302Chapter 21 notes

302Chapter 21 notes - 1 1 LEARNING OBJECTIVES CHAPTER 21...

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1 1 C HAPTER 21 Analysis of Financial Statements L EARNING O BJECTIVES 1. Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework. The informativeness of financial ratios is greatly enhanced when they are compared with past values and with values for other firms in the same industry. Common-size financial statements are computed by dividing all financial statement amounts for a given year by sales for that year. < This reveals the number of pennies of each expense for each dollar of sales. < The asset section of a common-size balance sheet tells how many pennies of each asset are needed to generate each dollar of sales. The DuPont framework decomposes return on equity (ROE) into three areas: < Profitability. Return on sales is computed as (net income sales) and is interpreted as the number of pennies in profit generated from each dollar of sales. < Efficiency. Asset turnover is computed as (sales assets) and is interpreted as the number of dollars in sales generated by each dollar of assets. < Leverage. Assets-to-equity ratio is computed as (assets equity) and is interpreted as the number of dollars of assets a company is able to acquire using each dollar invested by stockholders. The common-size income statement is the best tool for detecting which expenses are responsible for a company’s profitability problem. Financial ratios for detailed analysis of a company’s efficiency and leverage have been developed (refer to Exhibit 21-7). Margin is the profitability of each dollar in sales and turnover is the degree to which assets are used to generate sales. Companies with a low margin can still earn an acceptable level of return on assets if they have a high turnover. 2. Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies.
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2 Ratio comparisons can yield misleading implications if the ratios come from companies with differing accounting practices. Adjustments for accounting differences should be made before financial ratios are compared. 3. Understand how foreign companies report their financial reports to U.S. investors. Divergent rational accounting practices around the world have extremely significant impact on financial statements. Some companies voluntarily: < Translate financial statements into another language. < Denominate financial statement amounts to another currency. < Partially or fully restate financial statements to a set of accounting principles in another country. Foreign companies with shares traded in the United States must complete Form 20F which reconciles net income and stockholders’ equity under a foreign GAAP to what would have been reported under U.S. GAAP. 4. Adjust reported financial statement numbers for the impact of inflation and
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302Chapter 21 notes - 1 1 LEARNING OBJECTIVES CHAPTER 21...

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