chapter 3

Question 1

define return on equity

Answer 1

ROE = net income / average stockholders’ equity

measure return from perspective of company’s stockholders

measure the return the company has earned on the book value of the shareholders’ investment - how effective management has been in its role as stewards of capital invested by shareholders

Question 2

what’s the ROE formula if there’s preferred stock

Answer 2

ROE = (net income attributable to company shareholders - preferred dividends)/(average equity attributable to company shareholders - average preferred equity)

Question 3

is ROE computed in controlling or noncontrolling stockholders

Answer 3

only non controlling interest (parent company) stockholders

Question 4

what are the 2 methods for disaggregating ROE

Answer 4

1.The first method is the traditional
DuPont analysis
that disaggregates return on equity into
components of profitability, productivity, and leverage.
■
The second method extends the traditional DuPont analysis by taking an
ROE analysis with
an operating focus
that separates operating and nonoperating activities. This method, which
focuses on operating or core activities, provides insight into the factors that drive value creation

Question 5

what’s the DuPont model of ROE

Answer 5

ROE = (net income/average total assets) x (average total assets/average stockholders
equity) x NCIR

ROE = ROA x financial leverage x noncontrolling interest ratio

Question 6

what’s the point of ROE

Answer 6

takes the perspective of a company’s shareholders and measures rate of
return on shareholders’ investment—how much net income is earned relative to the equity invested
by shareholders. It reflects
both
company performance (as measured by Return on assets)
and
how assets are financed (relative use of liabilities and equity as measured by the leverage term).
ROE is higher when there is more debt and less equity for a given level of assets (this is because
the denominator in ROE, equity, is smaller). There is, however, a trade-off: while using more debt
and less equity results in higher ROE, the greater debt means higher risk for the company.

Question 7

define ROA

Answer 7

measures return from the perspective of the entire company. This
return includes both profitability (numerator) and total company assets (denominator).

to earn a high return on assets, the company must be profitable
and
manage assets to minimize the assets
invested to the level necessary to achieve its profit.

Question 8

what does ROA encourage managers to do

Answer 8

ROA anal-
ysis encourages managers to focus on the profit achieved from the assets under their control. This
means that managers seek to increase profits with the same level of assets
and
to decrease assets
without decreasing the level of profit. It is this dual focus that makes return on assets a powerful performance measure—focusing managers’ attention on
both
the income statement and balance sheet.

Question 9

what’s a note of the ROA calculation?

Answer 9

ROA measures the return on
all
the company’s assets, that is the total net income
generated from total assets. Because total asset equals total liabilities plus total equity, the ROA
computation is from the perspective of
all
of the stakeholders of the company. Therefore, we use
consolidated net income (net income
before
allocation to noncontrolling interest) in the numerator
and consolidated total assets (averaged) in the denominator.

Question 10

define financial leverage

Answer 10

measures the degree to which the
company finances its assets with debt versus equity.

ratio of average total assets to average stockholders equity

FL measures the leverage on
all
the company’s assets compared to equity from all sources. Therefore, we use consolidated equity
and do not exclude noncontrolling interest or preferred stock in the denominator of the FL ratio.

Question 11

ROE vs ROA and FL

Answer 11

Because
ROE focuses on a company’s common shareholders, it uses
Net income attributable to the com-
pany’s common shareholders
in the numerator and
Equity attributable to the company’s common
shareholders
in the denominator (both of which exclude net income and equity that are attribut-
able to the noncontrolling interest). ROA and FL, in contrast, focus on the entire company and, consequently, use Net income (more precisely,
Net income before allocation of noncontrolling
interest
) in the numerator and
Total stockholders’ equity
(including noncontrolling interest) in the
denominator. We, therefore, add a third term to the ROE computation to account for both share-
holder groups (the company’s shareholders

Question 12

what’s the formation for noncontrolling interest ratio

Answer 12

NCIR = (net income attributable to the company’s common shareholders/net income)/(average equity attributable to the company’s common shareholders/average total equity)

Question 13

what’s the disaggregating ROA formula

Answer 13

ROA = (net income/sales) x (sales/average total assets)

= profit margin x asset turnover

Return on assets is the product of profit margin and utilization of assets in generating sales (asset
turnover). This is the insight that DuPont analysis offers as it focuses managers’ attention on both
profitability
and
management of the balance sheet.

Question 14

define profit margin and asset turnover

Answer 14

Profit margin (PM).
PM
is what the company earns on each sales dollar; a company
increases profit margin by increasing its gross profit margin (Gross profit/Sales) and/or reduc-
ing its operating expenses and income tax expense as a percent of sales.
■
Asset turnover (AT).
AT
is the sales level generated from each dollar invested in assets; a
company increases asset turnover (
productivity
) by increasing sales volume with no increase
in assets and/or by reducing assets invested without reducing sales.

Question 15

what’s the goal with ROA

Answer 15

goal is to increase the productivity of the company’s assets in generating sales and then to
bring as much of each sales dollar to the bottom line (net income). Managers usually understand
product pricing, management of production costs, and control of overhead costs. Fewer manag-
ers understand the role of the balance sheet. The ROA approach to performance measurement
encourages managers to focus on returns achieved from assets under their control, and ROA is
maximized with a joint focus on both profitability and productivity.

Question 16

disaggregation of ROE on the first level vs second level

Answer 16

The disaggregation of ROE into ROA and financial leverage (FL) represents a
first level
of
analysis where we examine ROE over time and in comparison with peers to identify trends and
differences from the norm.
A
second level
analysis of the components of return on equity seeks to identify factors driving profitability (profit margin) and productivity (asset turnover) and to assess whether financial
leverage increases the risk of default and bankruptcy beyond acceptable levels.

Question 17

what is profit margin influenced by

Answer 17

gross profit on sales and SG%A expenses

Question 18

what is gross profit margin influenced by

Answer 18

selling price of company’s products and the cost to make or buy those products

Question 19

what do we prefer un gross profit margin

Answer 19

be high and increasing as the opposite usually signals more competition or less success with the company’s product line

Question 20

what reasons would gross profit margin decline

Answer 20

Perhaps competitive intensity increased and selling prices have dropped to remain competitive.
■
Perhaps the company’s product line has lost appeal or its technology is not cutting edge.
■
Perhaps the cost to make or buy products has increased due to increases in material or labor
costs and the company cannot pass on that cost increase to customers.
■
Perhaps there is a change in product mix away from high margin products to lower margin
products (remember that sales and gross profit include
all
of the company’s products, includ-
ing both high margin and low margin products).
■
Perhaps the volume of products sold has declined, resulting in an increase in manufacturing
cost as factory overhead is spread out over a smaller number of units produced.

Question 21

what’s the analysis of operating expense margin

Answer 21

Analysis of operating expense margin focuses on each expense in whatever detail the company
discloses in its income statement and notes. We compare the
operating expense margin, and the margins for each of its com-
ponents, over time and against peers (making sure that peers have
similar business models). We investigate deviations from histori-
cal trends or benchmarks to uncover the cause. We are inclined to
judge lower expense levels as favorable, but caution is advised.
Perhaps a lower expense level happens because the company has
tried to mitigate declining profits by reducing R&D, marketing,
or compensation costs. Such activities tend to result in short-term
improvements at long-term costs such as reduced market share
and damaged employee morale.

Question 22

how is productivity reflected

Answer 22

in return of assets through turnover of total assets (sales/total assets)

Question 23

what’s the starting point in working capital analysis

Answer 23

examine current ratio (current assets/current liabilities) and quick ratio ((cash + marketable securities + accounts receivables)/current liabilities)

Question 24

why does working capital analysis focus on AR, inventory and AP

Answer 24

These three accounts relate to a company’s core activities: buying (or manufac-
turing) and selling inventory. These activities make up the
operating cycle
and analyzing the activity
in these three accounts can reveal key insights into the company’s operating cash flow and liquidity.

Question 25

what’s the formula for DIO, DSO, and DPO

Answer 25

DIO = 365 x (average inventories/COGS)

DSO = 365 x (average AR/sales)

DPO = 365 x (average AP/COGS)

Question 26

what’s the cash conversion cycle

Answer 26

CCC = DIO + DSO - DPO

Question 27

what does the CCC reflect

Answer 27

Credit terms offered to customers
■
Types of inventory carried and depth and breadth of product lines (which influence the time
inventories remain unsold).
■
Time period in which suppliers are paid for goods and services.

Question 28

why is there variability in CCC across industries

Answer 28

reflects fundamental differences in business models.

Question 29

why do companies prefer lower cash conversion cycle

Answer 29

This means that the operating cycle is generating
profit and cash flow quickly.

Question 30

how is a negative cash conversion viewed?

Answer 30

viewed positively

Question 31

what’s the PP&E turnover by industry

Answer 31

highest: Communication services, Information Tech, Industrials, healthcare, Consumer Discretionary, Consumer Staples, Materials, Energy, Utilities

Question 32

what do improvements in PP&E turnover require

Answer 32

Divestiture of unproductive assets or entire business segments.
■
Joint ventures with other companies to jointly use PP&E assets
such as distribution networks, information technology, production facilities, and warehouses.
Divestiture of production facilities with agreements to purchase finished goods from the facilities’ new owners.
■
Sale and leaseback of administrative buildings.

Question 33

what are the usual obligations in a loan agreement for debt financing

Answer 33

Restrictions on certain activities, such as mergers or acquisitions of other companies without
approval of lenders.
■
Prohibitions against dividend payments or the repurchase of common stock without approval
of lenders.
■
Covenants to maintain required levels of financial ratios, such as a maximum level of finan-
cial leverage, minimum levels of the current and quick ratios, minimum level of equity, and
minimum level of working capital.
■
Prohibitions against the pledging of assets to secure new borrowings.
■
Remedies to lenders in event of default (failure to make required interest and principal pay-
ments when due). These remedies can include seizing company assets or, possibly, forcing
the company into bankruptcy and requiring liquidation.

Question 34

what does an analysis of financial leverage entail

Answer 34

Analysis typically involves ratios that investigate the
level
of borrowed money relative
to equity capital and the level of profitability and
cash flow
relative to required debt payments.
Although there are dozens of financial leverage-related ratios in commercial databases, the fol-
lowing two ratios capture the spirit of leverage analysis.
■
Total debt-to-equity ratio (Total debt/Total stockholders’ equity).
■
Times interest earned ratio (Earnings before interest and taxes/Interest expense, gross).

Question 35

check textbook page 16 in chapter 3 on summary ratios in DuPont disaggregation of ROE and tell me ratio, computation, what the ratio measure and positive indictors

Question 36

what’s the ROE formula with an operating focus

Answer 36

ROE = operating return + nonoperating return

(1) return from the company’s operating activities,
linked to revenues and expenses from the company’s sale of products or services, and (2) return
from nonoperating (financing and investing) activities.

Question 37

can companies use debt to increase their ROE

Answer 37

yes, but it increases the risk of failure to make required debt payments

Question 38

what’s the difference between borrowed money and operating liabilities

Answer 38

Accounts payable and accrued liabilities are interest free and are
self-liquidating,
meaning that they are paid when receivables are collected as part of the cash conversion cycle. On
the other hand, borrowed money is interest-bearing and often contains severe legal repercussions in
the event of nonpayment, possibly risking bankruptcy. The operating focus treats these two types
of liabilities differently for ROE analysis, treating borrowed money (debt) as a nonoperating item

Question 39

what’s the formula for Return on Net Operating Assets (RNOA)

Answer 39

RNOA = net operating profit after tax /Average net operating assets

NOPAT/NOA= NOPAT/sales x Sales/average NOA = net operating profit margin x net operating asset turnover

Question 40

what’s the formula of net operating assets

Answer 40

net operating assets = operating assets - operating liabilities

Question 41

what are included in operating assets

Answer 41

Operating assets are those assets directly linked to the company’s ongoing (continuing) business
operations of bringing its products or services to the market. The company needs these assets to
operate normally and they typically include the following:
■
Accounts receivable
■
Inventories
■
Prepaid expenses and supplies
■
Property, plant, and equipment (PP&E)
■
Right-of-use assets, which are long-term leased assets that are treated like PP&E assets that
are owned outright
■
Intangible assets and goodwill
The FASB previously
released a draft of a
proposed new format
for financial statements
to, among other things,
distinguish operating
and nonoperating
activities.
■
Deferred income tax assets
■
Equity method investments (EMI), which are strategic investments with partners, associated
companies, and joint ventures

Question 42

what’s operating liabilities

Answer 42

Operating liabilities are obligations that arise from operating revenues and expenses. These liabil-
ities arise from the core business activities of the company. Examples include:
■
Accounts payable
■
Accrued expenses (for unpaid wages and other operating expenses)
■
Unearned or deferred revenue (as it relates to operating revenue)
■
Income taxes payable (both short-term and long-term)
■
Deferred income tax liabilities
■
Pension and other post-employment obligations (that relate to employee retirement and
healthcare, which are operating activities)

Question 43

what’s classified as other assets and liabilities

Answer 43

non-operating items such as equity items

Question 44

what’s Net nonoperating obligations (NNO)

Answer 44

net nonoperating obligations = nonoperating liabilities - nonoperating assets

All balance sheets include nonoperating liabilities and/or nonoperating assets, although they are typ-
ically less numerous than the operating items. Generally, nonoperating refers to assets and liabilities
that are not used as part of the core business activities of the company. As a rule of thumb, if the
liability requires the payment of interest expense or if the asset earns interest or dividend income, it
is classified as nonoperating.

NNO refers to net “obligations” whereas NOA refers to net “assets.” We subtract any
nonoperating assets from nonoperating liabilities to arrive at NNO. For most companies, NNO is
a positive amount, meaning that nonoperating obligations are greater than nonoperating assets.

Question 45

what are some common nonoperating liabilities

Answer 45

Short-term and long-term debt, regardless of the purpose of the borrowing
■
Lease obligations, current and noncurrent portions
■
Interest payable
■
Dividends payable
Equity items
are not part of
operating or
nonoperating
items
■
Discontinued or held-for-sale liabilities
■
Derivative liabilities

Question 46

what are some common nonoperating assets

Answer 46

Cash and cash equivalents
■
Marketable securities (both current and noncurrent)
■
Discontinued or held-for-sale assets
■
Derivative assets

Question 47

why is cash and cash equivalents in nonoperating assets

Answer 47

It might seem odd that we classify cash and cash equivalents as a nonoperating asset, but this
account frequently consists almost totally of “cash equivalents,” which are short-term investments
with a scheduled maturity of 90 days or less. Technically, the cash needed to support routine business transactions is an operating asset. However, companies do not separately report that information and it is typically a small portion of the cash and cash equivalents line item. Therefore, we
consider the entire cash and cash equivalents account as a nonoperating asset. This is consistent
with current practice among external financial analysts.
Net Nonoperating Obligations (NNO)

Question 48

what’s operating activities and how does the Income statement capture it

Answer 48

Operating activities
are those that relate to bringing a company’s products or services to market and any after-sales
support. The income statement captures operating revenues and expenses, yielding operating
profit. Operating profit less income tax on operating profit results in net operating profit after tax
(NOPAT). This measure of a company’s operating performance warrants special attention because
it is the lifeblood of a company’s value creation and growth.

Question 49

why is net income not equivalent to net operating profit after tax

Answer 49

because
the income statement often includes nonoperating activities. These activities relate to such items
as borrowed money that creates interest expense and nonstrategic investments in marketable securities that yield interest or dividend revenue.

Question 50

what’s the formula to net operating profit after tax

Answer 50

NET OPERATING PROFIT AFTER TAX = NET OPERATING PROFIT BEFORE TAX - TAX ON OPERATING PROFIT

Question 51

what are the operating line items on the income statement

Answer 51

Operating activities relate to bringing a company’s products or services to market and providing
after-sales support. These include:
■
Revenues
■
Costs of goods sold (COGS)
■
Selling, general, and administrative expense (SG&A) such as wages, advertising, occupancy,
insurance, depreciation and amortization, litigation, and restructuring expenses
■
Research and development—often reported as part of SG&A
■
Impairments of operating assets such as PP&E, intangibles, and goodwill
■
Income from strategic investments (
not
marketable securities)—including joint ventures,
partnerships, associated companies, and equity-method investments
■
Gains and losses on disposals of operating assets such as PP&E and strategic investments
■
“Other” operating expenses or revenues—unless note disclosures indicate that the items are
nonoperating or they are included in the nonoperating portion of the income statement

Question 52

what the nonoperating line items on the income statement

Answer 52

Nonoperating income and expense items relate to nonoperating assets and liabilities. These items
include:
■
Interest expense on debt and lease obligations
■
Loss or income relating to discontinued operations
■
Debt issuance and retirement costs
■
Interest and dividend income on nonstrategic investments (marketable securities)
■
Gains or losses on the sale of nonstrategic investments
■
“Other” income or expense
if reported separately
from operating income (usually following
the operating section of the income statement)

Question 53

can nonoperating activities create a pretax net nonoperating expense? what does that mean?

Answer 53

For most companies, nonoperating activities create a pretax net nonoperating “expense” (meaning
that interest expense exceeds interest and other nonoperating income). When the reverse is true
(interest and other nonoperating income is greater than interest expense), then the net nonoperating item is “income”

Question 54

what’s the tax on operating profit formula

Answer 54

tax in operating profit = tax expense + (pretax net nonoperating expense x statutory tax rate)

= tax expense x tax shield

Question 55

define tax shield

Answer 55

which are the taxes that a company saves by
having tax-deductible nonoperating expenses (see Tax Shield box below for details). By defini-
tion, the taxes saved (by the tax shield) do not relate to operating profits; thus, we must add back
the tax shield to total tax expense to compute the tax on operating profit.

Question 56

when would a company have a negative tax shield and what is it?

Answer 56

: For companies where nonoperating revenues are greater than nonoperating expenses,
so-called nonoperating income, the “pretax net nonoperating expense” is a negative number
which yields a negative tax shield. A negative tax shield implies that the company is paying
more tax than it would have paid if not for the additional nonoperating income. Tax on oper-
ating profit is computed in the same manner as in the equation above: we add the negative tax
shield to tax expense.

Question 57

what’s the formula of return on net operating assets (RNOA)

Answer 57

RNOA = net operating profit after tax / average net operating assets

Question 58

what’s the approx formula of ROE when there’s no noncontrolling interest in operating and nonoperating components

Answer 58

ROE = operating return (RNOA) + nonoperating return

Question 59

why are we interested in financial leverage

Answer 59

because it is an important measure of the risk a company
is incurring with its reliance on debt. As debt increases so does the risk that the company is unable
to pay the interest and principal payments on the debt. Financial leverage quantifies this risk.
While financial leverage increases risk, it also increases the return to shareholders
but only
if the yield on the assets financed with the debt is greater than the borrowing rate on the debt
.

Question 60

how does DuPont and operating approaches impact of financial leverage differently

Answer 60

DuPont
approach measures the impact of financial leverage on ROE using only balance sheet
numbers:

Operating
approach measures the impact of financial leverage on ROE using
nonoperating
return
, which captures effects from both the balance sheet and the income statement. Nonoperating return provides a way to measure the impact of financial leverage on ROE.

Question 61

what’s the net operating profit margin

Answer 61

net operating profit margin (NOPM) = net operating profit after tax / sales

reveals how much operating profit the company earns
from each sales dollar. All things equal, a higher net operating profit margin is preferable. Net
operating profit margin is affected by
■
Gross profit
(Revenues – Cost of goods sold) which depends on product prices, manufactur-
ing or purchase costs, and competition in product pricing
■
Other operating expenses
and
overhead costs
that the company incurred to support oper-
ating activities

Question 62

what’s the net operating asset turnover (NOAT)

Answer 62

net operating asset turnover = sales/average net operating assets

measures the productivity of the company’s net operating
assets. This metric reveals the level of sales the company realizes from each dollar invested in
net operating assets. All things equal, a higher NOAT is preferable.

Question 63

how can companies increase net operating asset turnover

Answer 63

by either increasing sales for a given
level of investment in operating assets, or by reducing the amount of operating assets necessary
to generate a dollar of sales, or both. Reducing operating working capital (current operating
assets less current operating liabilities) is usually easier than reducing long-term net operating
assets. For example, companies can implement strategies to collect their receivables more quickly,
reduce their inventories, and delay payments to their suppliers. All of these actions reduce operat-
ing working capital and, thereby, increase NOAT. These strategies must be managed, however, so
as not to negatively impact sales or supplier relations. Working capital management is an import-
ant part of managing the company effectively.

Question 64

why is it difficult to reduce the level of long-term net operating assets

Answer 64

The level of
PP&E required by the company is determined more by the nature of the company’s business model
than by management action. For example, telecommunications companies require more capital
investment than do retail stores. Still, there are several actions that managers can take to reduce
capital investment. Some companies pursue novel approaches, such as corporate alliances, out-
sourcing, and use of special-purpose entities;

Question 65

what does the analysis of net operation asset turnover examine

Answer 65

examines the ratio over time and in comparison with
peers. As with asset turnover in the DuPont analysis, the net operating asset turnover includes
effects from the turnover (and corresponding days) for each of the working capital accounts
(accounts receivable, inventory, accounts payable) and effects from the long-term operating assets
turnover. A second-level analysis of net operating asset turnover examines these components to
uncover underlying trends that drive this ratio.

Question 66

what’s the tradeoff between margin and turnover

Answer 66

relatively straightforward when comparing companies that operate in one industry (
pure-play
firms). Analyzing conglomerates that operate in several
industries is more challenging. The margins and turnover rates for companies that operate in more
than one industry are a weighted average of the margins and turnover rates for the various industries
in which they operate.

Question 67

what’s the difference between IFRS balance sheet and US GAAP

Answer 67

IFRS companies routinely report “financial assets” or “financial liabilities” on the balance sheet.
IFRS defines financial assets to include receivables (operating item), loans to affiliates or asso-
ciates (can be operating or nonoperating depending on the nature of the transactions), securities
held as investments (nonoperating), and derivatives (nonoperating). IFRS notes to financial state-
ments detail what financial assets and liabilities consist of. This helps us accurately determine
NOA and net nonoperating obligations (NNO).
The IFRS income statement does not report operating income, which means we must devote
attention to classify operating versus nonoperating income components. IFRS income statements
often report items that are considered operating such as gains and losses on disposals of oper-
ating assets, or income from equity method investments, below the operating income line. We
must examine IFRS income statements and their notes to independently assess the nature of each
income statement item.

Question 68

how can ROE be disaggregated into FLEV x spread

Answer 68

ROE = [operating return (RNOA) + nonoperating return] x NCIR

nonoperating return = financial leverage x spread

Financial leverage = average NNO/average equity
spread = RNOA - NNEP

Question 69

how to increase ROE by financial leverage and spread

Answer 69

1. Increase FLEV
   —borrow more (proportionately), which increases NNO relative to equity and increases FLEV
2. Increase Spread
   —borrow at lower cost (RNOA held constant), which decreases NNEP and increases Spread

Question 70

what’s the limit on increasing nonoperating return

Answer 70

nonoperating return can only be increased as long as the company does not take on too much
debt. Credit risk (the risk of default or bankruptcy) increases with the level of debt. As the company takes on more
debt, lenders will mitigate the increased credit risk by charging higher interest rates. As borrowing costs increase,
there will be fewer investment opportunities (assets that the company can acquire) that earn an adequate return to
justify the increased borrowing. At some point, further borrowing will not be cost-effective. This explains why we do
not often see companies with excessive levels of financial leverage, or at least not over the long term.

Question 71

how does negative FLEV (financial leverage) affect the relation between ROE and RNOA

Answer 71

ROE is re-
duced as a consequence of the firm holding relatively low-earning financial assets that are financed by higher-cost
debt. Negative FLEV companies typically report an acceptable level of ROE, but have foregone the opportunity to
increase ROE even further.

Question 72

RNOA vs ROA

Answer 72

RNOA measured operating performance more accurately as NOA excludes Apple’s sizeable investment in cash and marketable securities,
NOA reveals the power of non-debt (interest-free) liabilities such as supplier credit and operating accruals
such as payables for utilities, wages, and so forth

Question 73

RNOA vs ROA for shareholder value

Answer 73

RNOA - operating activities that drive shareholder value, not investment
in marketable securities. In this case, the operating approach is an important (and superior) measure of Apple’s
financial performance.

Question 74

what’s the benefit of ratios

Answer 74

it is “unit free”—that is, ratios allow us to compare companies of different sizes
and contrast financial statements that are reported in different currencies

Question 75

define vertical analysis and horizontal analysis

Answer 75

Vertical analysis
expresses financial statements in ratio form. Specifically, we express income statement
items as a percent of net sales, and balance sheet items as a percent of total assets. Such
common-size, or right-size,
financial statements
facilitate comparisons
across companies
of different sizes and comparisons of accounts within
a set of financial statements.
Horizontal analysis
is the scrutiny of financial data
across time. Comparing data across two or more consecutive periods assists in analyzing trends in company performance and in predicting future performance. There are
two ways to perform a horizontal analysis

Question 76

what are the 2 ways to perform horizontal analysis

Answer 76

Compare vertical analysis over time. Once the balance sheet or income statement is expressed in percentage
terms, we can look for trends or changes year over year. This level of analysis points out areas that warrant
additional research. We use notes, the MD&A section of the Form 10-K, and external sources to explain un-
usual changes or concerning trends.
■
Express each financial statement item as a year-over-year percentage change, as follows.

(Current balance − Previous balance) / Previous balance

Special attention is required when the previous balance is a negative number

(current balance - previous balance)/absolute value of previous balance

Question 77

what’s the limitations of ratio analysis

Answer 77

1. Measurability
   . Financial statements reflect what can be reliably measured. This results in nonrecognition of
   certain assets, often internally developed assets, the very assets that are most likely to confer a competitive
   advantage and create value. Examples are brand name, a superior management team, employee skills, and a
   reliable supply chain.
2. Noncapitalized costs
   . Related to the concept of measurability is the expensing of costs relating to “assets”
   that cannot be identified with enough precision to warrant capitalization. Examples are brand equity costs from
   advertising and other promotional activities, and research and development costs relating to future products.
3. Historical costs
   . Assets and liabilities are usually recorded at original acquisition or issuance costs. Subsequent
   increases in value are not recorded until realized, and declines in value are only recognized if deemed permanent.

Company Changes -
Many companies regularly undertake mergers, acquire new companies, and divest subsidiaries. Such major operational changes can impair the comparability of company ratios across time. Companies also
change strategies, such as product pricing, R&D, and financing. We must understand the effects of such changes on
ratios and exercise caution when we compare ratios from one period to the next. Companies also behave differently
at different points in their life cycles. For instance, growth companies possess a different profile than do mature companies. Seasonal effects also markedly impact analysis of financial statements at different times of the year. Thus, we
must consider life cycle and seasonality when we compare ratios across companies and over time.

Conglomerate Effects -
Few companies are a pure-play; instead, most companies operate in several businesses or industries. Most publicly traded companies consist of a parent company and multiple subsidiaries,
often pursuing different lines of business. Most heavy equipment manufacturers, for example, have finance
subsidiaries (Financial statements of such conglomerates are consolidated and include
the financial statements of the parent and its subsidiaries. Consequently, such consolidated statements are challenging to analyze. Typically, analysts break the financials apart into their component businesses and separately
analyze each component. Fortunately, companies must report financial information (albeit limited) for major
business segments in their 10-Ks.

Fuzzy View -
Ratios reduce, to a single number, the myriad complexities of a company’s operations. No scalar
can accurately capture all qualitative aspects of a company. Ratios cannot meaningfully convey a company’s
marketing and management philosophies, its human resource activities, its financing activities, its strategic initia-
tives, and its product management. In our analysis we must learn to look through the numbers and ratios to better
understand the operational factors that drive financial results. Successful analysis seeks to gain insight into what
a company is really about and what the future portends. Our overriding purpose in analysis is to understand the
past and present to better predict the future. Calculating and analyzing ratios are crucial first steps in that process.