Chapter 3 Financial Statements and Ratio Analysis

Question 1

generally accepted accounting principles (GAAP)

Answer 1

The practice and procedure guidelines used to prepare and maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB).

Question 2

Financial Accounting Standards Board (FASB)

Answer 2

The accounting profession’s rule-setting body, which authorizes generally accepted accounting principles (GAAP).

Question 3

Public Company Accounting Oversight Board (PCAOB)

Answer 3

A not-for-profit corporation established by the Sarbanes-Oxley Act of 2002 to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports.

Question 4

stockholders’ report

Answer 4

Annual report that publicly owned corporations must provide to stockholders; it summarizes and documents the firm’s financial activities during the past year.

Question 5

letter to stockholders

Answer 5

Typically, the first element of the annual stockholders’ report and the primary communication from management.

Question 6

income statement

Answer 6

Provides a financial summary of the firm’s operating results during a specified period.

Question 7

dividend per share (DPS)

Answer 7

The dollar amount during the period on behalf of each outstanding share of common stock.

Question 8

balance sheet

Answer 8

Summary statement of the firm’s financial position at a given point in time.

Question 9

current assets

Answer 9

Short-term assets, expected to be converted into cash within 1 year or less.

Question 10

current liabilities

Answer 10

Short-term liabilities, expected to be paid within 1 year or less.

Question 11

long-term debt

Answer 11

Debt for which payment is not due in the current year.

Question 12

paid-in capital in excess of par

Answer 12

The amount of proceeds is in excess of the par value received from the original sale of common stock.

Question 13

retained earnings

Answer 13

The cumulative total of all earnings, net of dividends, that have been retained and reinvested in the firm since its inception.

Question 14

statement of stockholders’ equity

Answer 14

Shows all equity account transactions that occurred during a given year.

Question 15

statement of retained earnings

Answer 15

Reconciles the net income earned during a given year, and any cash dividends paid with the change in retained earnings between the start and the end of that year. An abbreviated form of the statement of stockholders’ equity.

Question 16

statement of cash flows

Answer 16

Provides a summary of the firm’s operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period.

Question 17

notes to the financial statements

Answer 17

Explanatory notes keyed to relevant accounts in the statements; they provide detailed information on the accounting policies, procedures, calculations, and transactions underlying entries in the financial statements.

Question 18

Financial Accounting Standards Board (FASB) Standard No. 52

Answer 18

Mandates that U.S.-based companies translate their foreign-currency-denominated assets and liabilities into U.S. dollars, for consolidation with the parent company’s financial statements. This process is done by using the current rate (translation) method.

Question 19

current rate (translation) method

Answer 19

Technique used by U.S.-based companies to translate their foreign-currency-denominated assets and liabilities into U.S. dollars, for consolidation with the parent company’s financial statements, using the year-end (current) exchange rate.

Question 20

ratio analysis

Answer 20

Involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.

Question 21

cross-sectional analysis

Answer 21

Comparison of different firms’ financial ratios at the same point in time; involves comparing the firm’s ratios with those of other firms in its industry or with industry averages.

Question 22

benchmarking

Answer 22

A type of cross-sectional analysis in which the firm’s ratio values are compared with those of a key competitor or with a group of competitors that it wishes to emulate.

Question 23

time-series analysis

Answer 23

Evaluation of the firm’s financial performance over time using financial ratio analysis.

Question 24

liquidity

Answer 24

A firm’s ability to satisfy its short-term obligations as they come due.

Question 25

current ratio

Answer 25

A measure of liquidity calculated by dividing the firm’s current assets by its current liabilities.

Question 26

quick (acid-test) ratio

Answer 26

A measure of liquidity calculated by dividing the firm’s current assets minus inventory by its current liabilities.

Question 27

activity ratios

Answer 27

Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows.

Question 28

inventory turnover

Answer 28

Measures the activity, or liquidity, of a firm’s inventory.

Question 29

average age of inventory

Answer 29

Average number of days’ sales in inventory.

Question 30

average collection period

Answer 30

The average amount of time needed to collect accounts receivable.

Question 31

average payment period

Answer 31

The average amount of time needed to pay amounts payable.

Question 32

total asset turnover

Answer 32

Indicates the efficiency with which the firm uses its assets to generate sales

Question 33

financial leverage

Answer 33

The magnification of risk and return through the use of fixed- cost financing, such as debt and preferred stock.

Question 34

degree of indebtedness

Answer 34

Measures the amount of debt relative to other significant balance sheet amounts.

Question 35

ability to service debt

Answer 35

The ability of a firm to make the payments required on a scheduled basis over the life of a debt.

Question 36

coverage ratios

Answer 36

Ratios that measure the firm’s ability to pay certain fixed charges.

Question 37

debt ratio

Answer 37

Measures the proportion of total assets financed by the firm’s creditors.

Question 38

debt-to-equity ratio

Answer 38

Measures the relative proportion of total liabilities and common stock equity used to finance the firm’s total assets.

Question 39

times interest earned ratio

Answer 39

Measures the firm’s ability to make contractual interest payments; sometimes called the interest coverage ratio.

Question 40

fixed-payment coverage ratio

Answer 40

Measures the firm’s ability to meet all fixed-payment obligations.

Question 41

common-size income statement

Answer 41

An income statement in which each item is expressed as a percentage of sales.

Question 42

gross profit margin

Answer 42

Measures the percentage of each sales dollar remaining after the firm has paid for its goods.

Question 43

operating profit margin

Answer 43

Measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted; the “pure profits” earned on each sales dollar.

Question 44

net profit margin

Answer 44

Measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted.

Question 45

return on total assets (ROA)

Answer 45

Measures the overall effectiveness of management in generating profits with its available assets; also called the return on investment (ROI).

Question 46

return on equity (ROE)

Answer 46

Measures the return earned on the common stockholders’ investment in the firm.

Question 47

market ratios

Answer 47

Relate a firm’s market value, as measured by its current share price, to certain accounting values.

Question 48

price/earnings (P/E) ratio

Answer 48

Measures the amount that investors are willing to pay for each dollar of a firm’s earnings; the higher the P/E ratio, the greater the investor confidence.

Question 49

market/book (M/B) ratio

Answer 49

Provides an assessment of how investors view the firm’s performance. Firms expected to earn high returns relative to their risk typically sell at higher M/B multiples.

Question 50

DuPont system of analysis

Answer 50

System used to dissect the firm’s financial statements and to assess its financial condition.

Question 51

DuPont formula

Answer 51

Multiplies the firm’s net profit margin by its total asset turnover to calculate the firm’s return on total assets (ROA).

Question 52

modified DuPont formula

Answer 52

Relates the firm’s return on total assets (ROA) to its return on equity (ROE) using the financial leverage multiplier (FLM).

Question 53

financial leverage multiplier (FLM)

Answer 53

The ratio of the firm’s total assets to its common stock equity.