Chapter 3

Question 1

What are uses of cash?

Answer 1

• Cash outflow - occurs when we “buy” something
• Increase in asset account (Everything except cash & equivalents is a use)
• Decrease in a liability or equity account (A/P is the only use)

Question 2

What is the statement of cash flows?

Answer 2

• Statement that summarizes the sources and uses of cash.

Question 3

What are the three major changes found in the statement of cash flows?

Answer 3

1. Operating activity - includes net income and changes in most current accounts
2. Investment activity - includes changes in fixed assets
3. Financing activity - includes changes in notes payable, long-term debt, and equity accounts as well as dividends

Question 4

What is a common-size balance sheet?

Answer 4

Computes all accounts as a percent of total assets.

Question 5

What is a common-size income statement?

Answer 5

Computes all line items as a percent of sales.

Question 6

Why are standardized financial statements useful?

Answer 6

1. Make it easier to compare financial information, particularly as the company grows.
2. Also useful for comparing companies of different sizes, particularly within the same industry.

Question 7

What are the five categories of financial ratios?

Answer 7

1. Short-term solvency or liquidity ratios
2. Long-term solvency or financial leverage ratios
3. Asset management or turnover ratios
4. Profitability ratios
5. Market value ratios

Question 8

What is total asset turnover?

Answer 8

• TAT = Sales/Total Assets
• Measure of asset use efficiency
• Not unusual for TAT < 1, especially if a firm has a large amount of fixed assets

Question 9

What is profit margin?

Answer 9

• Net income/Sales

- A measure of the firm’s operating efficiency (how well does it control costs)

Question 10

What is an equity multiplier?

Answer 10

• Totals Assets/Total Equity

- A measure of the firm’s financial leverage

Question 11

What are the internal uses for financial statements?

Answer 11

1. Performance evaluation - compensation and comparison between divisions
2. Planning for the future - guide in estimating future cash flows

Question 12

What are the external uses for financial statements?

Answer 12

1. Creditors
2. Suppliers
3. Customers
4. Stockholders

Question 13

What is the time-trend analysis?

Answer 13

• Used to see how the firm’s performance is changing through time
• Internal and external uses

Question 14

What is the Peer Group Analysis?

Answer 14

• Compare to similar companies or within industries

- SIC and NAICS codes

Question 15

What are the potential problems with financial statement analysis?

Answer 15

• No underlying theory; no way to know which ratios are most relevant
• Benchmarking is difficult for diversified firms
• Globalization and international competition makes comparison more difficult because of differences in accounting regulations
• Varying accounting procedures (i.e. FIFO vs. LIFO)
• Different fiscal years
• Extraordinary events

Question 16

What are sources of cash?

Answer 16

• Cash inflow - occurs when we “sell” something
• Decrease in asset account (Cash & equivalents is the only source)
• Increase in liability or equity account (Everything except A/P is a source)