A304 - Chapter 12

What are the different types of financial comparisons?

What are the different types of financial comparisons?

1. Comparisons between companies

2. Comparisons over time

3. Comparisons to industry

What is a Vertical Analysis?

Express each item as a percentage of the same base amount

What is an example of Vertical Analysis?

Express items as:

• A percentage of sales in the income statement

• A percentage of total assets in the balance sheet

What is a Horizontal Analysis?

Analyze trend in financial statement data for one company over time

What is an example of Horizontal Analysis?

• Amount of change

• Percentage change

How do you calculate % Increase (Decrease)?

Current Year Amount - Prior Year Amount / Prior Year Amount

What do return on investment ratios measure?

A company’s ability to generate returns to its capital providers

What do return on investment ratios capture?

The overall performance of a company over a period of time

What do profitability ratios measure?

A company’s ability to generate profit from its sales

How are profitability ratios used?

as a measure of the operating effectiveness of a company over a period of time

What do asset management ratios measure?

A company’s ability to use its assets to generate sales

How are asset management ratios used?

As a measure of the operating efficiency of a company over a period of time

What do credit risk ratios measure?

A company’s credit-worthiness

How do we categorize credit risk?

Into liquidity and solvency ratios

What do liquidity ratios focus on?

A company’s ability to pay current liabilities

What do solvency ratios focus on?

A company’s ability to pay long-term liabilities as well

How are valuation ratios constructed?

By dividing a company’s measure of value (stock price per share) by a measure of the current profitability (earnings per share)

What do valuation ratios capture?

The extent to which future earnings growth and the company’s risk profile are reflected in stock price

What is Earnings Management?

Used to describe how managers use assumptions, estimates, and discretion underlying many accounting rules to “manage” reported earnings

What incentives do managers face to engage in earnings management?

• Delivering expected earnings to stock market

• Avoid debt covenant violations with bank

• Meeting performance target tied to management bonus

What is Quality of Earnings?

• Ability of reported earnings to reflect true earnings

• Usefulness of reported earnings to predict future earnings

What do Conservative Accounting Practices result in reporting?

1. Lower Income

2. Lower Assets

3. Higher Liabilities

What do Aggressive Accounting Practices result in reporting?

1. Higher income

2. Higher assets

   1. Lower liabilities

What do changes in accounting estimates and practices alter?

The appearance of amounts reported in the income statement and balance sheet

What do changes in accounting estimates and practices usually have no effect on?

A company’s underlying cash flows

What is the DuPont framework used to analyze?

The performance of a company as measured by the ROE ratio

The DuPont Framework depicts return on equity as determined by what three components?

• Profitability

• Asset Efficiency

• Financial Leverage

How is profitability measured for the return on equity used in the DuPont Framework?

by the profit margin

How is asset efficiency measured for the return on equity used in the DuPont Framework?

by asset turnover

How is financial leverage measured for the return on equity used in the DuPont Framework?

by the equity multiplier