Financial Reporting Chapter 7 Quiz
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Questions and Answers

What does a high market value indicate about investor sentiment?

  • Investors are indifferent to the firm's performance.
  • Investors are pessimistic about the firm's future.
  • Investors consider the firm's assets are being undervalued.
  • Investors believe in the potential growth of the firm. (correct)

Which formula correctly represents the calculation of Dividend Yield?

  • Market Price per Share / Dividends per Share
  • Dividends per Share / Total Assets
  • Total Dividends / Number of Common Shares
  • Dividends per Common Share / Market Price per Common Share (correct)

What does Book Value per Share represent?

  • The market price of a share in the stock market.
  • The value of the firm’s assets as recorded in accounting books. (correct)
  • The total revenue generated per common share.
  • The liability per common share outstanding.

Why should preferred equity be measured at liquidation value?

<p>It indicates the value investors will receive if the firm is liquidated. (A)</p> Signup and view all the answers

What is the significance of an investor preferring long-term consideration?

<p>They desire control over the firm's operations. (D)</p> Signup and view all the answers

What does a higher percentage of earnings retained typically indicate about a firm?

<p>The firm is likely a growth firm. (D)</p> Signup and view all the answers

How is the Dividend Payout ratio calculated?

<p>Dividends per Common Share divided by Earnings Per Share. (B)</p> Signup and view all the answers

Which of the following best describes the Dividend Yield?

<p>The relationship between dividends per common share and the market price per common share. (A)</p> Signup and view all the answers

What effect does a low percentage of earnings retained have on a firm's dividend policy?

<p>It often results in higher dividend payments. (D)</p> Signup and view all the answers

What aspect of trend analysis is improved by excluding nonrecurring items?

<p>Understanding the percentage of earnings retained. (A)</p> Signup and view all the answers

Which statement is true regarding a company with a low Dividend Yield?

<p>It may still satisfy investors due to above-average returns on common equity. (B)</p> Signup and view all the answers

If a firm has an Earnings Per Share (EPS) of €10 and pays dividends of €3 per share, what is the Dividend Payout ratio?

<p>40% (B)</p> Signup and view all the answers

What is typically suggested about firms with a lower Dividend Payout ratio?

<p>They are reinvesting more profits for growth. (B)</p> Signup and view all the answers

What does the weighted average of outstanding shares represent in the given example?

<p>The average number of shares outstanding over the year (C)</p> Signup and view all the answers

Which fraction of the year corresponds to the period of July to September in the shares outstanding calculation?

<p>1/3 (D)</p> Signup and view all the answers

How is diluted earnings per share (DEPS) different from basic earnings per share (EPS)?

<p>DEPS includes the effect of potentially dilutive securities (C)</p> Signup and view all the answers

What is the weighted average of shares outstanding for the period from October to December?

<p>3,750 (B)</p> Signup and view all the answers

What condition is necessary for a security to be considered potentially dilutive?

<p>It must be convertible into shares (B)</p> Signup and view all the answers

What does a high Price/Earnings Ratio (PER) generally indicate about a company's growth potential?

<p>Investors are optimistic about the company's future growth. (C)</p> Signup and view all the answers

Which measure is used to provide a more conservative Price/Earnings Ratio?

<p>Diluted earnings per share (C)</p> Signup and view all the answers

How should the Price/Earnings Ratio be compared to assess a company's performance?

<p>Against competitors and industry averages. (D)</p> Signup and view all the answers

When interpreting a high Price/Earnings Ratio, what is a possible negative implication?

<p>There may be overestimation of the firm's actual value. (D)</p> Signup and view all the answers

What does a Price/Earnings Ratio of €100 market price to €1 earnings per share signify?

<p>Investors are purchasing shares at a high cost for minimal return. (A)</p> Signup and view all the answers

What does EPS stand for in financial contexts?

<p>Earnings per Share (C)</p> Signup and view all the answers

Which type of stock has priority for receiving dividends?

<p>Preferred Stock (A)</p> Signup and view all the answers

What aspect of share ownership is associated with receiving dividends?

<p>Earnings per Share (EPS) (A)</p> Signup and view all the answers

Which of the following ratios would be of particular interest to an investor?

<p>Profitability Ratio (B)</p> Signup and view all the answers

In calculating EPS, what is deducted from Net Income?

<p>Preferred Dividends (B)</p> Signup and view all the answers

What is the primary preference of investors regarding EPS?

<p>Higher ratios suggest a higher probability of dividends (C)</p> Signup and view all the answers

What does the term 'common shares outstanding' refer to?

<p>Shares owned by shareholders currently (A)</p> Signup and view all the answers

Why are dividends of major interest to shareholders?

<p>They provide a return on investment (A)</p> Signup and view all the answers

Flashcards

Investor

A person who owns shares of a company.

Shareholder

An owner of shares in a company.

Common Stock

Ordinary shares that give shareholders voting rights.

Preferred Stock

Shares with priority in receiving dividends but no voting rights.

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Earnings per Share (EPS)

Earnings on a common stock during an accounting period.

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Common Shares Outstanding

Total number of shares owned by investors in the company.

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Dividend

A portion of the company's profit paid to shareholders.

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Liquidity, Debt, and Profitability Ratios

Financial metrics used to assess a company's performance.

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Weighted Average Common Shares Outstanding

The average number of outstanding shares weighted by the time they were outstanding during a specific period. It's used to calculate earnings per share (EPS).

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Fraction of Year Outstanding

The portion of a year that shares were outstanding. It's calculated by dividing the number of months the shares were outstanding by 12.

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Diluted Earnings per Share (DEPS)

A calculation of earnings per share that includes the potential dilution from all convertible securities, such as options, warrants, and convertible debt.

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Dilutive Securities

Securities, such as options, warrants, and convertible debt, which can be converted into common stock, potentially increasing the number of outstanding shares and diluting earnings per share.

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How does DEPS differ from basic EPS?

Diluted Earnings Per Share (DEPS) incorporates the potential dilution from convertible securities, such as options, warrants, and convertible debt, while basic EPS does not account for these securities.

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What is Price/Earnings Ratio (PER)?

A financial metric that compares a company's stock price to its earnings per share. It helps investors evaluate a company's valuation relative to its profitability.

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High PER: Meaning?

Indicates investors are optimistic about the company's future growth potential. They are willing to pay a higher price for each dollar of current earnings.

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Low PER: Meaning?

Suggests investors are less optimistic about the company's future growth. They are willing to pay a lower price for each dollar of current earnings.

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PER: Interpretation?

Comparing a company's PER to its competitors or industry average can provide insight into its relative valuation. A higher PER might signal growth potential, while a lower PER might suggest stability or undervaluation.

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Diluted Earnings per Share (EPS): Importance for PER?

Using diluted EPS gives a more conservative and accurate PER, as it takes into account potential future dilution of shares. This makes the valuation more realistic.

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Dividend Yield (DY)

A financial ratio that measures the annual dividend per share relative to the current market price per share. It indicates the percentage return an investor receives from dividends.

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Book Value per Share

A measure of a company's net assets per share that is calculated by dividing the total shareholders' equity (minus preferred stock equity) by the number of outstanding common shares.

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Market Value vs. Book Value

Market value reflects the potential of a company as perceived by investors, while book value represents the company's assets as recorded on the balance sheet.

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High Market Value: What does it mean?

A high market value suggests that investors are optimistic about the company's future prospects and are willing to pay a premium for its shares.

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Long-term Investment Preference

An investor who prioritizes long-term growth and control over the company rather than immediate dividends. This is often seen in private firms or firms with high growth potential.

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Percentage of Earnings Retained

The portion of current earnings kept by a company for internal growth (not distributed as dividends). It reflects the company's reinvestment strategy.

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Trend Analysis for Earnings Retained

Analyzing the pattern of earnings retained over time, excluding one-time events (nonrecurring items) to get a clearer picture of the company's underlying growth strategy.

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Low Percentage of Earnings Retained

Indicates a more generous dividend policy, meaning a larger portion of earnings is distributed to shareholders.

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High Percentage of Earnings Retained

Usually found in growth firms who prioritize reinvesting earnings for expansion and future opportunities.

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Dividend Payout (DP)

The proportion of current earnings per share paid out as dividends. It shows the company's dividend distribution policy.

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Lower Dividend Payout

Typically seen in growth firms that focus on internal reinvestment rather than dividend distribution.

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Low Dividend Yield

Doesn't necessarily mean a bad investment if the company has strong growth potential and a history of high returns.

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Study Notes

Financial Reporting & Analysis

  • The text discusses financial reporting and analysis using accounting information.
  • The book is titled "Financial Reporting & Analysis: Using Financial Accounting Information" by Charles H. Gibson.

Chapter 7: Information for Investors; Dividends

  • A shareholder (or stockholder) is a person that owns shares in a company.
  • Investors are interested in the liquidity, debt, and profitability of a company.
  • Investors consider common stock and preferred stock.
  • Common stock holders have voting rights.
  • Preferred stock holders have priority to receive dividends but no voting rights.

Introduction

  • Certain types of analyses particularly concern investors.
  • Investors would also be interested in liquidity, debt, and profitability ratios.

1/ Earnings per Common Share (EPS)

  • EPS represents the income earned per share of common stock during an accounting period.
  • Investors prefer higher EPS, indicating a higher probability of receiving dividends.
  • EPS only pertains to common stock.
  • The formula for EPS is: Net Income - Preferred Dividends / Weighted Average Number of Common Shares Outstanding.

Weighted Average Common Outstanding Shares

  • This calculation considers the number of shares outstanding during different periods throughout the year.
  • Month-to-month share counts are used to provide the weighted average

Earnings per Share (Continued)

  • Current guidelines require a basic and diluted earnings per share presentation (DEPS).
  • Diluted earnings per share (DEPS) is calculated like basic EPS, but adds the dilutive effect of potentially dilutive securities to the calculation. It is used when additional shares arise from events like debt conversion.

2/ Price/Earnings Ratio (PER)

  • PER measures the relationship between the market price of a common share and the earnings per share.
  • Using diluted earnings per share provides a more conservative price-earnings ratio.
  • A higher PER (e.g., market price = €100, EPS = €1) suggests investors are optimistic about the company's growth potential. Conversely a lower PER indicates greater investor skepticism

Price/Earnings Ratio - Continued

  • High-growth potential firms typically have higher P/E ratios.
  • Comparing a firm's P/E ratio to its competitors and the industry average provides further insight.

Example

  • Example provided using Nike Inc. Includes market prices and earnings per share in 2007 and 2006.

3/ Percentage of Earnings Retained

  • This ratio reflects the portion of current earnings retained for internal growth, not distributed as dividends.
  • Analyzing this ratio can improve the analysis of trends, especially when nonrecurring items are excluded.
  • Companies with lower percentages are often more generous in their dividend policy.
  • Higher percentages are commonly seen in growth firms.
  • The formula for percentage of earnings retained is: (Net Income - All Dividends) / Net Income.

4/ Dividend Payout (DP)

  • DP measures the fraction of current earnings per common share distributed as dividends.
  • Lower payout ratios are often found in growth companies.
  • DP helps investors understand a company's dividend policy. The dividend payout ratio is determined by dividing dividends per common share by diluted or basic earnings per share

Example of Ratio 3

  • Example presented for Nike, Inc., showing the percentage of earnings retained for 2007 and 2006

5/ Dividend Yield (DY)

  • DY shows the relationship between dividends per common share and market price per common share.
  • Yield depends on the company's dividend policy and market prices.
  • A low dividend yield does not necessarily indicate a negative return if return on common equity is higher than average and the investors prioritize long term growth over immediate dividends

Dividend Yield (DY) Formula

Dividend Yield = Dividends per Common Share / Market Price per Common Share

6/ Book Value per Share

  • Book value per share represents the value of shares on the balance sheet.
  • Preferred equity should be valued based on liquidation value, if applicable. Alternatively market value can be used.
  • Book value reflects the value of assets on the firm's balance sheet.
  • Market value reflects the firm's potential. High market values indicate optimistic investors.
  • Book value per share is calculated as (Total Shareholders' Equity - Preferred Stock Equity) / Number of Common Shares Outstanding.

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Financial Reporting & Analysis Lecture 7

Description

This quiz covers Chapter 7 of 'Financial Reporting & Analysis' by Charles H. Gibson. Focused on information relevant to investors, it explores the differences between common and preferred stock, earnings per share, and key financial ratios. Test your understanding of essential financial concepts that guide investment decisions.

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