Lesson 5

Question 1

describe how financial statement analysis can be used for strategic purposes.

Answer 1

• helps to assess a company’s viability
• a tool to help ID areas for improvement in performance
• can include specific ratios in the financial perspective of the BSC
  Strategic measurement goals of ratio analysis
• comparisons to previous periods
• Comparisons to other companies
• comparisons to industry standards

Question 2

Describe and interpret horizontal and vertical analysis, and identify when these tools should be applied.

Answer 2

Horizontal analysis

• evaluates a series of fin data over a period of time. Used primarily in intracompany comparisons
• also called trend analysis
• can be expressed as either an amt or %

Vertical analysis

• evaluates fin stmt data by expressing each item in a financial stmt as a % of a base amt
• common-size analysis

Question 3

describe the concept of earning power and explain how to interpret irregular items in financial statements.

Answer 3

Earning power means the normal level of income to be obtained in the future. It differs from net income by the amt of irregular revenues, expenses, gains & losses. Users are interested in earning power as it helps them derive an estimate of future earnings without the noise of irregular items.

Irregular items:

• discontinued operations: the disposal of a significant component of a business. the income stmt needs to include the income/loss from discontinued operations and the gain/loss on disposal of the segment
• extraordinary items need to be unusual is nature and infrequent in occurrence. Extraordinary items need to be reported net of taxes in a separate section of the income stmt, immediately below discontinued operations.

Question 4

explain the concept of quality of earnings

Answer 4

• provides full and transparent information that will not confuse or mislead users of the financial stmts
• recent accounting scandals suggest some companies are focusing more on managing income than business
• factors that affect quality of earnings are:
  alternative accounting methods (FIFO, LIFO)
  pro-forma income
  improper recognition

Question 5

Outline the limitations of financial statement analysis.

Answer 5

• ratios rely on financial data that mgmt. may have manipulated
• financial ratios present a historical picture. They can only predict future events if past circumstances continue into the future.