Chapter 4

1. Discuss why information related with the cash flow of the company are very important for some group of users.

a) Accounting personnel- Want to know whether the organization will be able to cover payroll and other immediate expenses

b) Potential lenders or creditors - want a clear picture of a company's ability to repay

c) Potential investors - Need to judge whether the company is financially sound good or notd) Potential employees or contractors -Need to know whether the company will be able to afford

compensation or not.e) Shareholders of the business.

Benefit

- Provide information on a firm's liquidity and solvency and its ability to change cash flow in future circumstances.

- Provide additional information for evaluating changes in assets, liabilities and equity.

- Improve the comparability of different firms' operating performance by eliminating the effects of different accounting method.

- Indicate the amount, timing and probability of future cash flows.

2. Describes the four difference basic types of financial statement analysis available.

Common-size analysis is the restatement of financial statement information in a standardized form.– Horizontal common-size analysis uses the amounts

in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value.

• Useful when comparing growth of different accounts over time.

– Vertical common-size analysis uses the aggregate value in a financial statement for a given year as the base, and each account’s amount is restated as a percentage of the aggregate.

• Balance sheet: Aggregate amount is total assets.• Income statement: Aggregate amount is

revenues or sales.

Financial ratio analysis is the use of relationships among financial statement accounts to gauge the financial condition and performance of a company.

• Ratios are classified based on the type of information the ratio provides:

Activity Ratios • Effectiveness in putting its asset investment

to use.

Liquidity Ratios • Ability to meet short-term, immediate

obligations. Solvency Ratios

• Ability to satisfy debt obligations. Profitability ratios

• Ability to manage expenses to produce profits from sales.

Year to year change Analysis• Use both absolute and percentages• Guidelines

– When an item has value in the base year and none in the next period, the decrease is 100%

– A meaningful percent change cannot be computed when one number is positive and the other number is negative

– No percent change is computable when there is no figure for the base year

Industry Variations• Financial components vary by type of industry• Merchandising

– Inventory is a principal asset– Sales may be primarily for cash or on

credit• Service

– Inventory is low or nonexistent• Manufacturing

– Large inventory holdings– Substantial investment in plant assets– Cost of sales often represents the

major expense

3. Explain how financial ratio analysis will enable the users to make a good decision

1. Analyzing Financial StatementsRatio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the

financial position of the company. Different users such as investors,management. bankers and creditors use the ratio to analyze the financial situation of the company for their decision making purpose.

2. Judging EfficiencyAccounting ratios are important for judging the company's efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.

3. Locating WeaknessAccounting ratios can also be used in locating weakness of the company's operations even though its overall performance may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.

4. Formulating PlansAlthough accounting ratios are used to analyze the company's past financial performance, they can also be used to establish future trends of its financial performance. As a result, they help formulate the company's future plans.

5. Comparing Performance- It is essential for a company to know how well it is performing over the years and as

compared to the other firms of the similar nature. Besides, it is also important to know how well its different divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.

Chapter 5

1. Among the profitability measures are the return on assets, return on sales, return on investment and return on equity. How does this measures differ?

Return on sales (ROS) is net profit as a percentage of sales revenue.ROS is an indicator of profitability and is often used to compare the profitability of companies and industries of differing sizes.

Return on assets (ROA) is a financial ratio that shows the percentage of profit a company earns in relation to its overall resources. It is commonly defined as net income divided by total assets. Net income is derived from the income statement of the company and is the profit after taxes.

Return on investment (ROI) is the benefit to the investor resulting from an investment of some resource. A high ROI means the investment gains compare favorably to investment cost.

Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders' equity. The formula for ROE is: ROE = Net Income/Shareholders' Equity. ROE is sometimes called "return on net worth."

2. What is meant by profitability trends and how can profitability trends give information to the analyst?

Profitability Trend

A profitability trend is the evolution of profit within a business. An upward trend means that profit has generally increased over time in the short or long run. A downward profitability trend means profits are declining.

How?- Firm performance is evaluated using trend analysis—

- calculating ratios on a per-period basis, and tracking their values over time.

-This analysis can be used to spot trends that may be cause for concern, such as an increasing average collection period for outstanding receivables or a decline in the firm's liquidity status.

- In this role, ratios serve as red flags for troublesome issues, or as benchmarks for performance measurement.

Example If a company's gross profit margin falls steadily over time, the manager should step in to address declining revenue or rising costs. An upward gross profit margin trend is a good sign of company financial health. If operating and net profit trends decline, the manager may also have to review fixed and unusual costs.

Besides, It is more alarming if your downward trend goes against industry norms. If the industry has shown a 3 percent increase in gross profit margin over two years, but your gross profit margin has declined, your business is going against the trend. Ideally, your company's profitability trends are equal to or better than the industry. If the whole industry is experience an economic downturn, a more modest decline in profitability for your business is reasonable.

3. Explain the meaning of interim report. What is the weakness of an interim report?

Interim report

- Additional sources of information on profitability

- Reports that cover fiscal periods of less than one year

- Using the same reporting principles with those used in annual reports

- Interim reports are unaudited, thus are less reliable than annual reports.

- Contain more estimates such as tax expense.

- Interim statements can help the analyst to determine trends and identify trouble areas before the year-end report is available.

Weakness?