Chapter 3 - Financial Statement Analysis

Question 1

What is a Balance Sheet?

Answer 1

A balance sheet is a summary of assets, liabilities, and shareowner’s equity at historical acquisition costs

Question 2

What is the information on a balance sheet relative to?

Answer 2

Information on a balance sheet is as of a particular day

Question 3

What are current assets?

Answer 3

Current assets are cash and items that will be converted into cash in less than a year (receivables, inventory)

Question 4

What does PP&E stand for?

Answer 4

Property, plant, & equipment

Question 5

What is accumulated depreciation?

Answer 5

Accumulated depreciation is the write down of an asset’s book value due to usage and age

Question 6

What is Net PP&E?

Answer 6

Net PP&E is the PP&E - Accumulated Depreciation

Question 7

What are current liabilities?

Answer 7

Current liabilities are debt and obligations due within one year

Question 8

What is net working capital?

Answer 8

Net working capital is current assets less current liabilities

Question 9

What is long term debt?

Answer 9

Long term debt is bonds and loans maturing beyond one year

Question 10

What is stockholders equity?

Answer 10

Stockholder’s equity is the capital invested in the company

Question 11

What is Paid-in capital?

Answer 11

Paid-in capital is the amount raised by issuing a stock

Question 12

What is retained earnings?

Answer 12

Retained earnings are the past earnings kept by a firm

Question 13

What are the 10 components of a balance sheet?

Answer 13

A balance sheet is information as of a particular day that is written down summaries of assets, liabilities, and shareowners equity at historical acquisition. The 10 components of BS are 1) Current Liabilities 2) Current Assets 3) Long Term debt 4) PP&E 5) Accumulated Depreciation 6) Net PP&E (PP&E-Acc. Dep.) 7) Retained Earnings 8) Stockholder’s Equity 9) Paid-in Capital 10) Net working capital

Question 14

What is the income statement?

Answer 14

The income statement reports profitability for a particular period

Question 15

What are Sales (or Revenue)?

Answer 15

Sales or revenue are receipts from customers

Question 16

What is the Cost of Goods sold?

Answer 16

The Cost of Goods Sold (COGS) are the production expenses (labor, materials, etc.)

Question 17

What is the Gross Margin?

Answer 17

The gross margin is the sales(or revenue) -COGS

Question 18

What is Depreciation expense?

Answer 18

depreciation expense is the amount lost due to usage and age

Question 19

What is the General, Selling, & Administrative expense?

Answer 19

General selling & administrative expense is the overhead items but is omitted for simplicity

Question 20

What is the operating income?

Answer 20

The operating income is the gross margin - depreciation

Question 21

What is the interest expense?

Answer 21

The interest expense is the debt service

Question 22

What is the taxable income?

Answer 22

The taxable income is the operating income - interest expense

Question 23

What is the income tax?

Answer 23

The income tax represents the amount paid in income tax

Question 24

What is the net income?

Answer 24

The net income is the taxable income - income tax

Question 25

What are the 10 components of the Income statement?

Answer 25

The income statement reports the profitability of a particular period. The 10 components of income statement are 1) sales(or revenue) 2) Cost of Goods Sold (COGS) 3) Depreciation Expense 4) Gross margin (Sales - COGS) 5) GS&A 6) Interest expense 7) Taxable income (Gross margin - interest expense) 8) Income tax 9) Net Income (Taxable Income - Income Tax) 10) Operation Expense

Question 26

Law firms are frequently incorporated as limited partnerships. Why would law firms and other service firms select that form rather than, say, a corporation?

Answer 26

Service firms may select to be a partnership rather than a corporation for many reasons. These include, uneven distribution to partner/owners, control and the elimination of the principal-agent problem, little need for third party capital, avoidance of double taxation

Question 27

why do most investors keep a close eye on th ecommodity copper?

Answer 27

Copper is viewed to be one of the best indicators of future economic growth because it is a critical ingredient in many manufactured products// Recently, it has a high correlation with emergin market stocks

Question 28

How do you calculate the real rate of return?

Answer 28

Real rate of return = (nominal rate - inflation rate) / (1 + inflation rate)

Question 29

Why are real rates of return important to investors?

Answer 29

Real rates of return are important to investors because inflation erodes purchasing power of currencies, real rates of return enable investors to see whether their nominal return is keeping pace with inflation

Question 30

When the yield curve is especially flat, this suggests what?

Answer 30

When the yield curve is relatively flat, this suggests that investors believe that inflation will remain stable for the forseeable future

Question 31

How did investors foresee economic growth when the yield curve is steep?

Answer 31

Investors believe that the future will hold higher economic growth couples with inflation as the fed implements monetary policy

Question 32

What are the three principal components of a company's financial statement and what does each reveal to investors?

Answer 32

An income statement which reveals the profitability of firms in a particular period, the balance sheet that records assets, liabilities and shareowner's equity of the firm and the cash flow statement which shows the company's changes in cash position since the prior reporting date. Taken together, the three components (income, balance sheet, and cash flow statement) enable investors to understand the profitability, solvency, and liquidity of the company.

Question 33

You're the manager of a Bath and Body works store and christmas sales were weak. Management has told you that you need to run a 25% discount to move the remaining holiday merchandise. What should you expect to see happen to your return on assets and inventory turnover ratios?

Answer 33

Inventory turnover will increase as inventory decreases and sales increases. Return on Assets is slightly more ambiguous. If the return on assets encourages a huge boost in sales increases the operating margin then, because this EBIT is in the numerator and inc but if it was to have the opposite effect and the EBIT becomes super small, then the ratio will also decrease

Question 34

You're the head of the collections dept at GM responsible for badgering overdue customers until they pay their bills, the company's current ratio is falling solely due to changes in the receivables balance you are responsible for, should you expect to be fired or promoted?

Answer 34

Receivables represent the amounts owed to GM and are a current asset of the company. A drop in the receivables would suggest that the collections dept is doing a good job. Therefore you should should be promoted

Question 35

You are able to undertake a major acquisition and plan to pay for the new business by issuing debt. The rating agencies are concerned that by doing so your Leverage ratio is going to rise too high, and they are now threatening to lower your debt rating from A to BBB. If you think the downgrade could result in higher debt costs for your company what could you do to keep your leverage ratio in check as you fund your acquisition?

Answer 35

Leverage debt is equal to the average debt divided the avg shareholder equity. If your ratio is going to rise to high, you can either plan to use a different, more liquid resource to finance your project to address the avg debt portion of the ratio but you could also increase the avg shareholder's equity by increasing or issuing dividends.

Question 36

You are a chairwoman of GM and hear complaints from your dealers that cars arent selling as well in Feb as they did in January. What financial ratio could you look at to see if their complaints were worth worrying about? If they are a concern, what steps could you take to improve that ratio?

Answer 36

I would look at the inventory turnover ratio. The inventory turnover ratio is the COGS divided by the avg inventory. I would aim to improve a falling Inventory turnover ratio I could increase sales incentives or cut factory production to cut inventory levels.

Question 37

The return on equity of your firm is worse than its peers, what is an example of a step you could take to improve it?

Answer 37

The return on equity is the net income divided by the average equity. If you wanted to improve this you would need to do something to EBIT. To do this you could cut overhead or other expenses or look for ways to increase sales margins.

Question 38

The Price to Earnings ratio of facebook is 35 while the PE of twitter is 8. If the avg PE for social media companies is 15 how do you think the leaders of facebook and twitter feel right now?

Answer 38

Facebook good, twitter bad. PE elvels reflect investor confidence