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CHAPTER 16 FINANCIAL STATEMENT ANALYSIS DISCUSSION QUESTIONS 1. The two major types of financial statement analysis discussed in this chapter are common-size analysis and ratio analysis. 2. Horizontal analysis expresses line items of financial statements as a percentage of a prior-period amount. Vertical analysis ex- presses the line item as a percentage of some other line item for the same time peri- od. Both should be done as each provides different insights into the financial strength of a company. 3. Horizontal analysis reveals trends—both fa- vorable and unfavorable. Vertical analysis reveals the current strengths and weak- nesses of key financial factors. In both cases, the information provided is useful for decision making. For example, vertical ana- lysis helps managers determine the relation- ship of costs to sales. Horizontal analysis can show the upward or downward trend in sales and costs over time. 4. Liquidity ratios measure the ability of a firm to meet its short-term obligations. Leverage ratios measure the ability of a firm to meet both long- and short-term obligations. Profit- ability ratios measure the earning ability of a firm. 5. Two types of standards used in ratio analys- is are historical and industrial standards. Historical standards allow one to assess trends over time. Industrial standards allow one to assess a company’s performance rel- ative to that of other firms. 6. The current ratio includes all current assets, from very liquid cash to less liquid inventor- ies. The quick ratio excludes inventories and thus provides a better measure of liquidity (inventories are sometimes obsolete or may turn over slowly). 7. It may indicate a need to modify credit and collection policies to speed up the conver- sion of receivables to cash. 8. A high inventory turnover ratio does not ne- cessarily provide evidence of stockouts and disgruntled customers. In a JIT environment, a high turnover ratio is desired and viewed as a positive signal of success. As long as the company is able to produce quickly to fill customer orders, a high inventory turnover ratio may be a good sign of success. 9. The debt ratio is computed as total liabilities divided by total assets. By restricting the debt ratio, the bank is trying to reduce the risk of default by ensuring that assets re- main relatively high compared with liabilities. 10. The purchase alternative would increase the liabilities reported on the balance sheet. In- creasing liabilities may cause the company to violate some existing debt covenants. The lease payment, however, had immediate im- pact on the income statement rather than the balance sheet. 11. The debt ratio may provide a measure of the riskiness of the investment. The higher the ratio, the more likely the company will go bankrupt, causing the investors to lose much of their investment. 12.
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This note was uploaded on 06/03/2008 for the course MA 022 taught by Professor Keating during the Fall '07 term at BC.

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