Chapter 3: Financial Statements and Ratio Analysis

Question 1

The statement of comprehensive income

Answer 1

provides a financial
summary of a company’s operating results during a specified
period.
- prepared annually for reporting purposes
- computed monthly by management
- quarterly for
tax purposes.
6

Question 2

The Statement of Financial Position

Answer 2

presents a summary of a firm’s
financial position at a given point in time

Question 3

Assets

Answer 3

what the firm owns

Question 3

Liabilities

Answer 3

what the firm has borrowed.

Question 4

Equity

Answer 4

the owners’
investment

Question 5

The Statement of Changes in Equity

Answer 5

• reconciles the net income
  earned during a financial year and any cash dividends paid.
• The change in retained earnings is between the start and end of
  that year.
• includes total amounts attributable to owners and non-
  controlling interests

Question 6

The Statement of Cash flows

Answer 6

• provide a summary of cash flows over
  the period of concern, typically the year just ended.
• provides insight in the company’s
  investment, financing and operating activities
• ties together
  the statement of comprehensive income and previous and current
  statement of financial positions.

Question 7

ratio analysis

Answer 7

Involves methods of calculating
and interpreting financial
ratios to analyze and monitor
the firm’s performance.

Question 8

cross-sectional analysis

Answer 8

Comparison of different firms’
financial ratios at the same
point in time; involves
comparing the firm’s ratios
to those of other firms in its
industry or to industry
averages.

Question 9

benchmarking

Answer 9

A type of cross-sectional
analysis in which the firm’s
ratio values are compared to
those of a key competitor or
group of competitors that it
wishes to emulate.

Question 10

time-series analysis

Answer 10

Evaluation of the firm’s
financial performance over
time using financial ratio
analysis

Question 11

liquidity

Answer 11

A firm’s ability to satisfy its
short-term obligations as they
come due.

Question 12

current ratio

Answer 12

A measure of liquidity
calculated by dividing the
firm’s current assets by its
current liabilities

Current ratio = Current assets/Current liabilities

Question 13

quick (acid-test) ratio

Answer 13

A measure of liquidity
calculated by dividing the
firm’s current assets minus
inventory by its current
liabilities

Quick ratio = (Current assets- Inventory) / Current liabilities

Question 14

activity ratios

Answer 14

Measure the speed with which
various accounts are converted
into sales or cash—inflows or
outflows

Question 14

inventory turnover

Answer 14

Measures the activity, or
liquidity, of a firm’s inventory

Inventory turnover = Cost of goods sold / Inventory

Question 15

average collection period

Answer 15

The average amount of time
needed to collect accounts
receivable

Average collection period = Accounts receivable / Average sales per day
= Accounts receivable / Annual sales / 365

Question 15

average age of inventory

Answer 15

Average number of days’ sales
in inventory.

Question 16

average payment period

Answer 16

The average amount of time
needed to pay accounts
payable.

Average payment period = Accounts payable / Average purchases per day
= Accounts payable / Annual purchases / 365

Question 17

total asset turnover

Answer 17

Indicates the efficiency with
which the firm uses its assets to
generate sales.

Total asset turnover = Sales / Total asset

Question 18

financial leverage

Answer 18

The magnification of risk and
return through the use of fixed
cost financing, such as debt
and preferred stock.

Question 18

ability to service debts

Answer 18

The ability of a firm to make
the payments required on a
scheduled basis over the life of
a debt

Question 18

degree of indebtedness

Answer 18

Measures the amount of debt
relative to other significant
balance sheet amounts.

Question 19

coverage ratios

Answer 19

Ratios that measure the firm’s
ability to pay certain fixed
charges.

Question 20

debt ratio

Answer 20

Measures the proportion of total assets financed by the firm’s creditors Debt ratio = Total liabilities / Total assets

Question 21

times interest earned ratio

Answer 21

Measures the firm’s ability to make contractual interest payments; sometimes called the interest coverage ratio. Times interest earned ratio = Earnings before interest and taxes / taxes

Question 22

fixed-payment coverage ratio

Answer 22

Measures the firm’s ability to meet all fixed-payment obligations. Fixed payment coverage ratio = ( Earnings before interest and taxes + Lease payments) / (Interest + Lease payments) + {(Principal payments + Preferred stock dividends) x [1/(1- T)]}

Question 23

net profit margin

Answer 23

Measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted Net profit margin = Earnings available for common stockholders / Sales

Question 24

operating profit margin

Answer 24

Measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted; the “pure profits” earned on each sales dollar. Operating profit margin = Operating profits / Sales

Question 24

earnings per share (EPS)

Answer 24

represents the number of dollars earned during the period on behalf of each outstanding share of common stock Earnings per share = Earnings available for common stockholders / Number of shares of common stock outstanding

Question 24

market ratios

Answer 24

Relate a firm’s market value, as measured by its current share price, to certain accounting values.

Question 24

price/earnings (P/E) ratio

Answer 24

Measures the amount that investors are willing to pay for each dollar of a firm’s earnings; the higher the P/E ratio, the greater the investor confidence P/E ratio = Market price per share of common stock , Earnings per share

Question 24

DuPont system of analysis

Answer 24

System used to dissect the firm’s financial statements and to assess its financial condition.

Question 25

gross profit margin

Answer 25

Measures the percentage of each sales dollar remaining after the firm has paid for its goods Gross profit margin = Sales- Cost of goods sold / Sales = Gross profits / Sales

Question 25

return on common equity (ROE)

Answer 25

Measures the return earned on the common stockholders’ investment in the firm. ROE = Earnings available for common stockholders / Common stock equity

Question 25

return on total assets (ROA)

Answer 25

Measures the overall effectiveness of management in generating profits with its available assets; also called the return on investment (ROI). ROA = Earnings available for common stockholders / Total assets

Question 26

market/book (M/B) ratio

Answer 26

Provides an assessment of how investors view the firm’s performance. Firms expected to earn high returns relative to their risk typically sell at higher M/B multiples. Book value per share of common stock = Common stock equity / Number of shares of common stock outstanding