CHAPTER 4 and 5: Financial Statement Analysis

ESSAY Questions
1. Publicly traded firms must prepare audited financial statements according to generally
accepted accounting principles (GAAP). How do comparability problems arise?
Difficulty: Easy

Answer:
Many accounts may be valued by more than one generally accepted accounting
principle. As a result, firms often select the GAAP that presents the firm in the most
attractive position. Thus, the analyst trying to compare firms using different GAAPs
must be aware of these differences and make his or her own adjustments of the
financial statements in order to determine which firm is the more attractive investment
alternative. Generally accepted accounting principles for inventory valuation and
depreciation are two of the more common areas where comparability problems may
arise.
This question is designed to ascertain whether or not the student understands whether
the analyst merely takes financial statements at "face value" or whether the analyst
must perform considerable additional work with the financial statements in order to
value the firms.

2. In an increasingly globalized investment environment, comparability problems

become even greater. Discuss some of the problems for the investor who wishes to
have an internationally diversified portfolio.
Difficulty: Easy
Answer:
Firms in other countries are not required to prepare financial statement according to U.
S. generally accepted accounting principles. Accounting practices in other countries
vary from those of the U. S. In some countries, accounting standards may be very lax
or virtually nonexistent. Some of the major differences are: reserve practices, many
countries allow more discretion in setting aside reserves for future contingencies than
is typical in the U. S.; depreciation practices, in the U. S., firms often use accelerated
depreciation for tax purposes, and straight line depreciation for accounting purposes,
while most other countries do not allow such dual accounts, and finally, the treatment
of intangibles varies considerably across countries.

Finally, the problem of obtaining financial information may be considerable for some
international investments, varying currency exchange rates present additional
complications, translation of statements into English is another complication; potential
government expropriation of assets and political unrest may be problems in some
countries. In general, for the individual investor, investing in global or international
mutual funds is a less risky way to add diversification to the portfolio than is
attempting to value individual international securities.
This question is designed to insure that the student understands the comparability
problems and additional risks of international investing.

3. Many different debt, or financial leverage, ratios are reported. Explain the relationship
between total assets/equity and debt/equity.
Difficulty: Easy
Answer:
Total assets/equity is the ratio used in computing the ROE in the "duPont breakout
formula". Assets may be purchased with either debt or equity or some combination
thereof. Thus, the sum of debt and equity financing equals total assets. If one is given
the debt/equity ratio and needs the total assets/equity ratio (for example, for the above
cited calculation), one merely adds the amounts of debt and equity in the capital
structure in order to obtain the amount of total assets. For example:
Debt = $50,000;
Equity = $50,000;
Debt/equity = 1;
$50,000 + $50,000 = $100,000 (total assets);
Total assets/Equity = $100,000/$50,000 = 2; or 1 + 1 = 2.
This question is designed to see if the student understands the relationship between
basic balance sheet financial ratios.
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4. Discuss the differences between economic earnings and accounting earnings. Which
is preferred in financial analysis? Which is most widely used, and why?
Difficulty: Easy

Answer:
Economic earnings consist of the sustainable cash flow that can be paid out to
stockholders without impairing the productive capacity of the firm. The focus is on
the present value of expected cash flows. Accounting earnings are based on accrual
methods and can be manipulated to a certain extent. They are subject to the firm's
decisions about its accounting methods such as inventory valuation and amortization
of capital expenditures. Net Income will be different in each case. Financial analysis
is based on economic earnings, which are often difficult to measure, whereas
accounting earnings are widely available. Annual and quarterly reports contain a
firm's financial statements. They do provide important information about the health
and prospects of the firm. Accounting earnings are therefore most frequently used for
analysis.
This question tests whether the student understands the differences between the two
types of earnings, why they differ, and how the difference influences the choice of
earnings used in financial analysis.

5. The duPont system decomposes ROE into the following components:

6.

7.

8.
9.

10.

11. Horizontal and vertical analyses are analytical tools frequently used to analyze financial statements.
What type of information or insights can be obtained by using these two techniques? Explain how the
output of horizontal analysis and vertical analysis can be compared to industry averages and/or
competitive companies.

Solution
Horizontal analysis allows an analyst to develop a picture of current trends in a company's operations.
The analyst can see whether the accounts are increasing or decreasing and how large these changes
actually are. Vertical analysis allows an analyst to evaluate financial statement items within a single
financial statement. This technique helps the analyst to evaluate the relative size of the financial
statement items and how the items relate to the financial statement as a whole. An example would be if
current liabilities were a very large percentage of total liabilities and stockholders' equity.

Both techniques allow the company to evaluate their performance and position relative to their
competitors and their industry as a whole. For example, the company could evaluate its current trend in
sales and see how favorably its sales performance compared to the sales performance of other
companies in the industry. Another example would be comparing the relative size of long-term liabilities
or retained earnings. This would show which companies have taken on a large amount of debt and
which companies have invested in themselves.

12. Manuel Mentirosa, the CEO of Mystical Products, is a successful entrepreneur but a poor
student of accounting. He asks you to explain to him, in a memo, the bases of comparison for
ratio analysis.

Solution

To: Manuel Mentirosa

From: Student name
Re: Bases of Comparison for Ratio Analysis

There are three bases of comparison for ratio analysis. They include:
Intracompany: This basis compares a ratio for the current year to the same ratio
for one or more prior years.
Intercompany: This basis compares a ratio for one company with the same ratio
for one or more competing companies.
Industry averages: This basis compares a ratio for a company with the industry
average for the same ratio.
(Signed)

13. (Ethics)
A trusted employee of Wilderness Tours was caught in the act of embezzling funds. He confessed to
earlier embezzlements, but retracted the confession on the advice of his attorney. Over the course of
the most recent quarter, it has been determined that $20,000 was embezzled.

Wilderness Tours has suffered adverse publicity in the recent past because of serious injury to
five tourists that occurred during a two week "Winter Wilds Adventure" tour. The company has
therefore decided to avoid publicity and has agreed to drop all charges against the embezzling
employee. In return, the employee has agreed to a notation of "Terminated—Not to be Rehired"
to be appended to his personnel file.
Required:

1. Who are the stakeholders in the decision not to prosecute?

2. Was it ethical for the company to decide not to prosecute? Explain.

Solution
1. The stakeholders include

 The embezzling employee

 The other employees
 Company management
 Other companies who might hire the embezzling employee

2. The company was certainly within its legal rights not to prosecute the embezzling employee.
However, the decision not to prosecute may not be ethical. First, it does not serve public justice. The
embezzling employee could find a job elsewhere, and harm someone else financially. Second, to the
extent that other employees know of the act and of the decision, morale may be harmed. The
decision is also not the best one for the employee. Having never been forced to face the
consequences of his dishonest acts, he is not deterred from (and may even feel encouraged to)
commit similar acts in the future. The one argument that would support the premise that the
decision was ethical is that the public disclosure would cause harm greater than that caused by
keeping silent. Even this argument lacks force, because it implies a lack of moral courageousness.

14. (Communication)
Kwik Express specializes in the overnight transportation of medical equipment and laboratory
specimens. The company has selected the following information from its most recent annual
report to be the subject of an immediate press release.
 The financial statements are being released.
 Net income this year was $2.2 million. Last year's net income had been $2.0 million.
 The current ratio has changed to 2:1 from last year's 1.5:1
 The debt/total assets ratio has changed to 4:5 from last year's 3:5
 The company expanded its truck fleet substantially by purchasing ten new delivery vans. The
company already had twelve delivery vans.
 The company is now the largest medical courier in the mid-Atlantic region.
Required:

Prepare a brief press release incorporating the information above. Include all information. Think
carefully which information (if any) is good news for the company, and which (if any) is bad news.

Solution
Press Release

Kwik Express released its financial statements today, disclosing a 10% increase in earnings,
to $2.2 million from $2 million last year. The company also improved its short-term liquidity.
Its current ratio improved to 2:1 from last year's 1.5:1. Part of the improved performance is
no doubt due to the addition of ten new delivery vans to its fleet, allowing it to become the
largest medical courier in the mid-Atlantic region. The purchase of the vans, however,
caused the debt/total asset ratio to decline. There are now $4 of debt for every $5 in assets,
while last year, there were only $3 of debt to $5 in assets.