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ANALYSIS OF FINANCIAL STATEMENTS Answers to Questions 1. The kind of decisions that require the analysis of financial statements include whether to lend money to a firm, whether to invest in the preferred or the common stock of a firm, and whether to acquire a firm. To properly make such decisions, it is necessary to understand what financial statements are available, what information is included in the different types of statements, and how to analyze this financial information to arrive at a rational decision. 2. Analysts employ financial ratios simply because numbers in isolation are typically of little value. For example, a net income of $100,000 has little meaning unless analysts know the sales figure that generated the income and the assets or capital employed in generating these sales or this income. Therefore, ratios are used to provide meaningful relationships between individual values in the financial statements. Ratios also allow analysts to compare firms of different sizes. 3. A major problem with comparing a firm to its industry is that you may not feel comfortable with the measure of central tendency for the industry. Specifically, you may feel that the average value is not a very useful measure because of the wide dispersion of values for the individual firms within the industry. Alternatively, you might feel that the firm being analyzed is not “typical,” that it has a strong “unique” component. In either case, it might be preferable to compare the firm to one or several other individual firms within the industry that are considered comparable to the firm being analyzed in terms of size or clientele. For example, within the computer industry it might be optimal to compare IBM to Burroughs and/or Control Data rather than to some total industry data that might include numerous small firms. 4. In general, jewelry stores have very high profit margins but low asset turnover. It could take them months to sell a 1-carat diamond ring, but once it is sold, the profit could be tremendous. On the other hand, grocery stores usually have very low profit margins but very high asset turnover. Assuming both business risk and financial risk of the firms are equal, the ROE’s should likewise be equal. 5. Business risk is measured by the relative variability (i.e., the coefficient of variation) of operating earnings for a firm over time. In turn, the variability of operating earnings is a function of sales volatility and the amount of operating leverage (i.e., fixed costs of production) employed by the firm. Sales variability is the prime determinant of earnings volatility. In addition, the greater the firm’s operating leverage, the more variable the operating earnings series will be relative to the sales variability. 10 - 1
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This note was uploaded on 05/20/2010 for the course FIN 5DLS taught by Professor Leejohn during the One '10 term at La Trobe University.

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