Chapter 4

Question 1

It involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company.

Answer 1

FINANCIAL STATEMENTS ANALYSIS

Question 2

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.

Answer 2

CURRENT SHAREHOLDERS OR OWNERS

Question 3

They are interested in “sold” companies, ones whose financial statements indicate stable earnings and dividends with limited or moderate growth.

Answer 3

POTENTIAL INVESTORS

Question 4

They are interested in a firm’s short-run liquidity, its ability to pay current obligations as they mature.

Answer 4

SHORT-TERM CREDITORS

Question 5

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.

Answer 5

LONG-TERM CREDITORS

Question 6

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.

Answer 6

BACKGROUND STUDY AND EVALUATION OF FIRM INDUSTRY, ECONOMY, AND OUTLOOK

Question 7

This refers to the analysis of the company’s ability to meet near-term demand for cash and normal operating requirements.

Answer 7

SHORT-TERM SOLVENCY ANALYSIS

Question 8

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.

Answer 8

CAPITAL STRUCTURE AND LONG-TERM SOLVENCY ANALYSIS

Question 9

This involves the evaluation of how well assets have been employed by management in terms of generating revenues and maximizing returns on such resources.

Answer 9

OPERATING EFFICIENCY AND PROFITABILITY ANALYSIS

Question 10

Some of the reasons that would push managers to manipulate reported earnings:

Answer 10

1. MEET INTERNAL EARNINGS TARGET
2. MEET EXTERNAL EXPECTATIONS
3. TO EVEN-OUT INCOME
4. PROVIDE “WINDOW DRESSING” FOR AN IPO OR A LOAN

Question 11

Some of the common techniques used to manage earnings:

Answer 11

1. STRATEGIC MATCHING
2. CHANGE IN METHODS OR ESTIMATES WITH LITTLE OR NO DISCLOSURE
3. DEPARTURE FROM ACCOUNTING STANDARDS
4. FICTITIOUS TRANSACTIONS

Question 12

The assessment of earnings quality is critical in the analysis of financial statements.

Answer 12

QUALITY OF EARNINGS

Question 13

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.

Answer 13

STRATEGIC MATCHING

Question 14

Companies often change accounting estimates regarding bad debts return or pension funds

Answer 14

CHANGE IN METHODS OR ESTIMATES WITH LITTLE OR NO DISCLOSURE

Question 15

One of the often-used techniques in managing earnings to show more favorable results is “fraudulent reporting” or deliberate violation of accounting rules.

Answer 15

DEPARTURE FROM ACCOUNTING STANDARDS

Question 16

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.

Answer 16

FICTITIOUS TRANSACTIONS

Question 17

They are index numbers showing relative changes in financial data resulting with the passage of time.

Answer 17

TREND PERCENTAGES

Question 18

Expected conditions may be represented by:

Answer 18

1. PREDETERMINED STANDARDS
2. PAST PERFORMANCE
3. COMPETITOR’S PERFORMANCE OR INDUSTRY AVERAGE

Question 19

Some of the indications that a company enjoys a satisfactory short-term solvency position are:

Answer 19

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

Question 20

A company is generally considered enjoying a satisfactory long-term financial position if it is able to

Answer 20

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.

Question 21

Some indicators of managerial efficiency in the use of the resources are:

Answer 21

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

Question 22

It represents an important tool in motivating managers to increase sales efforts, control costs and use resources more efficiently.

Answer 22

EARNINGS TARGET

Question 23

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:

Answer 23

INCOME SMOOTHING

Question 24

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.

Answer 24

WINDOW DRESSING

Question 25

A financial analyst or user must look at the composition of assets, their condition and liquidity, the timing of repayment of liabilities and the total amount of debt outstanding.

Answer 25

QUALITY OF ASSETS AND RELATIVE AMOUNT OF DEBT

Question 26

The major areas that may be covered in the analysis are:

Answer 26

A. SHORT-TERM SOLVENCY
B. CAPITAL STRUCTURE AND LONG-TERM SOLVENCY
C. OPERATING EFFICIENCY AND PROFITABILITY
D. SEGMENTED ANALYSIS (WHEN RELEVANT)

Question 27

Limitations inherent in the accounting data the analyst works with. These are brought about by among others:

Answer 27

A. VARIATION AND LACK OF CONSISTENCY IN THE APPLICATION OF ACCOUNTING PRINCIPLES, POLICIES, AND PROCEDURES.
B. TOO-CONDENSED PRESENTATION OF DATA, AND
C. FAILURE TO REFLECT CHANGE IN PURCHASING POWER

Question 28

The study of percentage changes in comparative statements is called

Answer 28

HORIZONTAL ANALYSIS