Financial Ratio Analysis

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Questions and Answers

A company's current ratio has increased. Is this always a positive sign of improved liquidity? Explain your answer.

Not necessarily. While a higher current ratio generally indicates better liquidity, it could also signal inefficient asset management, such as excessive inventory or slow-paying receivables.

Explain the difference between common-size income statements and common-size balance sheets. What is the base value used for each?

A common-size income statement expresses each line item as a percentage of revenue, while a common-size balance sheet expresses each line item as a percentage of total assets.

A firm has a high Return on Equity (ROE) but a low Return on Assets (ROA). What does this imply about the company’s financial leverage?

This implies that the company is using a high degree of financial leverage (debt) to boost its ROE. The difference between ROE and ROA is magnified by the leverage.

What are some limitations of ratio analysis? Provide at least two distinct limitations.

Limitations include: (1) reliance on historical data, which may not be indicative of future performance, and (2) potential for accounting distortions that can affect ratio values and comparability. Signup and view all the answers

How can the Du Pont analysis help in understanding the drivers of a company's Return on Equity (ROE)?

Du Pont analysis breaks down ROE into profit margin, asset turnover, and equity multiplier, allowing for a deeper understanding of which factors are driving the company's profitability. Signup and view all the answers

A company's receivables turnover ratio is decreasing over time. What could this indicate, and what are the potential implications?

This indicates that the company is collecting its receivables more slowly. This could imply weakening credit policies, customer financial difficulties, or a need to re-evaluate collection procedures, potentially leading to increased bad debt expenses and cash flow problems. Signup and view all the answers

Explain how deferred tax assets and liabilities arise and why they are important to consider when analyzing a company's financial health.

Deferred tax assets/liabilities arise from temporary differences between accounting and taxable income. They're important because they indicate future tax consequences of past transactions and can impact a company's future cash flows and profitability. Signup and view all the answers

Describe the major differences between the last-in, first-out (LIFO) and first-in, first-out (FIFO) inventory costing methods, and explain how they can impact a company's financial statements during periods of rising prices.

LIFO assumes the most recent inventory purchases are sold first, while FIFO assumes the oldest are sold first. During rising prices, LIFO results in a higher cost of goods sold and lower net income, while FIFO results in a lower cost of goods sold and higher net income. LIFO also results in a lower inventory valuation than FIFO during inflation. Signup and view all the answers

A company has made a significant change in its accounting policies. Where would you typically find information about this change, and why is it important for financial statement analysis?

Information about changes in accounting policies is typically found in the notes to the financial statements. It's crucial for analysis because it can significantly impact the comparability of financial statements across periods and with other companies. Signup and view all the answers

What does a persistent negative free cash flow (FCF) indicate about a company, and what are the potential consequences?

A persistent negative FCF indicates that a company is consistently spending more cash than it is generating from its operations. This may indicate the company is not financially sustainable in the long run, unless it can find other sources of funding. Signup and view all the answers

Flashcards

Income Statement

Reports a company's financial performance over a period of time by summarizing revenues, expenses, gains, and losses.

Balance Sheet

A financial statement that presents a firm’s financial position at a specific point in time.

Cash Flow Statement

Summarizes the cash inflows and outflows of a company over a period of time.

Statement of Changes in Equity

Financial statement detailing changes in owners' equity over a reporting period.

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Financial Statement Notes

Notes that provide additional information about items in the financial statements.

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Financial Statement Analysis

The process of evaluating a company's past, present, and potential performance and financial position.

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Stakeholders

Individuals or groups who have an interest in a company’s financial performance and position.

Financial Ratio Analysis

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Podcast

Questions and Answers

A company's current ratio has increased. Is this always a positive sign of improved liquidity? Explain your answer.

Explain the difference between common-size income statements and common-size balance sheets. What is the base value used for each?

A firm has a high Return on Equity (ROE) but a low Return on Assets (ROA). What does this imply about the company’s financial leverage?

What are some limitations of ratio analysis? Provide at least two distinct limitations.

How can the Du Pont analysis help in understanding the drivers of a company's Return on Equity (ROE)?

A company's receivables turnover ratio is decreasing over time. What could this indicate, and what are the potential implications?

Explain how deferred tax assets and liabilities arise and why they are important to consider when analyzing a company's financial health.

Describe the major differences between the last-in, first-out (LIFO) and first-in, first-out (FIFO) inventory costing methods, and explain how they can impact a company's financial statements during periods of rising prices.

A company has made a significant change in its accounting policies. Where would you typically find information about this change, and why is it important for financial statement analysis?

What does a persistent negative free cash flow (FCF) indicate about a company, and what are the potential consequences?