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Summarizing Chapter 2

o Describe the purpose of each of the four major financial

statements.

The purposes of each of the 4 major financial statements are:

Income Statement—the purpose of the income statement is to provide a financial summary of
the firm’s operating results during a specified time period. It includes both the sales for the firm
and the costs incurred in generating those sales. Other expenses, such as taxes, are also
included on this statement.
Balance Sheet—the purpose of the balance sheet is to present a summary of the assets owned
by the firm, the liabilities owed by the firm, and the net financial position of the owners as of a
given point in time. The assets are often referred to as investments and the liabilities and owners
equity as financing.
Statement of Retained Earnings—this statement reconciles the net income earned during the
year, and any cash dividends paid, with the change in retained earnings during the year.
Statement of Cash Flows—this statement provides a summary of the cash inflows and the cash
outflows experienced by the firm during the period of concern. The inflows and outflows are
grouped into the cash flow areas of operations, investment, and financing.

o Why are the notes to the financial statements important to

professional securities analysts?
The notes to the financial statements are important because they provide detailed
information not directly available in the financial statements. The footnotes provide information on
accounting policies, procedures, calculation, and transactions underlying entries in the financial
statements.

o How is the current rate (translation) method used to

consolidate a firm’s foreign and domestic financial statements?
Financial Accounting Standards Board Statement No. 52 describes the rules for consolidating a
company’s foreign and domestic financial statements. It requires U.S.-based companies to
translate foreign-currency-denominated assets and liabilities into U.S. dollars using the current
rate (translation) method. This method uses the exchange rate prevailing on the date the fiscal
year ends (the current rate). Income statement items can be translated using either the current
rate or an average exchange rate for the period covered by the statement. Equity accounts are
converted at the exchange rate on the date of the investment. In the retained earnings account
any gains and losses from currency fluctuations are stated separately in an equity reserve
accountthe cumulative translation adjustment accountand not realized until the parent
company sells or closes the foreign operations.

o With regard to financial ratio analysis, how do the viewpoints held

by the firm’s present and prospective shareholders, creditors,
and management differ?
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Current and prospective shareholders place primary emphasis on the firm’s current and
future level of risk and return as measures of profitability, while creditors are more concerned
with short-term liquidity measures of debt. Stockholders are, therefore, most interested in income
statement measures, and creditors are most concerned with balance sheet measures.
Management is concerned with all ratio measures, since they recognize that stockholders and
creditors must see good ratios in order to keep the stock price up and raise new funds.

o What is the difference between cross-sectional and time-series

ratio analysis? What is benchmarking?
Cross-sectional comparisons are made by comparing similar ratios for firms within the same
industry, or to an industry average, as of some point in time. Time-series comparisons are made
by comparing similar ratios for a firm measured at various points in time. Benchmarking is the
term used to describe this cross-sectional comparison with competitor firms.

o What types of deviations from the norm should the analyst pay
primary attention to when performing cross-sectional ratio
analysis? Why?
The analyst should devote primary attention to any significant deviations from the norm,
whether above or below. Positive deviations from the norm are not necessarily favorable. An
above-normal inventory turnover ratio may indicate highly efficient inventory management but
may also reveal excessively low inventory levels resulting in stock outs. Further examination into
the deviation would be required.

o Why it is preferable to compare ratios calculated using financial

statements that are dated at the same point in time during the
year?
Comparing financial statements from different points in the year can result in inaccurate
and misleading analysis due to the effects of seasonality. Levels of current assets can fluctuate
significantly, depending on a company’s business, so statements from the same month or year
end should be used in the analysis to ensure valid comparisons of performance.
o Under what circumstances would the current ratio be the preferred
measure of overall firm liquidity? Under what circumstances
would the quick ratio be preferred?
The current ratio proves to be the better liquidity measure when all of the firm’s current
assets are reasonably liquid. The quick ratio would prove to be the superior measure if the
inventory of the firm is considered to lack the ability to be easily converted into cash.
o To assess the firm’s average collection period and average
payment period ratios, what additional information is needed, and
why?
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Additional information is necessary to assess how well a firm collects receivables and
meets payables. The average collection period of receivables should be compared to a firm’s
own credit terms. The average payment period should be compared to the creditors’ credit
terms.

o What is financial leverage?

Financial leverage is the term used to describe the magnification of risk and return
introduced through the use of fixed-cost financing, such as debt and preferred stock.
o What ratio measures the firm’s degree of indebtedness? What
ratios assess the firm’s ability to service debts?
The debt ratio and the debt-equity ratio may be used to measure the firm’s degree of
indebtedness. The times-interest-earned and the fixed-payment coverage ratios can be used to
assess the firm’s ability to meet fixed payments associated with debt.
o What three ratios of profitability are found on a common-size
income statement?
Three ratios of profitability found on a common-size income statement are: (1) the
gross profit margin, (2) the operating profit margin, and (3) the net profit margin.

o What would explain a firm’s having a high gross profit margin

and a low net profit margin?
Firms that have high gross profit margins and low net profit margins have high levels of
expenses other than cost of goods sold. In this case, the high expenses more than compensate
for the low cost of goods sold (i.e., high gross profit margin) thereby resulting in a low net profit
margin.

o Which measure of profitability is probably of greatest interest to

the investing public? Why?
The owners are probably most interested in the Return on Equity (ROE) since it indicates
the rate of return they earn on their investment in the firm. ROE is calculated by taking earnings
available to common shareholder and dividing by stockholders’ equity.

o How do the price/earnings (P/E) ratio and the market/book (M/B)

ratio provide a feel for the firm’s risk and return?
The price-earnings ratio (P/E) is the market price per share of common stock divided by
the earnings per share. It indicates the amount the investor is willing to pay for each dollar of
earnings. It is used to assess the owner’s appraisal of the value of the firm’s earnings. The level
of the P/E ratio indicates the degree of confidence that investors have in the firm’s future. The
market/book (M/B) ratio is the market price per of common stock divided by the firm’s book value
per share. Firms with high M/B ratios are expected to perform better than firms with lower
relative M/B values.

o Financial ratio analysis is often divided into five areas: liquidity,

activity debt, profitability, and market ratios. Differentiate each
of these areas of analysis from the others. Which is of the
greatest concern to creditors?
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Liquidity ratios measure how well the firm can meet its current (short-term) obligations when
they come due.
Activity ratios are used to measure the speed with which various accounts are converted (or
could be converted) into cash or sales.
Debt ratios measure how much of the firm is financed with other people’s money and the firm’s
ability to meet fixed charges.
Profitability ratios measure a firm’s return with respect to sales, assets, or equity (overall
performance).
Market ratios give insight into how well investor in the marketplace feel the firm is doing in terms
of return and risk.
The liquidity and debt ratios are most important to present any prospective creditors.

o Describe how you would use a large number of ratios to perform

a complete ratio analysis of the firm.
The analyst may approach a complete ratio analysis on either a cross-sectional or time-
series basis by summarizing the ratios into their five key areas: liquidity, activity, debt,
profitability, and market. Each of the key areas could then be summarized, highlighting specific
ratios that should be investigated.

o What three areas of analysis are combined in the modified

DuPont formula? Explain how the DuPont system of analysis is
used to dissect the firm’s results and isolate their causes.
The DuPont system of analysis combines profitability (the net profit margin), asset
efficiency (the total asset turnover) and leverage (the debt ratio). The division of ROE among
these three ratios allows the analyst to the segregate the specific factors that are contributing to
the ROE into profitability, asset efficiency, or the use of debt.
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Financial Statements
1) Income Statement
Provides F. summary of the firm’s Operating results during a specified period.
Sales
Less: COGS
Gross Profit
Less: operating expenses:
- Administrative exp
- Stationary exp
- Depreciation exp
Operating Profit (EBIT)
Less: interest expense
Earning before tax
Less: Tax rate
Net Profit
Less: dividends to preferred stockholders
Earning available to common stock holders

2) Balance sheet
Summary statement of the firm’s F. position @ given point in time.

3) Statement of Owner's Equity

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Shows all equity account transactions that occurred during a given year
This statement shows the changes in each type of stockholders’ equity account and the total
stockholders’ equity during the accounting period. This statement usually includes:

• Preferred stock
• Common stock
• Issue of par value stock
• Additional paid-in capital
• Treasury stock repurchase
• Retained earning

4) Statement of Cash Flow

Provides a summary of the firm’s operating, investment& financing cash flows & reconciles them
.with changes in its cash& MS during the period

Statement of Retained earnings:

An abbreviated form of the statement of OE, reconciles the net income
earned during a given year & any cash dividend paid with the change in RE bet the start & the
:end of that year. This statement includes the following items
Beg RE
Add: NI
:Less: Dividend to
Common stockholder
Preferred stockholder
End RE
______________________________________________________________________
________

• Financial statements are prepared by accrual basis except statement of cash flow prepared by
cash basis.
• Accrual basis: Revenues are recognized at the time of sale & expenses recognized when
incurred.
• Cash basis: Revenues are recognized when cash is received, expenses recognized when
cash is paid.
• Ratio analysis

Time series( 2
Involves comparison of
Cross sectional( 1
current to past
Involves comparing the
.performance
firm’s ratios to those of
Evaluation of the firm’s F.)
other firms in its industry
performance over time
.or to industry averages
using financial ratio
.analysis
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• Categories of financial ratios
Types of Ratios Its implication
1)Liquidity Ratios:  It measures the firm’s ability to satisfy its short
term obligations as they come due.
i. Current ratio: current assets  In general, the greater the coverage of liquid
Current liabilities assets to short-term liabilities the better as it
ii. Quick ratio: current assets- inventory is a clear signal that a company can pay its
Current liabilities debts that are coming due in the near future
and still fund its ongoing operations. On the
other hand, a company with a low coverage
rate should raise a red flag for investors as it
may be a sign that the company will have
difficulty meeting running its operations, as
Well as meeting its obligations.
 Quick ratio: Also known as the "acid test," this
ratio specifies whether your current
assets that could be quickly converted
into cash are sufficient to cover current
liabilities. Until recently, a Current Ratio
of 2:1 was considered standard. A firm
that had additional sufficient quick
assets available to creditors was
believed to be in sound financial
condition.
 We exclude inventory which is the least liquid
current asset bec:-it can’t sold easily, if
sold they might be on credit & then
converted to cash.
 the higher the ratio, the more liquidity of the
firm
oProfitability ratios shed light upon the overall
2)Profitability Ratios: effectiveness of management regarding the returns
i. Gross profit margin: _gross profit_ % generated on sales and investment.
Sales o These ratios, much like the operational
ii. Operating profit margin: __op.profit (EBIT) performance ratios, give users a good
_% understanding of how well the company utilized its
Sales resources in generating profit and shareholder
iii. Net profit margin: __net profit_ % value.
Sales oThe objective of margin analysis is to detect
iv. Earning per share (EPS): _earning consistency or positive/negative trends in a
available(NP) company's earnings. Positive profit margin analysis
No. of shares translates into positive Investment quality. To a
outstanding large degree, it is the quality, and growth, of a
v. Dividend per share (DPS):dividend paid company's earnings that drive its stock price.
No. of shares oEPS, DPS: represent the no of dollars earned on
outstanding behalf of each share.
vi. (ROA) (ROI): _ earning available (NP) oROA: measure the effectiveness of mgt in
% generating profits with its available assets.
Total assets o ROE: measure the return earned on the common
vii. (ROE): __ earning available (NP) % stockholder's investment in the firm.
Common stock equity o The HIGHER THE RATIOS ……THE HIGHER
PROFITABILITY ACHIEVED BY THE FIRM
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o These ratios look at how well a company turns
3)Activity Ratios: its assets into revenue as well as
i. inventory turnover: _COGS How efficiently a company converts its sales into
Inventory cash.
o Basically, these ratios look at how efficiently and
effectively a company is using its resources to
average age of inventory= ___365_____ generate sales and increase shareholder value.
inventory turnover
oIn general, the better these ratios are, the
better it is for shareholders.
ii. T.asset turnover: Sales
T.A oT.asset turnover: This ratio is a rough
measure of the productivity of a company's
fixed assets with respect to generating sales.
omost companies, their investment in fixed
assets represents the single largest
Component of their total assets.

oThis annual turnover ratio is designed to

reflect a company's efficiency in managing
these significant assets.

oInventory turnover: High inventory ratio is an

indicator that the company sells its inventory
rapidly and that the inventory does not languish,
which may mean there is less risk that the
inventory reported has decreased in value.
oToo high a ratio could indicate a level of
inventory that is too low, perhaps resulting in
frequent shortages of stock and the potential of
losing customers.
oIt could also indicate inadequate production
levels for meeting customer demand.
o Multiply your inventory turnover by your gross
margin percentage. If the result is 100 percent
or greater, your average inventory is not too
high.

o The higher the yearly turnover rate, the

better.
iii. Average collection period: _A/R________ oThese ratios provide an indicator of the
average sales/day effectiveness of a company's credit policy.

oThe Average Collection Period (ACP) is

iv. Average payment period: another litmus test for the quality of your
__A/P____________ receivables business, giving you the average
Average length of the collection period.
purchase/day Compared with credit collection policy
(The lower ... the better)

Average sales = annual sales/365 oThe average payment period (APP) this
Annual purchase= is % of COGS ratio is very useful in credit checks of firms
applying for credit.
o This ratio will indicate how much credit the
company uses from its suppliers.
Compared with credit payment policy
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(The higher ... the better)

o These ratios give users a general

4)Debt Ratios: idea of the company's overall debt load as well as
i. Debt ratio: __T.liabilities__ ℅ its mix of equity and debt.
T.asset
oDebt ratios can be used to determine the overall
level of financial risk a company and its
shareholders face.

oIn general, the greater the amount of debt

Held by a company the greater the financial risk of
bankruptcy.

oThe debt ratio is used to gain a general idea

as to the amount of leverage being used by a
company. Allow percentage means that the
company is less dependent on leverage.

oThe lower the percentage, the less leverage a

company is using and the stronger its equity
position.

o In general, the higher the ratio, the more risk

that company is considered to have taken on.

o Measure % of debts used for generating

profit.

oThe higher the ratio the higher dependence of

the firm on other people’s money to generate
profit.

ii. Time int. earned ratio: EBIT o Interest coverage ratio is used to
Int. determine how easily a company can pay
interest expenses on outstanding debt.
o The lower the ratio, the more the company
is
Burdened by debt expense.
o Creditors have a high comfort level with
companies that can easily service debt
interest payments.
5)Market Ratios: oMarket Ratios Relate a firm’s Mkt Value, as
i. Price per earning (P/E) ratio: Mkt price measured by its current share price to certain
per share of CS accounting values.
EPS
ii. Mkt / book (M/B) ratio: _Mkt price per o(M/B) assess of how investors view the firm’s
share of CS performance.
BV per share of CS (The high M/B, the better performance of the
BV per share=__CS equity_____________ co.)
No. of shares of CS outstanding
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o(P/E) measure the amount the investor willing
to pay for each$ the firm earn.
(The higher P/E the greater investor
confidence).

With My best wishes

Hend Ibrahim