from continuing operations (and after discontinued operations if exist)

Always reported net of tax

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20
Q

Comprehensive Income on Statement of Comprehensive Income

A

Shows net income + or - comprehensive items. (unrealized gains/losses on available for sale securities)
Also shown on balance sheet

These are reported separately from net income to remove the market volatility from income but included in reports to give information to users (eg: income if the securities were to be sold)

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21
Q

Times Interest Earned

A

A Solvency ratio
AKA: Interest coverage
Indicates the company’s ability to meet interest payments as they come due

= (Net income + interest expense + income tax expense) / interest expense

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22
Q

Net of Income Taxes

A

= item x (1 - tax rate) (check)

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23
Q

Debt to total assets ratio

A

A solvency ratio
measures the percentage of total assets that creditors provide

= total liabilities (aka total debt) / total assets

24
Q

Solvency Ratios

A

Ratios that measure the ability of a company to survive over a long period of time

  • Debt to total assets ratio
  • times interest earned

(both show debt paying ability of the company)

25
Q

Payout Ratio

A

A profitability Ratio
Measures the percentages of earnings distributed in the form of cash dividends

= cash dividends declared on common stock / net income

26
Q

Price Earnings Ratio

A

A profitability ratio
AKA P-E ratio
Reflects the investors assessment of a company’s future earnings

= market price per share of stock / earnings per share

27
Q

Earnings Per Share

A

A profitability ratio
AKA: EPS
Measures net income earned on each share of stock

= Net income (less preferred dividends) / weighted-average common shares outstanding

Weighted average common shares outstanding = (beginning + ending)/2

Per FASB earnings per share must be shown on income statement

28
Q

Return on common stockholders’ equity

A

A profitability ratio
Shows how many dollars of net income the company earned for each dollar invested by the owners (profitability of owner’s investment)

= Net income (less preferred dividends) / Average common stockholders equity

(Average common stockholders’ equity = (beginning + ending)/2)

29
Q

Return on Assets

A

A profitability ratio
AKA: Return on total assets
An overall measure of profitability of assets

= Net Income / Average Total Assets

(Average total assets = (beginning assets + ending assets)/ 2)

Per book: Net income= Net income + interest expense ( this determines real return on income regardless of financing choices)

30
Q

Asset Turnover

A

A profitability ratio
Measures how efficiently a company uses its assets to generate sales

= Net sales / Average total assets

(Average total assets = (beginning assets + ending assets)/ 2)

31
Q

Profit Margin

A

A profitability ratio
Measures the percentage of each dollar of sales that results in net income

= Net income / net sales

(expressed as a percentage)

32
Q

Profitability Ratio

A

Measures the income or operating success of a company over a given period of time.

Income level affects the company’s ability to obtain debit and equity financing = the ability for the company to grow

Ratios:

  • Profit Margin
  • Asset Turnover
  • Return on Assets
  • Return on Common Stockholders’ Equity
  • Earnings-per-Share
  • Price-Earnings ratio
  • Payout Ratio
33
Q

Days in inventory

A

A liquidity ratio
A variant of inventory turnover
Measures average number of dates inventory is held (varies considerably by industry)

= Total days in period (usually 365) / Inventory Turnover

34
Q

Average Collection Period

A

A liquidity ratio
A variant of receivables turnover ratio
Measures average days to collect receivables

= Total Days in period (usually 365) / Receivables Turnover

35
Q

Inventory Turnover

A

A liquidity ratio
Measures the average number of times the inventory is sold during a period. (the liquidity of the inventory)

= cost of goods sold / average inventory

(Average inventory = (beginning inventory + ending inventory)/2)

36
Q

Accounts Receivable Turnover

A

A liquidity ratio
Measures the average number of times a company collects receivables during a period (the liquidity of receivables)

= Net Credit Sales / Average Net Accounts Receivable

Net credit sales generally = net sales
Net accounts receivable = net of allowance for doubtful accounts
Average Net Accounts Receivable = (Beginning A/R + Ending A/R)/ 2

37
Q

Acid Test Ratio

A

A liquidity ratio
Measures Immediate liquidity

= (Cash + Short Term + Net Accounts Receivable)/ Current Liabilities

Ignores inventory and prepaid accounts (not considered liquid enough)
Net accounts receivable = net of allowance for doubtful accounts

38
Q

Current Ratio

A

A liquidity ratio
Measures the amount of current assets for every dollar of current liabilities (short-term debt paying ability)

= current assets / current liabilities

39
Q

Liquidity Ratios

A

Measure the short term ability of a company to pay its maturing obligations and to meet unexpected needs for cash.

Often of interest to short-term creditors (bankers and suppliers)

Ratios:

  • Current Ratio
  • Acid Test Ratio
  • Receivables Turnover
  • Inventory Turnover
40
Q

Financial Analysis under IFRS

A

Basic tools of financial analysis are the same under IFRS and GAAP

Presentation of comprehensive income must be reported in statement of comprehensive income

41
Q

Red Flags in Financial Statements

A
  • Movement of Sales, merchandise inventory, and receivables (usually move in synch)
  • Earnings problems
  • Decreased cash flow
  • Too much Debt
  • inability to collect receivables
  • Buildup of merchandise inventories
42
Q

Treading on the Equity

A

AKA using leverage
Earning more income on borrowed money than the related interest expense, thereby increasing earnings for the owners of the business

43
Q

EBIT

A

Earnings before interest and taxes

= Net income + interest expense + income tax expense

44
Q

Benchmarking

A

The practice of comparing a company’s performance with best practices from other companies

Generally benchmarked against a key competitor or against the industry average

45
Q

Common-Size statements

A

A financial statement that reports only percentages (no dollar amounts)

46
Q

Dollar Value Bias

A

The bias one sees from comparing numbers in absolute (dollars) rather than relative (percentage) terms

47
Q

Trend Analysis

A

A form of horizontal analysis in which percentages are computed by selecting a base period as 100% and expressing the amounts for following periods as a percentage of the base period amounts.

Trend % = (any period amount / base period amount) x100

determines if trend in net sales revenue (or other) is positive or negative over a longer period of time (several years)

48
Q

Parts of an annual report

A
  • Business Overview
  • Management Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
  • Report of independent registered public accounting firm (will issue unqualified, qualified or adverse opinion)
  • Financial Statements
  • Notes to financial statements
49
Q

Annual Reports

A

Provides information about company’s financial positions

SEC requires that publicly traded companies file annual and quarterly reports

50
Q

Dividend Payout

A

Measures percentage of earnings paid annually to common stockholders as cash dividends

= annual dividend per share / earnings per share

51
Q

Dividend Yield

A

Ratio of annual dividends per share of stock to the stock market price per share. Measures percentage of a stock’s market value that is returned annually as dividends to stockholders.

= Annual dividends per share / market price per share

52
Q

Debt to Equity Ratio

A

Measures the proportion of total liabilities to total equity (measuring financial leverage)

= Total Liabilities / total equity

>1 = financing more assets with debt than equity
<1 = financing more assets with equity than debt
53
Q

Gross Profit Percentage

A

AKA Gross margin percentage
Measures the profitability of each sales dollar above cost of goods sold

= gross profit / net sales revenue

Gross profit = net sales revenue - cost of goods sold
(aka gross margin)

54
Q

Cash Ratio

A

A measure of the company’s ability to pay current liabilities from cash and cash equivalents.

= (cash + cash equivalents)/ total current liabilities

Cash Equivalents = investments that can be converted to cash in three months or less

55
Q

Working Capital

A

A measure of a businesses ability to meet its short-term obligations with its current assets

= current assets - current liabilities

56
Q

Base Period

A

The earlier period in a financial report. Used as base for computing percentages.

Horizontal analysis % = (dollar amount of change / base period amount ) x 100

MS2 Accounting Intro Review (16 decks)

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