Chapter 4 Flashcards
It involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company.
FINANCIAL STATEMENTS ANALYSIS
They are concerned about their investment income as well as about the company’s overall profitability, stability and sound capital structure necessary for continued successful operations.
CURRENT SHAREHOLDERS OR OWNERS
They are interested in “sold” companies, ones whose financial statements indicate stable earnings and dividends with limited or moderate growth.
POTENTIAL INVESTORS
They are interested in a firm’s short-run liquidity, its ability to pay current obligations as they mature.
SHORT-TERM CREDITORS
They are concerned about the long-term security of their interest income and the company’ ability to maintain successful earnings and cash flows to meet continuing financial commitments.
LONG-TERM CREDITORS
Since economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully, it is necessary to start the analysis of a firm’s financial statements with an evaluation of the environment in which the firm conducts business.
BACKGROUND STUDY AND EVALUATION OF FIRM INDUSTRY, ECONOMY, AND OUTLOOK
This refers to the analysis of the company’s ability to meet near-term demand for cash and normal operating requirements.
SHORT-TERM SOLVENCY ANALYSIS
This pertains to the evaluation of the amount and proportion of debt in a firm’s capital structure to assess its ability to service debt. This will also cover the analysis of the use of financial leverage to maximize the returns to the owners.
CAPITAL STRUCTURE AND LONG-TERM SOLVENCY ANALYSIS
This involves the evaluation of how well assets have been employed by management in terms of generating revenues and maximizing returns on such resources.
OPERATING EFFICIENCY AND PROFITABILITY ANALYSIS
Some of the reasons that would push managers to manipulate reported earnings:
- MEET INTERNAL EARNINGS TARGET
- MEET EXTERNAL EXPECTATIONS
- TO EVEN-OUT INCOME
- PROVIDE “WINDOW DRESSING” FOR AN IPO OR A LOAN
Some of the common techniques used to manage earnings:
- STRATEGIC MATCHING
- CHANGE IN METHODS OR ESTIMATES WITH LITTLE OR NO DISCLOSURE
- DEPARTURE FROM ACCOUNTING STANDARDS
- FICTITIOUS TRANSACTIONS
The assessment of earnings quality is critical in the analysis of financial statements.
QUALITY OF EARNINGS
This involves timing its transactions so that large one-time gains and losses occur in the same period resulting in a smooth upward trend in reported earnings.
STRATEGIC MATCHING
Companies often change accounting estimates regarding bad debts return or pension funds
CHANGE IN METHODS OR ESTIMATES WITH LITTLE OR NO DISCLOSURE
One of the often-used techniques in managing earnings to show more favorable results is “fraudulent reporting” or deliberate violation of accounting rules.
DEPARTURE FROM ACCOUNTING STANDARDS
This technique could involve deliberate recording of non-existent revenue transactions and customers or reporting sales when contracts are not fully completed and goods not yet delivered.
FICTITIOUS TRANSACTIONS
They are index numbers showing relative changes in financial data resulting with the passage of time.
TREND PERCENTAGES
Expected conditions may be represented by:
- PREDETERMINED STANDARDS
- PAST PERFORMANCE
- COMPETITOR’S PERFORMANCE OR INDUSTRY AVERAGE
Some of the indications that a company enjoys a satisfactory short-term solvency position are:
A. FAVORABLE CREDIT POSITION
B. SATISFACTORY PROPORTION OF CASE TO THE REQUIREMENTS OF THE CURRENT VOLUME
C. ABILITY TO PAY CURRENT DEBTS IN THE REGULAR COURSE OF BUSINESS
D. ABILITY TO EXTEND MORE CREDIT TO CUSTOMERS
E. ABILITY TO REPLENISH INVENTORY PROMPTLY
A company is generally considered enjoying a satisfactory long-term financial position if it is able to
A. MAINTAIN A WELL-BALANCED RELATIONSHIP BETWEEN BORROWED FUNDS AND EQUITY.
B. EFFECTIVELY EMPLOY BORROWED FUNDS AND EQUITY.
C. DECLARE SATISFACTORY AMOUNT OF DIVIDENDS TO SHAREHOLDERS.
D. ENGAGE IN RESEARCH AND DEVELOPMENT TO PROVIDE NEW PRODUCTS OR IMPROVE OLD PRODUCTS, METHOD OR PROCESSES.
E. MEET THEIR COMMITMENT TO BORROWERS AND OWNERS.
Some indicators of managerial efficiency in the use of the resources are:
A. ABILITY TO EARN A SATISFACTORY RETURN ON ITS INVESTMENT OF BORROWED FUNDS AND EQUITY
B. ABILITY TO CONTROL OPERATING COSTS WITHIN REASONABLE LIMITS
C. OPTIMUM LEVEL OF INVESTMENT IN ASSETS
It represents an important tool in motivating managers to increase sales efforts, control costs and use resources more efficiently.
EARNINGS TARGET
The practice of carefully timing the recognition of revenues and expenses to even out the amount of reported earnings from one year to the next is called:
INCOME SMOOTHING
These are measures taken by management to make the company appear as strong and profitable as possible in its statement of financial position, income statement, and cash flow statement.
WINDOW DRESSING
