FINANCIAL ANALYSIS AND LONG-TERM PLANNING

1. List some reasons why financial statement analysis is conducted. Identify some of the participants that analyze firms financial statements. The real usefulness is that financial statements are analyzed to determine a firms future earnings and dividends along with its risks. Firms management, potential purchasers of the bonds/equity, analysts, suppliers, banks, bondholders, equity holders, and potential investors examine ratios. 2. What is ratio analysis? Also briefly describe the three basic categories or ways that ratio analysis is used. Ratios are constructed by dividing various financial statement numbers into one another. Ratios can be used in trend analysis or time series analysis to evaluate a firms performance over time; cross-sectional analysis, in which different firms are compared to each other at the same point in time; and industry comparative analysis are used to compare a firms ratios against average ratios for other companies in the firms industry. 3. Identify the types of ratios that are used to analyze a firms financial performance based on its income statements and balance sheets. The categories are liquidity, asset management, financial leverage, profitability, and market value ratios. 4. Which type or category of ratios relates stock market information to financial statement items? The market value ratios are used torelate stock market information to financial statement items. 5. What do liquidity ratios indicate? Identify some basic liquidity ratios. Liquidity ratios indicate the ability of a firm to meet its short-term obligations as they come due. It includes current ratio, quick ratio, and the average payment period. 6. What do asset management management ratios. ratios indicate? Identify some basic asset

Chapter Twelve

Asset management ratios indicate the extent to which assets are used to support sales. Ratios include total assets turnover, fixed assets turnover, average collection period, and inventory turnover. 7. What do financial leverage ratios indicate? Identify some measures of financial leverage. Financial leverage ratios are used to show the level of debt used to finance assets and the ability of the firm to service its debt obligations. Ratios include total debt to total assets, total debt to equity, equity multiplier, interest coverage ratio, fixed charge coverage ratio. 8. What do profitability ratios indicate? Identify some measures of profitability.
May Anne Aves BS Accountancy III

Profitability ratios indicate the extent to which borrowed or debt funds are used to finance assets, as well as the ability of the firm to meet its debt payment obligations. Ratios include operating profit margin, net profit margin, operating return on assets, return on total assets, and return on equity. 9. What do market value ratios indicate? Identify some market value ratios. Market value ratios show the value of a firm in the market place relative to financial statement values. Ratios include price/earnings ratio and price-to-bookvalue ratio. 10. Describe the Du Pont method or system of ratio analysis. What are the two major components of the system? The Du Pont method categories return on assets into the product of two components: profit margin and total assets turnover and Return on Equity can also be broken into return on assets and the equity multiplier. It shows how a firm can generate profits through profitability or turnover or, in ROE, by increasing financial leverage. 11. How is the Du Pont system related to both the balance sheet and the income statement? Du Pont analysis relates to both the balance sheet and income statement, as ROA and ROE are ratios using components from both. 12. How is the process of financial planning used to estimate asset investment requirements? Financial planning begins with a sales forecast for one or more years. These sales forecast are the basis for written financial palans referred to as budgets. FOR established firms, these sales forecast are usually based on historical sales data that are used in statistical anlyses to project into the future. The sales forecast with the total asset turnover ratio is used to approximate potential total assets. The difference between the estimated future level and the present level of total assets is the amount of assets to be obtained and financed. 13. Explain how internally generated funds are used to reduce the need for external financing to fund asset investments. Internally generated funds for financing new asset investments come from profits. Internally generated funds are added to retained earnings specifically the years net income that is left after dividends are disseminated or distributed. These funds aid finance the change in assets as they reduce the need for outside financing. 14. Explain how financial planning is used to determine a firms external financing requirements. First, forecast the expected sale increase. Secondly, determine the dollar amount of new asset investment necessary to support the sales increase. Thirdly, subtract the expected amount of retained profits from the planned asset investment. Then, subtract the amount of spontaneous increases expected in accounts payable and

May Anne Aves BS Accountancy III

accrued liabilities from the planned asset investment. Finally, the remaining dollar amount of asset investments determines the external financing needs (EFN). 15. What is cost-volume-profit analysis? How can it be used by a firm? Cost-volume-profit analysis is used by managers to approximate operating profits at different levels of unit sales. Operating income is estimated as sales revenue less variable costs less fixed costs. 16. What is the purpose of knowing the break-even point? A variation, called breakeven analysis, can be used to estimate how many units of product must be sold in order for the firm to break even or have a zero profit. 17. What will happen to the break-even point if the contribution margin rises (falls)? The contribution margin represents the portion of each unit sold toward paying annual fixed costs. There is an inverse relationship between the break-even point and the contribution margin. Therefore, as the contribution margin rises, fewer products must be sold to cover fixed costs, so the break-even point falls. As the contribution margin falls, greater products must be sold to cover fixed costs, so the break-even point rises. 18. What does a firms degree of operating leverage (DOL) indicate? DOL measures the sensitivity of operating income to changes in the level of output. 19. Describe what would happen to the DOL if all costs are fixed? Variable? The magnification or leverage effect is solely due to the level of fixed costs. A higher level of fixed cost results in a higher level of operating leverage. However, if all costs are fixed, any additions in sales above the break-even point directly increase earnings before interest and taxes by a similar amount. If a firms costs are all variable, the firms degree of operating leverage will equal one and there will be no leverage effect of a change in sales on operating profit. The greater the firms fixed costs relative to its variable costs, the greater will be the degree of operating leverage, or vice versa.

May Anne Aves BS Accountancy III