financial statement analysis

Question 1

why need financial statement analysis?

Answer 1

• general purpose financial reports main source of financial data to external users
• investors major user group, and base their economic decisions on these reports. therefore important to understand number reported

Question 2

Financial statement analysis is necessary because:

Answer 2

• information expressed in monetary terms is of limited use on its
own; comparison is key.
• it reveals relationships between financial statement items and trends in financial data.
• it enables assessment of past performance and can be used to forecast performance.

Question 3

Types of useful comparative information:

Answer 3

Intra-entity basis: comparisons within a single entity (detects changes in financial relationships and trends).
Industry averages: between entities in the same industry (determines position relative to others).
Inter-entity basis: between other entities (indicates competitive position).

Question 4

Basic comparative analysis techniques:

Answer 4

Horizontal analysis: evaluates a series of financial data over time.
Vertical analysis: evaluates financial items in relation to a base amount.
Ratio analysis: evaluates a comprehensive range of financial relationships representing different aspects of an entity’s activities
percentage analysis

Question 5

horizontal analysis?

Answer 5

• Used to evaluate a series of financial statement data over a period of time.
• Analyses increases or decreases that have occurred from a particular base year.
• Figures are stated as both dollar amounts and as percentages.
• Percentages removes the effect of size, so relative magnitude of change is revealed.

Question 6

horizontal analysis formula?

Answer 6

One year is selected as the base year and then increases or decreases are based on the formula:
current year amt - base year amt/ base year amt

Question 7

percentage analysis: trend?

Answer 7

• Used to assess growth prospects.
• Requires data for 3 or more years.
• Each year compared to base year.

Question 8

vertical analysis?

Answer 8

Evaluates financial statement data by expressing each item as a percentage of a base amount to indicate relative magnitude.

Useful for comparing companies of different sizes.

Calculated percentages can also be tracked over time to determine patterns of change.

Question 9

ratio analysis can be used to make both?

Answer 9

intra company and inter-entity comparison

Question 10

limitations of financial statement analysis?

Answer 10

estimates
cost 
alternative accounting methods
atypical data 
diversification

Question 11

limitations of financial statement analysis?

estimates

Answer 11

Financial statements contain estimates, e.g., allowance for doubtful debts, depreciation expense and costs of warranties. If estimates are inaccurate, the financial ratios and percentages will also be inaccurate.

Question 12

limitations of financial statement analysis?

cost

Answer 12

Many items are carried at historic cost. This does not account for price-level changes.

Question 13

limitations of financial statement analysis?

alternative accting methods

Answer 13

Differences in accounting policies for the similar financial activities are often allowed:
e.g. methods of depreciation.

Question 14

limitations of financial statement analysis?

atypical data

Answer 14

Some end-of-period data may not represent normal business conditions.

Question 15

limitations of financial statement analysis? diversification

Answer 15

Diversification within entities limits usefulness of financial statement analysis. Segment data may provide more relevant and comparable information.

Question 16

The current ratio and the quick ratio are both measures of liquidity. Explain how the quick ratio overcomes some of the limitations of the current ratio.

Answer 16

current ratio cal doesnt include inventory and prepaid expense. cash marketable securities and net receivables are more liquid when compared with inventory and prepaid expenses. inventory not readily saleable and prepaid expense may not be transferrable to others.
quick ratio provide better picture of company’s short term liquidity than current ratio

Question 17

How efficient is an entity in using its assets to produce sales?

Answer 17

asset turnover

Question 18

How long does it take for customers to pay their accounts?

Answer 18

average collec period

Question 19

How many dollars of profit were generated for each dollar of sales?

Answer 19

profit margin

Question 20

How liquid is this entity?

Answer 20

current/quick ratio or current cash debt coverage

Question 21

Discuss the need for comparative analysis and identify the tools of financial statement analysis.

Answer 21

comparative analysis to evaluate entity’s short term liquidity, profitability and long term solvency. it can detect changes in financial relationships and signal trends, and can provide insight into entity’s competitive position in industry. financial statement analysis horizontally, vertically and with ratios

Question 22

increase in profit margin and earning per share mean?

Answer 22

profitability of company improved

Question 23

company price earning ratio increase mean

Answer 23

investors may be looking more favourably at company

Question 24

debt to total asset decreases mean

Answer 24

attempt to reduce debt

Question 25

cash dividend payment ratio decrease suggest

Answer 25

help overall solvency

Question 26

higher current ratio suggest

Answer 26

more liquid

Question 27

convert inventory to cash lower better as

Answer 27

average days in inventory + collection period less

Question 28

higher cash debt coverage and time interest earned indcate

Answer 28

more able to service its debt