Chapter 2 - Introduction to Financial Statements Analysis

Question 1

List the four major financial statements required by the SEC for publicly traded firms.

Answer 1

Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Stockholder’s Equity

Question 2

financial statements

Answer 2

Firm-issued (usually quarterly and annually) accounting reports with past performance information.

Question 3

10-Q

Answer 3

The quarterly reporting form that U.S. companies use to file their financial statements with the U.S. Securities and Exchange Commission (SEC).

Question 4

10-K

Answer 4

The annual form that U.S. companies use to file their financial statements with the U.S. Securities and Exchange Commission (SEC).

Question 5

annual report

Answer 5

The yearly summary of business sent by U.S. public companies to their shareholders that accompanies or includes the financial statement.

Question 6

Generally Accepted Accounting Principles (GAAP)

Answer 6

A common set of rules and a standard format for public companies to use when they prepare their financial reports.

Question 7

auditor

Answer 7

A neutral third party that corporations are required to hire that checks the annual financial statements to ensure they are prepared according to GAAP, and to verify that the information is reliable.

Question 8

balance sheet

Answer 8

A list of a firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time.

also called the statement of financial position

Question 9

statement of financial position

Answer 9

List of the firm’s assets and liabilities that provides a snapshot of the firm’s financial position at a given point in time.

also called the balance sheet

Question 10

assets

Answer 10

The cash, inventory, property, plant and equipment, and other investments a company has made.

Question 11

liabilities

Answer 11

A firm’s obligations to its creditors.

Question 12

stockholders’ equity

Answer 12

An accounting measure of a firm’s net worth that represents the difference between the firm’s assets and its liabilities.

Question 13

balance sheet identity

Answer 13

Assets = Liabilities + Stockholders’ Equity

Question 14

current assets

Answer 14

Cash or assets that could be converted into cash within one year. This category includes marketable securities, accounts receivable, inventories, and pre-paid expenses such as rent and insurance.

Question 15

marketable securities

Answer 15

Short-term, low-risk investments that can be easily sold and converted to cash (such as money market investments, like government debt, that mature within a year).

Question 16

accounts receivable

Answer 16

Amounts owed to a firm by customers who have purchased goods or services on credit.

Question 17

inventories

Answer 17

A firm’s raw materials as well as its work-in-progress and finished goods.

Question 18

long-term assets

Answer 18

Net property, plant, and equipment, as well as property not used in business operations, start-up costs in connection with a new business, investments in long-term securities, and property held for sale.

Question 19

depreciation expense

Answer 19

Amount deducted, for accounting purposes, from an asset’s value to reflect wear and tear over a given period.

Question 20

accumulated depreciation

Answer 20

The cumulative depreciation of an asset up to a given point in its life; equal to last period’s accumulated depreciation plus the current period’s depreciation expense.

Question 21

book value

Answer 21

The acquisition cost of an asset less its accumulated depreciation.

Question 22

goodwill

Answer 22

The difference between the price paid for a company and the book value assigned to its assets.

Question 23

intangible assets

Answer 23

Non-physical assets, such as intellectual property, brand names, trademarks, and goodwill. Intangible assets appear on the balance sheet as the difference between the price paid for an acquisition and the book value assigned to its tangible assets.

Question 24

amortization

Answer 24

A charge that captures the change in value of acquired assets. Like depreciation, amortization is not an actual cash expense.

Question 25

impairment charge

Answer 25

Captures the change in value of the acquired assets; is not an actual cash expense.

Question 26

current liabilities

Answer 26

Liabilities that will be satisfied within one year. They include accounts payable, notes payable, short-term debt, current maturities of long-term debt, salary or taxes owed, and deferred or unearned revenue.

Question 27

accounts payable

Answer 27

The amounts owed to creditors for products or services purchased with credit.

Question 28

short-term debt

Answer 28

Debt with a maturity of less than one year.

Question 29

net working capital

Answer 29

The difference between a firm’s current assets and current liabilities that represents the capital available in the short-term to run the business.

Question 30

long-term liabilities

Answer 30

Liabilities that extend beyond one year.

Question 31

long-term debt

Answer 31

Any loan or debt obligation with a maturity of more than a year.

Question 32

capital lease

Answer 32

A lease viewed as an acquisition for accounting purposes. The asset acquired is listed on the lessee’s balance sheet, and the lessee incurs depreciation expenses for the asset. In addition, the present value of the future lease payment is listed as a liability, and the interest portion of the lease payments is deducted as an interest expense. Also known as a finance lease.

Question 33

deferred taxes

Answer 33

An asset or liability that results from the difference between a firm’s tax expenses as reported for accounting purposes, and the actual amount paid to the taxing authority.

Question 34

book value of equity

Answer 34

The difference between the book value of a firm’s assets and its liabilities; also called stockholders’ equity, it represents the net worth of a firm from an accounting perspective.

Question 35

market capitalization or market cap

Answer 35

The total market value of equity; equals the market price per share times the number of shares.

Question 36

market-to-book ratio or price-to-book ratio (P/B)

Answer 36

Market-to-Book Ratio = Market Value of Equity / Book Value of Equity

The ratio of a firm’s market (equity) capitalization to the book value of its stockholders’ equity. Also referred to as the price-to-book or P/B ratio.

Question 37

value stocks

Answer 37

Firms with low market-to-book ratios. (less than 1)

Question 38

growth stocks

Answer 38

Firms with high market-to-book ratios. (greater than 1)

Question 39

enterprise value

Answer 39

Enterprise Value = Market Value of Equity + Debt − Cash

The total market value of a firm’s equity and debt, less the value of its cash and marketable securities. It measures the value of the firm’s underlying business.

Question 40

income statement

Answer 40

A list of a firm’s revenues and expenses over a period of time.

also called statement of financial performance, or profit and loss statement (P&L)

Question 41

net income or earnings

Answer 41

The last or “bottom line” of a firm’s income statement that is a measure of the firm’s income over a given period of time.

Question 42

gross profit

Answer 42

The third line of an income statement that represents the difference between a firm’s sales revenues and its costs.

Question 43

operating income

Answer 43

A firm’s gross profit less its operating expenses.

Question 44

Earnings before Interest and Taxes (EBIT)

Answer 44

A firm’s earnings before interest and taxes are deducted.

Question 45

earnings per share (EPS)

Answer 45

A firm’s net income divided by the total number of shares outstanding.

Question 46

stock options

Answer 46

A form of compensation a firm gives to its employees that gives them the right to buy a certain number of shares of stock by a specific date at a specific price.

Question 47

convertible bonds

Answer 47

Corporate bonds with a provision that gives the bondholder an option to convert each bond owned into a fixed number of shares of common stock.

Question 48

dilution

Answer 48

An increase in the total number of shares that will divide a fixed amount of earnings; often occurs when stock options are exercised or convertible bonds are converted.

Question 49

diluted EPS

Answer 49

A firm’s disclosure of its potential for dilution from options it has awarded which shows the earnings per share the company would have if the stock options were exercised.

Question 50

statement of cash flows

Answer 50

An accounting statement that shows how a firm has used the cash it earned during a set period.

Question 51

capital expenditures

Answer 51

Purchases of new property, plant, and equipment.

Question 52

retained earnings

Answer 52

The difference between a firm’s net income and the amount it spends on dividends.

Question 53

statement of stockholders’ equity

Answer 53

An accounting statement that breaks down the stockholders’ equity computed on the balance sheet into the amount that came from issuing new shares versus retained earnings.

Question 54

management discussion and analysis (MD&A)

Answer 54

A preface to the financial statements in which a company’s management discusses the recent year (or quarter), providing a background on the company and any significant events that may have occurred.

Question 55

off-balance sheet transactions

Answer 55

Transactions or arrangements that can have a material impact on a firm’s future performance yet do not appear on the balance sheet.

Question 56

gross margin

Answer 56

Gross Margin = Gross Profit / Sales

a ratio that reflects a firm’s ability to sell a product for more than the cost of producing it

Question 57

operating margin

Answer 57

Operating Margin = Operating Income / Sales

a profitability ratio revealing how much a company earns before interest and taxes from each dollar of sales

Question 58

EBIT margin

Answer 58

EBIT margin = EBIT / Sales

a profitability ratio that reveals the relative efficiency of the firms’ operations

Question 59

net profit margin

Answer 59

Net Profit Margin = Net Income / Sales

a profitability ratio that shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes

Question 60

current ratio

Answer 60

Current Ratio = Current Assets / Current Liabilities

a liquidity ratio that assesses if the firm has sufficient working capital to meet its short-term needs. the higher the ratio the less risk of a cash shortfall

Question 61

quick ratio

Answer 61

quick ratio = current assets (other than inventory) / current liabilities

a liquidity ratio (more stringent) that assesses if the firm has sufficient working capital to meet its short-term needs. the higher the ratio the less risk of a cash shortfall

Question 62

cash ratio

Answer 62

cash ratio = cash / current liabilites

the most stringent liquidity ratio that shows if the firm has enough cash to meet its short-term needs.

Question 63

accounts receivable days

Answer 63

Accounts Receivable Days = Accounts Receivable / Average Daily Sales

a working capital ratio that shows how fast the firm can turn sales into cash

Question 64

accounts payable days

Answer 64

Accounts Payable Days = Accounts Payable / Average Daily Cost of Sales

An expression of a firm’s accounts payable in terms of the number of days’ worth of cost of goods sold that the accounts payable represents.

Question 65

inventory days

Answer 65

inventory days = inventory / average daily cost of sales

An expression of a firm’s inventory in terms of the number of days’ worth or cost of goods sold that the inventory represents.

Question 66

inventory turnover

Answer 66

The ratio of the annual cost of sales to inventory. A measure of how efficiently a firm is managing its inventory. higher turnover corresponds to shorter days, and thus a more efficient use of working capital.

Question 67

turnover ratios

Answer 67

Measures of working capital computed by expressing annual revenues or costs as a multiple of the corresponding working capital account (accounts receivable, accounts payable, and inventory).

Question 68

accounts receivable turnover

Answer 68

accounts receivable turnover = annual sales / accounts receivable

The ratio of annual sales to accounts receivable. A measure of how efficiently the firm is managing accounts receivable. higher turnover corresponds to shorter days, and thus a more efficient use of working capital.

Question 69

accounts payable turnover

Answer 69

accounts payable turnover = annual cost of sales / accounts payable

The ratio of annual cost of sales to accounts payable. A measure of how quickly the firm is paying its suppliers. higher turnover corresponds to shorter days, and thus a more efficient use of working capital.

Question 70

interest coverage ratio

Answer 70

An assessment by lenders of a firm’s leverage. Common ratios consider operating income, EBIT, or EBITDA as a multiple of the firm’s interest expenses.

A high ratio indicates that the firm is earning much more than is necessary to meet its required interest payments.

Question 71

EBITDA

Answer 71

EBITDA=EBIT+Depreciation and Amortization

A computation of a firm’s earnings before interest, taxes, depreciation, and amortization are deducted.

Question 72

leverage

Answer 72

the extent to which it relies on debt as a source of financing

Question 73

debt-equity ratio

Answer 73

Debt-Equity Ratio = Total Debt / Total Equity

The ratio of a firm’s total amount of short- and long-term debt (including current maturities) to the value of its equity, which may be calculated based on market or book values.

Question 74

debt-to-capital ratio

Answer 74

Debt-to-Capital Ratio = Total Debt / Total Equity+Total Debt

The ratio of a firm’s total amount of short- and long-term debt (including current maturities) to the sum of the value of its debt and the value of its equity, which may be calculated based on market or book values.

Question 75

net debt

Answer 75

Net Debt=Total Debt−Cash & Short-term Investments

debt in excess of a firm’s cash reserves

Question 76

debt-to-enterprise-value ratio

Answer 76

The fraction of a firm’s enterprise value that corresponds to net debt.

Question 77

equity multiplier

Answer 77

Measure of leverage that indicates the value of assets held per dollar of shareholder equity.

Question 78

price-earnings ratio (P/E)

Answer 78

The ratio of the market value of equity to the firm’s earnings, or its share price to its earnings per share.

Question 79

return on equity (ROE)

Answer 79

return of equity = net income / book value of equity

Question 80

return on assets (ROA)

Answer 80

The ratio of net income plus interest expense to the total book value of the firm’s assets. This measure of ROA includes the benefit of the interest tax shield associated with leverage. As a benchmark, ROA is most comparable to the firm’s unlevered cost of capital.

Question 81

return on invested capital (ROIC)

Answer 81

Return on Invested Capital = EBIT (1−tax rate) / Book Value of Equity+Net Debt

The ratio of a firm’s after-tax profit excluding any interest expense (or income) to the sum of the book value of its equity and net debt. As a benchmark, ROIC is most comparable to the firm’s weighted average cost of capital.

Question 82

DuPont Identity

Answer 82

Expression of the ROE in terms of the firm’s profitability, asset efficiency, and leverage.