Financial Ratios - Chapter 3

Question 1

Deficiencies of Financial Statements

Answer 1

Inflation Effects
Inventory Valuation 
Extraordinary Gains and Losses
Pension Fund Liabilities 
Foreign Exchange Transactions 
Other Distortions

Question 2

Who might be, in particular, interested in the ratios?

Answer 2

Investors 
Managers
Lenders
Customers
Employees
Competitors
IRS (perhaps?)

Question 3

Common-size analysis

Answer 3

expresses line items or accounts in the financial statements as percentages.

Question 4

When line items are expressed as a percentage of a base period amount, it is a

Answer 4

horizontal analysis

Question 5

Vertical analysis expresses what?

Answer 5

the line item as a percentage of some other line item for the same period.
With this approach, within-period relationships can be assessed

Question 6

Uses of Financial Ratios within the Firm

Answer 6

Identify deficiencies in a firm’s performance and take corrective actions.
Evaluate employees’ performance and determine incentive compensation.
Compare the financial performance of different divisions within the firm

Question 7

Uses of Financial Ratios Outside the Firm

Answer 7

Lenders in deciding whether or not to make a loan to a company.
Credit-rating agencies in determining a firm’s credit worthiness.
Investors in deciding whether or not to invest in a company.
Major suppliers in deciding to sell and grant credit terms to a company.

Question 8

Limitations of Ratio Analysis

Answer 8

Difficulty in identifying industry categories or finding peers
Published peer group or industry averages are only approximations
Accounting practices differ among firms
Financial ratios can be too high or too low
Industry averages may not provide a desirable target ratio or norm
Use of average account balances to offset effects of seasonality