Vol. 3 LM4 Common-Size Balance Sheets

Question 1

Define

common-size analysis

Common-size Analysis

Answer 1

describe tools and techniques used in financial analysis, including their uses and limitations, either by vertical or horizontal methods using ratios

Common-size Analysis

Question 2

Define

describe tools and techniques used in financial analysis, including their uses and limitations

Answer 2

common-size analysis

Question 3

A vertical common-size balance sheet is prepared by

Common-size Analysis

Answer 3

dividing each item on the blanace sheet by the same period’s total assets and expressing the results as percentages

Common-size Analysis

Question 4

The term ____ is used to denote a common-size analysis using only one reporting period or one base financial statement, whereas ____ refers to an anlysis comparing a specific financial statement with prior or future time periods

Answer 4

vertical analysis; horizontal analysis

Common-size Analysis

Question 5

Concept

compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be significantly different sizes and/or operate in different currencies

Answer 5

cross-sectional analysis

Question 6

Describe

cross-sectional analysis

Answer 6

compares a specific metric for one company with the same metric for another company or group of companies, allowing comparisons even though the companies might be significantly different sizes and/or operate in different currencies

Question 7

Concept

provides important information regarding historical performance and growth and, given a sufficiently long history of accurate seasoned information

Answer 7

trend analysis

Question 8

Fill in the blank

In financial statement analysis, the “trend analysis” usually refers to comparisons across time periods of ____ not involving statistical tools

Answer 8

3-10 years

Question 9

Use of Comparative Growth Information

In July 1996, Sunbeam, a US company, brought in new management to turn the company around. In the following year, 1997, using 1996 as the base, the following was observed based on reported numbers:
* Revenue +19%
* Inventory +58%
* Receivables +38%

Answer 9

• It is generally more desirable to observe inventory and receivables growing at a slower (or similar) rate compared to revenge growth
• Receivables growing faster than revenue can indicate operational issues, such as lower credit standards or aggressive accounting policies for revenue recognition
• inventory growing faster than revenue can indicate an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits

explanation is in the aggressive accounting policies
Sunbeam was later charged by the U.S. SEC with improperly accelerating the recognition of revenue

Question 10

comparative growth information

Receivables growing faster than revenue can indicate

Answer 10

operational issues such as lower credit standards or aggressive accounting policies for revenue recognition

Question 11

comparative growth information

inventory growing faster than revenue can indicate

Answer 11

an operational problem with obsolescence or aggressive accounting policies, such as an improper overstatement of inventory to increase profits

Question 12

common-size financial statement ratios

a common indicator of profitability

Answer 12

the net profit margin
* calculated as net income divided by sales
* this ratio appears on a vertical common-size income statement

Question 13

because of the large number of ratios, it is helpful to think about ratios in terms of

Answer 13

broad categories based on what aspects of performance a ratio is intended to detect

Question 14

financial ratio category

measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory

Answer 14

activity ratios

Question 15

Describe

activity ratios

Answer 15

measures how efficiently a company performs day-to-day tasks, such as the collection of receivables and management of inventory

Question 16

financial ratio category

measures the company’s ability to meet its short-term obligations

Answer 16

liquidity ratios

Question 17

describe

liquidity ratios

Answer 17

measures the company’s ability to meet its short-term obligations

Question 18

financial ratio category

• measures a company’s ability to meet long-term obligations
• subsets of these ratios are also known as “leverage” and “long-term debt” ratios

Answer 18

solvency ratios

Question 19

Describe

solvency ratios

Answer 19

• measures a company’s ability to meet long-term obligations
• subsets of these ratios are also known as “leverage” and “long-term debt” ratios

Question 20

financial ratio category

measures the company’s ability to generate profits from its resources (assets)

Answer 20

profitability ratios

Question 21

Describe

profitability ratios

Answer 21

measures the company’s ability to generate profits from its resources (assets)

Question 22

financial ratio category

measure the quantity of an asset or flow associated with ownership of a specified claim

Answer 22

valuation ratios

Question 23

Describe

valuation ratios

Answer 23

measure the quantity of an asset or flow associated with ownership of a specified claim

Question 24

goal

financial ratios

Answer 24

to understand the underlying causes of divergence between a company’s ratios and those of the industry

Question 25

# list three principles an analyst should evaluate financial ratios

Answer 25

1. *Company goals and strategy* 2. *Industry norms (cross-sectional analysis)* 3. *Economic conditions*

Question 26

# financial ratio analysis *Company goals and strategy*

Answer 26

* actual ratios can be compared with company objectives to determine whether objectives are being attained and whether the results are consistent with the company's strategy

Question 27

# financial ratio analysis *Industry norms (cross-sectional analysis)*

Answer 27

A company can be compared with others in its industry by relating its **financial ratios** to *industry norms* or to a subset of the companies in an industry. Care must be taken because: * many ratios are industry specific, and not all ratios are important to all industries * companies may have several different lines of business -> this will cause aggregate financial ratios to be disorted * differences in accounting methods used by companies can distort financial ratios * differences in corporate strategies can affect certain financial ratios

Question 28

# financial ratio analysis *Economic conditions*

Answer 28

* For cyclical companies, financial ratios tend to improve when the economy is strong and weaken during recessions * therefore, financial ratios should be examined in light of the current phase of the business cycle

Question 29

# ratio are also known as **asset utilization ratios** or **operating efficiency ratios**

Answer 29

activity ratios

Question 30

# Concept these ratios reflect the efficient management of both working capital and longer term assets

Answer 30

activity ratios

Question 31

# Fill in the blank ____ has a direct impact on liquidity (the ability of a company to meet its short-term obligations)

Answer 31

efficiency

Question 32

# ratio Since *efficiency* has a direct impact on *liquidity*, certain ____ are also useful in assessing *liquidity*

Answer 32

activity ratio

Question 33

# Components **inventory turnover**

Answer 33

* **activity ratio** numerator: **cost of sales** or **cost of goods sold** denominator: average inventory

Question 34

# Components **days of inventory on hand** (DOH)

Answer 34

* **activity ratio** numerator: number of days in period denominator: **inventory turnover** = **cost of goods sold**/average inventory

Question 35

# Components **receivables turnover**

Answer 35

* **activity ratio** numerator: revenue denominator: average receivables

Question 36

# Components **days of sales outstanding** (DSO)

Answer 36

* **activity ratio** numerator: number of days in period denominator: **receivables turnover** = revenue/average receivables

Question 37

# Components **payables turnover**

Answer 37

* **activity ratio** numerator: purchases denominator: average trade payables

Question 38

# Components **number of days of payables**

Answer 38

* **activity ratio** numerator: number of days in period denominator: **payables turnover** = purchases / average trade payables

Question 39

# Components **working capital turnover**

Answer 39

* **activity ratio** numerator: revenue denominator: average working capital

Question 40

# Components **fixed asset turnover**

Answer 40

* **activity ratio** numerator: revenue denominator: average net fixed assets

Question 41

# Components **total asset turnover**

Answer 41

* **activity ratio** numerator: revenue denominator: average total assets

Question 42

# process How do you compensate for the fact that activity ratios combine information from the **income statement** and the **balance sheet**?

Answer 42

* because the **income statement** measures what happened *during* a period whereas the **balance sheet** shows what happened at the *end* of the period, averaged balance sheet data are normally used used for consistency

Question 43

# time horizon If a semiannual report is prepared, it can be taken over

Answer 43

three periods * beginning * middle * end of year

Question 44

# number * if a quarter is 3 month, we can annualize by ____ * if a quarter is 90 days, we can annualize by ____

Answer 44

* 4 (12 months / 3 months) * 4.06 (365 days / 90 days)

Question 45

# Computation of activity ratios 1. an analyst would like to evaluate Lenovo Group's efficiency in collecting its trade accounts receivable during the **fiscal year ended** 31 March 2018 (FY2017). The analyst gathers the following information from Lenovo's annual and interim reports Trade receivable as of 31 March 2017 * $4,468,392 Trade receivable as of 31 March 2018 * $4,972,722 Revenue for year ended 31 March 2018 * $45,349,943 Calculate Lenovo's receivables turnover and number of days of sales outstanding (DSO) for the fiscal year ended 31 March 2018

Answer 45

Receivables turnover = Revenue / average receivables * = 45,349,943 / [ (4,468,392 + 4,972,72) / 2 ] * = 45,349,943 / 4,720,557 * = 9.6069 times, or 9.6 rounded DSO = Number of days in period / receivables turnover * = 365 / 9.6 * = 38.0 days

Question 46

# interpretation of **activity ratios** a higher inventory turnover ratio implies

Answer 46

* a shorter period that inventory is held, and thus, a lower DOH * relative to industry norms might indicate highly effective inventory management alternatively, * could indicate the company does not carry adequate inventory, so shortages could potentially hurt revenue

Question 47

# interpretation of **activity ratios** a lower inventory turnover and commensurately high DOH implies

Answer 47

slow-moving inventory, perhaps due to technological obsolescence

Question 48

# interpretation of **activity ratios** the number of DSO represents

Answer 48

the elapsed time between a sale and cash collection * reflecting how fast the company collects cash from customers to whom it offers credit

Question 49

# Interpretation of **activity ratios** a relatively high receivables turnover ratio (and commensurately low DSO) might indicate

Answer 49

highly efficient credit and collection

Question 50

# interpretation of **activity ratios** a relatively low receivables turnover ratio

Answer 50

would typically raise questions about the efficiency of the company's credit and collections

Question 51

# indications of **activity ratios** what might indicate highly efficient credit and collection

Answer 51

a relatively high receivables turnover ratio (and commensurately low DSO) might indicate

Question 52

# interpretation of **activity ratios** the number of days of payables and the payables turnover ratio reflects

Answer 52

* the average number of days the company takes to pay its suppliers * the payables turnover ratio measures how many times per year the company theoretically pays off all its creditors

Question 53

# interpretation of **activity ratios** A payables turnover ratio that is high relative to the industry could indicate

Answer 53

the company is not making full use of available credit facilities

Question 54

# interpretation of **activity ratios** an excessively low turnover ratios could indicate (high days payable)

Answer 54

could indicate trouble making payments on time, or alternatively, exploitation of lenient supplier terms

Question 55

# Concept is defined as current assets minus current liabilities * current assets - current liabilities

Answer 55

**working capital**

Question 56

# describe **working capital turnover**

Answer 56

* indicates how efficiently the company generates revenue with its working capital

Question 57

# Indication working capital turnover ratio = 4.0

Answer 57

* indicates that the company generates $4 of revenue for every $1 of working capital

Question 58

# indication high working capital turnover ratio

Answer 58

greater efficiency (i.e., the company is generating a high level of revenues relative to working capital

Question 59

# Concept measures how efficiently the company generates revenues from its investments in fixed assets

Answer 59

**fixed asset turnover**

Question 60

# Define **fixed asset turnover**

Answer 60

measures how efficiently the company generates revenues from its investment in fixed assets

Question 61

# indication higher fixed asset turnover ratio

Answer 61

more efficient use of fixed assets in generating revenue

Question 62

# indication low ratio can indicate inefficiency

Answer 62

* a capital-intensive business environment * a new business not yet operating at full capacity—in which case the analyst will not be able to link the ratio directly to efficiency

Question 63

# considerations in asset turnover

Answer 63

would be lower for a company whose **assets** are newer—therefore, *less depreciated* where a **higher carrying value** is reflected in the financial statement—than those of company will older assets

Question 64

# Reason year-to-year changes in the **fixed asset turnover** may not be as important

Answer 64

* increases in **fixed assets** may not follow a smoooth pattern

Question 65

# Concept measures the company's overall ability to generate revenues with a given level of assets

Answer 65

**total asset turnover**

Question 66

# When interpreting **activity ratios** the analysts should ...

Answer 66

* examine not only the individual ratios, but also * the collection of relevant ratios to determine the overall efficiency of a company

Question 67

# interpret **activity ratios** * focuses on cash flows * measures a company's ability to meet its short-term obligations

Answer 67

**liquidity ratios** OR liquidity analysis

Question 68

# day-to-day operations liquidity management

Answer 68

is typically achieved through efficient use of assets

Question 69

# disclosure+ description contingent liabilities in the non-banking sector

Answer 69

* usually disclosed in the footnotes to the company's financial statements * represent potential cash outflows, when appropriate, should be included in an assessment of a company's liquidity

Question 70

# disclosure + description in the banking sector, contingent liabilities

Answer 70

* represent potentially significant cash outflows that are not dependent on the bank's financial condition * macroeconomic or market crisis can trigger a substantial increase in cash outflows because of the increase in defaults and business bankruptcies

Question 71

# Reason macroeconomic or market crisis can trigger a substantial increase in cash outflows related to contingent liabilties

Answer 71

* because of the increase in defaults and business bankruptcies that often accompany such events * such crises are usually characterized by diminished levels of overall liquidity, which can further exacerbate funding shortfalls

Question 72

# sector contingent liabilities warrant particular attention

Answer 72

banking sector

Question 73

# ratios three measures of a company's ability to pay current liabilities

Answer 73

* current * quick * cash

Question 74

# Concept measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in

Answer 74

**defensive interval ratio**

Question 75

# Concept colloquial term for the **defensive interval ratio**

Answer 75

burn rate

Question 76

# Concept a financial metric not in ratio form, measures the length of time required for a company to go from cash paid (*used in its operations*) to cash received (*as a result of its operations*)

Answer 76

**cash conversion cycle**

Question 77

# Concept is sometimes expressed as the length of time funds are tied up in working capital

Answer 77

**cash conversion cycle**

Question 78

# Calculation current ratio

Answer 78

**Numerator** * ..........current assets **Denominator** * .........current liabilities

Question 79

# Calculation quick ratio

Answer 79

**Numerator** * Cash + Short-term marketable investments + Receivables **Denominator** * current liabilities

Question 80

# Calculation cash ratio

Answer 80

**Numerator** * Cash + Short-term marketable investments **Denominator** * current liabilities

Question 81

# Calculation defensive interval ratio

Answer 81

**Numerator** * Cash + Short-term marketable investments + Receivables **Denominator** * daily cash expenditures

Question 82

# Calculation cash conversion cycle (net operating cycle)

Answer 82

DOH + DSO - number of days of payables

Question 83

# indication a higher current ratio

Answer 83

* indicates a higher level of liquidity (i.e., a greater ability to meet short-term obligations)

Question 84

# indication current ratio of 1.0

Answer 84

would indicate that the book value of its current assets exactly equals the book value of its current liabilities

Question 85

# Concept is more conservative than the current ratio because it includes only the more liquid current assets

Answer 85

quick ratio

Question 86

# Ratio ratio reflects the fact that certain current assets—such as prepaid expenses, some taxes and employee-related prepayments—represent costs of the current period that have been paid in advance and cannot usually be converted back

Answer 86

quick ratio

Question 87

# Concept ratio also reflects the fact that inventory might not be easily and quickly converted into cash

Answer 87

quick ratio

Question 88

# Concept in situations where inventories are illiquid, this ratio may be a better indicator of liquidity

Answer 88

quick ratio

Question 89

# Describe quick ratio

Answer 89

* This ratio reflects the fact that inventory might not be easily and quickly converted into cash * certain current assets—such as prepaid expenses, some taxes, and employee-related prepayments—represent costs of the current period that have been paid in advance

Question 90

# Concept normally represents a reliable measure of an entity's liquidity in a crisis situation

Answer 90

cash ratio

Question 91

# Describe cash ratio

Answer 91

normally represents a reliable measure of an entity's liquidity in a crisis situation

Question 92

# reason cash ratio is susceptible to market crises

Answer 92

* fair value of highly marketable short-term investments could decrease significantly as a result of market factors

Question 93

# indication a defensive interval ratio of 50

Answer 93

indicates that the company can continue to pay its operating expenses for 50 days before running out of quick assets

Question 94

# analysis very low defensive interval ratio relative to peer companies

Answer 94

the analyst would want to ascertain whether there is sufficient cash inflow expected to mitigate the low defensive interval ratio

Question 95

# Concept This metric indicates the amount of time that elapses from the point when a company invests in working capital until the point at which the company collects cash

Answer 95

cash conversion cycle (net operating cycle)

Question 96

# describe cash conversion cycle in merchandising company

Answer 96

The time between the outlay of cash and the collection of cash

Question 97

# indication a shorter cash conversion cycle

Answer 97

indicates greater liquidity better credit collection

Question 98

# indication a longer cash conversion cycle

Answer 98

* indicates lower liquidity * implies that the company must finance its inventory and accounts receivable for a longer period of time

Question 99

# liquidity analysis

Answer 99

* the minimal DOH indicates that Apple maintains lean inventories attributable to key aspects of the company's business model where manufacturing is outsourced * in isolation, the increase in number of days payable (86 to 112) might suggest an inability to pay suppliers; however, Apple's $70 billion in cash and short-term investments would suggest otherwise. * negative cash cycle—Apple takes advantage of favorable credit terms * Apple has excess cash to invest for over 50 days