Chapter 7: Balance Sheet Analysis & Planning

Question 1

what does the income statement measure

Answer 1

the financial performance over a specific period

Question 2

what does a complete analysis consist of

Answer 2

• analyzing both the income statement and balance sheet
• Ex. A company could have performed well on their income statement, but at the same time be in a bad financial position from the balance sheet
• Ex. A company could have a net loss in a specific quarter, but still be in good financial position at the end of that quarter

Question 2

what does the balance sheet show

Answer 2

a company’s financial position at a point in time

Question 3

what are loan covenants

Answer 3

The terms and conditions of a loan that require the borrower to meet certain requirements established by the lender

Question 4

what is the ability to satisfy the financial markers driven by

Answer 4

• by the income statement
• Ex. long-term debt is on the balance sheet, but the ability of a company to pay off the debt depends on the performance on the income statement
• Ex. company will need cash to pay dividends, but it must first generate that cash from strong performance; displayed on the income statement

Question 4

where are the financial markets about capital found

Answer 4

on the balance sheet
Ex. long-term debt & share capital

Question 5

what is the analysis on the balance sheet dependent on

Answer 5

Analysis on the balance sheet references the income statement and specific line items’ relationship with it (looking at dependencies to explain the variances on the balance sheet)

Question 6

what is the analysis on the income statement dependent on

Answer 6

on drivers

Question 6

what is Return on Assets (ROA)

Answer 6

• Performance metric that indicates how effective a company’s assets are in generating net income
• Expressed as a %
• Want ROA to be as high as possible

Question 7

why shouldnt profitability ratios be calculated with only the income statement

Answer 7

• Even if a company generates net income, it doesn’t mean its efficiently profitable
• Ex. Company A & Company B both generated $10M in revenue and $1M in net income for a period
• Company A invested an average total assets of $20M to generate their revenue
• Company B invested an average total assets of $40M to generate their revenue
• Looking at only the income statement profitability ratios, both companies would seem to be equally profitable, having a net profit margin of 10%
• But calculating ROA, Company A has a ROA of 5% & Company B has an ROA of 2.5%
• Therefore, Company A is more efficiently profitable because they used their assets more effectively to generate the same revenue and income as Company B

Question 7

how does a company know if their ROA is good

Answer 7

• Expectations of a high ROA is determined by the industry
• To determine if a company is managing their assets effectively requires knowledge of that company’s industry and comparison against their competitors
• The state of the economy can also impact industry averages at any given time, so what is considered “good” is usually relative

Question 8

why is it useful to observe a company’s ROA overtime (and who is it useful for)

Answer 8

Observing the company’s ROA performance overtime is also useful for management, and is useful for lenders (banks) to understand how effective management is in using borrowed money to invest in business assets and generate a return

Question 9

what is Return on Equity (ROE)

Answer 9

• A performance measure that demonstrates how effectively a company uses equity holders’ investments to generate income
• Tells how good a company is at turning cash from investors into profit
• Important metric for public companies
• Expressed as a %
• Want a higher ROE
• The higher the ROE, the more effectively the company generates a return on shareholders’ investment
• Shareholders invest in the company with an expectation that the company will use the cash they give to make a profit, which will increase the value of the shareholder’s investment (share price appreciation)

Question 10

what can be done to make ROE useful

Answer 10

ROE should be compared with historical performance and/or ROE of competitors to understand how the company is performing relative to its peers

Question 11

what is asset turnover

Answer 11

• Indicates how well a company is managing its assets based on revenue/sales (instead of net income like ROA)
• Asset turnover doesn’t consider operating costs and is focused only on measuring sale generation ability
• The ratio is the amount of sales generated for each dollar invested in assets
• Expressed as a #
• You want the ratio to be higher

Question 12

what does it mean when companies have higher asset turnovers

Answer 12

• Companies with higher asset turnover ratios tend to be considered productive
• But productivity is also relative
• Should consider what the industry average is, and how well competitors are performing

Question 13

what is the purpose of a budget

Answer 13

to prepare a snapshot of where the company wants to be in the future

Question 14

what does a budget reflect

Answer 14

• The budget should reflect what the company expects will happen & what they know will happen in the budgeted period
• Balance sheet line items will be based off of expectations of ratios and relationships
• Also sometimes a company knows for certain that it will take on additional capital or purchase new assets