Chapter 4

1. Discuss why information related with the cash flow of the company are very important for
some group of users.
a) Accounting personnel- Want to know whether the organization will be able to cover
payroll and other immediate expenses
b) Potential lenders or creditors - want a clear picture of a company's ability to repay
c) Potential investors - Need to judge whether the company is financially sound good or
not
d) Potential employees or contractors -Need to know whether the company will be able to
afford compensation or not.
e) Shareholders of the business.
Benefit
- Provide information on a firm's liquidity and solvency and its ability to change cash flow
in future circumstances.
- Provide additional information for evaluating changes in assets, liabilities and equity.
- Improve the comparability of different firms' operating performance by eliminating the
effects of different accounting method.
- Indicate the amount, timing and probability of future cash flows.

2. Describes the four difference basic types of financial statement analysis available.
Common-size analysis is the restatement
of financial statement information in a
standardized form.
Horizontal common-size analysis
uses the amounts in accounts in a
specified year as the base, and
subsequent years amounts are stated as
a percentage of the base value.
Useful when comparing growth of
different accounts over time.
Vertical common-size analysis uses
the aggregate value in a financial
statement for a given year as the base,
and each accounts amount is restated as
a percentage of the aggregate.
Balance sheet: Aggregate amount is
total assets.
Income statement: Aggregate amount
is revenues or sales.

Financial ratio analysis is the use of

relationships among financial statement
accounts to gauge the financial condition
and performance of a company.
Ratios are classified based on the
type of information the ratio
provides:
Activity Ratios
Effectiveness in putting its asset
investment to use.
Liquidity Ratios
Ability to meet short-term,
immediate obligations.
Solvency Ratios
Ability to satisfy debt obligations.
Profitability ratios
Ability to manage expenses to
produce profits from sales.

Year to year change Analysis

Use both absolute and percentages
Guidelines
When an item has value in the
base year and none in the next
period, the decrease is 100%
A meaningful percent change
cannot be computed when one
number is positive and the other
number is negative
No percent change is computable
when there is no figure for the
base year

Industry Variations
Financial components vary by type of
industry
Merchandising
Inventory is a principal asset
Sales may be primarily for
cash or on credit
Service
Inventory is low or
nonexistent
Manufacturing
Large inventory holdings
Substantial investment in
plant assets
Cost of sales often represents
the major expense

3. Explain how financial ratio analysis will enable the users to make a good decision
1. Analyzing Financial Statements
Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the
financial position of the company. Different users such as investors,management. bankers and creditors use the ratio to
analyze the financial situation of the company for their decision making purpose.
2. Judging Efficiency
Accounting ratios are important for judging the company's efficiency in terms of its operations and management. They help
judge how well the company has been able to utilize its assets and earn profits.
3. Locating Weakness

Accounting ratios can also be used in locating weakness of the company's operations even though its overall performance
may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.
4. Formulating Plans
Although accounting ratios are used to analyze the company's past financial performance, they can also be used to
establish future trends of its financial performance. As a result, they help formulate the company's future plans.
5. Comparing Performance- It is essential for a company to know how well it is performing over the years and as
compared to the other firms of the similar nature. Besides, it is also important to know how well its different divisions are
performing among themselves in different years. Ratio analysis facilitates such comparison.

Chapter 5
1. Among the profitability measures are the return on assets, return on sales, return on
investment and return on equity. How does this measures differ?
Return on sales (ROS) is net profit as a percentage of sales revenue.ROS is an indicator of
profitability and is often used to compare the profitability of companies and industries of differing sizes.
Return on assets (ROA) is a financial ratio that shows the percentage of profit a company earns in
relation to its overall resources. It is commonly defined as net income divided by total assets. Net
income is derived from the income statement of the company and is the profit after taxes.
Return on investment (ROI) is the benefit to the investor resulting from an investment of some resource. A
high ROI means the investment gains compare favorably to investment cost.

Return on equity (ROE) is a measure of profitability that calculates how many dollars of profit a
company generates with each dollar of shareholders' equity. The formula for ROE is: ROE = Net
Income/Shareholders' Equity. ROE is sometimes called "return on net worth."
2. What is meant by profitability trends and how can profitability trends give information to
the analyst?
Profitability Trend
A profitability trend is the evolution of profit within a business. An upward trend means that profit has
generally increased over time in the short or long run. A downward profitability trend means profits are
declining.
How?
- Firm performance is evaluated using trend analysis

- calculating ratios on a per-period basis, and tracking their values over time.
-This analysis can be used to spot trends that may be cause for concern, such as an increasing average
collection period for outstanding receivables or a decline in the firm's liquidity status.

- In this role, ratios serve as red flags for troublesome issues, or as benchmarks for performance
measurement.

Example If a company's gross profit margin falls steadily over time, the manager should step in to address declining revenue
or rising costs. An upward gross profit margin trend is a good sign of company financial health. If operating and net profit
trends decline, the manager may also have to review fixed and unusual costs.

Besides, It is more alarming if your downward trend goes against industry norms. If the industry has shown a 3 percent
increase in gross profit margin over two years, but your gross profit margin has declined, your business is going against the
trend. Ideally, your company's profitability trends are equal to or better than the industry. If the whole industry is experience
an economic downturn, a more modest decline in profitability for your business is reasonable.

3. Explain the meaning of interim report. What is the weakness of an interim report?
Interim report
-

Additional sources of information on profitability

Reports that cover fiscal periods of less than one year

Using the same reporting principles with those used in annual reports

Interim reports are unaudited, thus are less reliable than annual reports.

Contain more estimates such as tax expense.

Interim statements can help the analyst to determine trends and identify trouble areas
before the year-end report is available.

Weakness?