Financial Statement Analysis

Question 1

What is operating leverage?

Answer 1

Operating leverage is the extent that a company’s operating income (earnings before interest and taxes) will change, based on a change in sales.

The higher the fixed costs relative to the variable costs, the higher the operating leverage.

A high operating leverage is good when sales increase because profits will be much higher but not so good when sales decrease because profits will be much lower.

Question 2

What are the two different formulas used to calculate the degree of operating leverage (DOL)?

Answer 2

DOL = % Change in Earnings Before Interest and Taxes (EBIT) ÷ % Change in Sales
DOL = Contribution Margin ÷ EBIT

Question 3

What is financial leverage?

Answer 3

Financial leverage is the balance between debt and equity financing in a company’s capital structure.

Debt financing results in tax-deductible interest expense. Equity financing results in dividend payments that are not an expense reported on the income statement. A high degree of financial leverage equates to a greater degree of risk for the company.

Question 4

What are the two different formulas used to calculate the degree of financial leverage (DFL)?

Answer 4

DFL = % Change in Net Income ÷ % Change in EBIT
DFL = EBIT ÷ EBT

Question 5

What is the Degree of Total Leverage?

Answer 5

The Degree of Total Leverage measures the total level of risk faced by an organization.

Degree of Total Leverage = DOL x DFL

Question 6

What is basic earnings per share (EPS)?

Answer 6

Basic earnings per share (EPS) is calculated for common shareholders only, even if the company has preferred stock issued and outstanding. It represents the net income earned on each share of common stock that is outstanding.

EPS = (Net Income − Preferred Dividends) ÷ Weighted Average Common Shares Outstanding

Question 7

What is diluted earnings per share (diluted EPS)?

Answer 7

Diluted EPS = (Net Income − Preferred Dividends) ÷ Diluted Weighted Average Common Shares Outstanding

The dilution comes from the shares of stock that could have been exercised or converted to common stock on the closing date of the financial statements. These shares come from stock options, stock warrants, convertible bonds.

Question 8

What is the Earnings Yield Ratio?

Answer 8

Earnings Yield Ratio = EPS ÷ Market Price per Share

Question 9

What is the Dividend Yield Ratio?

Answer 9

Dividend Yield = Dividend per Share ÷ Market Price per Share

Question 10

What is the Dividend Payout Ratio?

Answer 10

Dividend Payout Ratio = Dividends ÷ Earnings

Question 11

What is the total shareholder return?

Answer 11

The total shareholder return on an investment in common stock is the total of all the dividend payments received since the investment was made and the appreciation in stock price. This implies that the shareholder has sold his or her investment.

Question 12

How are shares of convertible preferred stock similar to convertible bonds?

Answer 12

Both cause an increase in the number of common stock shares upon conversion.

When convertible preferred stock is converted into common stock, the number of shares of common stock outstanding increase and the number of shares of preferred stock decrease. The number of common shares received per share of preferred stock is typically set as part of the issuance of the preferred stock. When convertible bonds are converted into common stock, the number of shares of common stock outstanding increases. The number of common shares received per bond is typically set as part of the issuance of the convertible bonds. Therefore, this is the correct answer.

Question 13

List five limitations of ratio analysis.

Answer 13

Choice of inventory valuation method.
Composition of current assets.
Choice of depreciation method.
Earnings-per-share calculation.
Composition of return on assets.
Note: answers could vary.

Question 14

No single ratio can predict the success or failure of a company. What different types of ratios are necessary for financial analysis?

Answer 14

Liquidity ratios
Solvency ratios
Profitability ratios
Leverage ratios

Question 15

Name some liquidity and solvency ratios. Why is it important to evaluate both liquidity and solvency?

Answer 15

Liquidity ratios: current ratio, quick ratio

Solvency ratios: debt-to-assets ratio, debt-to-equity ratio, times interest earned ratio

Evaluation of both liquidity and solvency is important because it is possible for a company to have good liquidity (ability to pay short-term liabilities) and poor solvency (ability to survive over a long period of time) and vice versa.

Question 16

What does an assessment of leverage reveal?

Answer 16

Operating leverage is based on the company’s cost structure: the relative amount of fixed costs to variable costs. In general, the higher the fixed costs relative to variable costs, the riskier the business.

Financial leverage looks at the company’s capital structure and the balance between debt and equity financing. A high degree of financial leverage means a greater degree of risk for the company.

Question 17

What are some keys to a successful analysis using ratios?

Answer 17

Know what amounts are used in the calculations and that the components of the calculations are consistent.

Compare the current-year results to prior-year results, a competitor firm’s results, and industry averages.

Determine if there have been any changes in accounting methods from year to year.

Determine if there have been any acquisitions or divestitures during the year.

Be familiar with the industry, sector, and market the company operates in.

Question 18

What are return ratios used to measure?

Answer 18

How well a firm uses its asset base to generate profits

The amount of profit in relation to common shareholders’ equity

Success of chief executive officers and business unit leaders

One investment as compared to other potential investments

Question 19

Why must investors and managers be careful when using ROA and ROE to measure return?

Answer 19

There can often be different meanings or definitions for assets, equity, and income. The investor or manager needs to be sure to know what calculations are being used in order to ensure that the components in the calculations are consistently used.

Question 20

What is the Sustainable Growth Rate (SGR) and how is it calculated?

Answer 20

The SGR is the maximum rate a firm can grow at using its own revenue. Said another way, it is how much a firm can grow without having to borrow money for this growth.

SGR = ROE × (1 – Dividend Payout Ratio)

Question 21

How is Gross Margin calculated and what does it measure?

Answer 21

Gross Margin = Gross Profit ÷ Net Sales

Gross Margin measures the amount of each sales dollar available to cover operating expenses, including selling and administrative expenses, other expenses, and income tax expense.

Question 22

How is Operating Margin calculated and what does it measure?

Answer 22

Operating Margin = Income from Operations ÷ Net Sales

Operating Margin measures the amount of each sales dollar available to cover interest expense, other expenses, and income tax expense.

Question 23

How is Profit Margin calculated and what does it measure?

Answer 23

Profit Margin = Net Income ÷ Net Sales

Profit Margin measures the amount of each sales dollar earned for the common stockholders of the company.

Question 24

What are the three steps to consolidate a foreign subsidiary into the parent’s financial statements?

Answer 24

Modify the subsidiary’s financials to conform to U.S. GAAP.
Re-measure the trial balance into the functional currency only if the subsidiary’s is not the functional currency.
Translate the financials from the functional currency into the reporting currency.

Question 25

How does the consolidation process of a subsidiary change when the subsidiary’s currency is not the functional currency vs. when it is?

Answer 25

If the subsidiary’s currency is not the functional currency, first, re-measure the financial statements into parent’s currency using the historical rate/temporal method. Then, translate nonmonetary accounts at historical rate and monetary accounts at the current exchange rate on the balance sheet date.

If the subsidiary’s currency is the functional currency, translate the financial statements into the parent’s currency using the current rate method.

Question 26

What are changes in accounting principle and how do they affect financial statements?

Answer 26

Changes in accounting principle are when guidance is changed in the Accounting Standards Codification or when management elects to change from one GAAP method to another.

This requires the adjustment of prior-period financial statements to incorporate the effect of the new principle.

Question 27

What are changes in accounting estimates and how do they affect the financial statements?

Answer 27

Changes in accounting estimates are changes in an estimated amount based on new information, such as bad-debt percentage or depreciation life.

This change is reported prospectively, meaning in the current period and future periods only.

Question 28

What are changes in reporting entities and how are they represented in the financial statements?

Answer 28

Changes in reporting entities are when the financial statements represent a different reporting entity.

These changes are reported retrospectively. Prior-period financial statements are updated to reflect the financial information for the new reporting entity “as if” the new entity existed all along.

Question 29

What is error correction and how does it vary depending on if the error relates to the current or a prior period?

Answer 29

Error correction is adjusting the financial statements due to the discovery of a material error that affected the reporting of net income or loss. Errors in the current period are corrected at that time and do not require retrospective adjustments. Errors in a prior period must be corrected by adjusting the beginning balance of retained earnings and prior-period financial statements need to be restated.