Chapter 5: Using Financial Statement Information

Question 1

in what two ways are financial statements useful?

Answer 1

prediction (they help to predict a company’s future earnings and cash flows), and control (they help investors and creditors influence and monitor the business decisions of company managers)

Question 2

control of management

Answer 2

investors and creditors, who provide the company with its capital, can direct and monitor the actions of its managers by requiring that their contracts be written in terms of financial accounting numbers. creditors are also interested in protecting their investments by influencing the business decisions of management

Question 3

predictions

Answer 3

to the extent that past events are indicative of the future, financial accounting numbers can be used to make predictions about company’s future earnings and cash flows.

Question 4

leverage

Answer 4

refers to using borrowed funds (debts) to generate returns for the shareholders. a company that borrows $10k at an 8% interest rate and invests the funds to generate a 12% return is using leverage effectively by creating profits for the shareholders without using any of their invested equity. effective leverage, therefore, can give a hefty boost to return on equity

Question 5

solvency

Answer 5

ability to meet payment demands as a company. to be solvent, a company must either have enough liquid assets on hand and/or be able to generate enough cash through operations to meet the debt payments

Question 6

asset quality

Answer 6

successful investments in assets generate large amounts of revenues; unsuccessful asset investments do not. asset quality is often defined as the extent to which assets generate revenues

Question 7

expense control

Answer 7

profits can only be generated if expenses, the operating costs associated with generating revenues, are less than the revenues

Question 8

results

Answer 8

companies that effectively manage their leverage position, maintain solvency by meeting their debt obligations as they come due, invest in high quality assets that generate large revenue amounts, and effectively control their expenses are profitable, and those profits create large returns relative to the asset investment necessary to create them (return on assets) and large returns for the shareholders relative to their equity investment in the company

Question 9

comparisons of financial statements across time

Answer 9

financial accounting numbers can be made more meaningful if they are compared across time. many companies provide comparisons across five- to ten-year periods. such disclosures can help a user develop a “feel” for the company’s activities

Question 10

comparisons of financial statements within the industry

Answer 10

compare statements with those of similar companies. similar companies are usually found in the same industry; thus, industry-wide statistics are often a useful basis for comparison

Question 11

comparisons within the financial statements: common size statements and ration analysis

Answer 11

a third way to analyze financial statement numbers is to compare them to other numbers on the financial statements of the company at a particular point in time (either common-size financial statements, or ration analysis

Question 12

common size financial statements

Answer 12

financial statement numbers can be expressed as percentages of other numbers on the same statements. on the balance sheet, assets and liabilities can be expressed as percentages of total assets. these can help indicate why changes occur in a company’s financial performance and financial condition

Question 13

financial ratios

Answer 13

there are no hard and fast rules about comparing ratios of percentages across balance sheets and income statements. secondly, in the computation of many ratios, income statement numbers are compared to balance sheet numbers. because the income statement refers to a period of time and the balance sheet refers to a specific point in time, in calculating these ratios it is usually best to compute an average for the balance sheet number

Question 14

capital structure leverage

Answer 14

measures the extent to which a company relies on borrowings, or essentially measures the amount of leverage in the company (average total assets/average shareholder’s equity)

Question 15

assessing the business environment

Answer 15

good analysts answer critical questions (what is the nature of the company’s operations, and what strategy is the company using to generate profits within the industry? what is the company’s industry? what are the relationships between the company and its suppliers and customers, and who holds the bargaining power?) to provide a forward looking perspective on the company and create a useful context in which to interpret the financial statements

Question 16

reading and studying the financial statement footnotes

Answer 16

after the analyst understands the company’s business environment, financial statement information can be studied. the analysis consists of three steps: 1) read the audit report, 2) identify significant transactions and the company’s important segments, 3) read the 4 financial statements

Question 17

earnings quality

Answer 17

refers to the extent to which the reported financial statements deviate from the true financial condition and performance of the company

Question 18

what are the four strategies used by managers to “manage” reported accounting numbers?

Answer 18

overstating operating performance, taking a bath, creating hidden reserves, and employing off balance sheet financing,

Question 19

what fundamental steps are a part of projecting future financial statements?

Answer 19

1) predict future sales 2) predict future profit margin 3) based on the sales prediction, estimate the level of assets necessary to support that level of sales 4) choose a target financing mix (liabilities vs. equity)