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Chap019 - Chapter 19 Financial Statement Analysis CHAPTER...

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Chapter 19 - Financial Statement Analysis CHAPTER 19: FINANCIAL STATEMENT ANALYSIS PROBLEM SETS 1. The major difference in approach of international financial reporting standards and U.S. GAAP accounting stems from the difference between ‘principles’ and ‘rules.’ U.S. GAAP accounting is rules-based, with extensive detailed rules to be followed in the preparation of financial statements; many international standards, including those followed in European Union countries, allow much greater flexibility, as long as conformity with general principles is demonstrated. Even though U.S. GAAP is generally more detailed and specific, issues of comparability still arise among U.S. companies. Comparability problems are still greater among companies in foreign countries. 2. Earnings management should not matter in a truly efficient market, where all publicly available information is reflected in the price of a share of stock. Investors can see through attempts to manage earnings so that they can determine a company’s true profitability and, hence, the intrinsic value of a share of stock. However, if firms do engage in earnings management, then the clear implication is that managers do not view financial markets as efficient. 3. Both credit rating agencies and stock market analysts are likely to be more or less interested in all of the ratios discussed in this chapter (as well as many other ratios and forms of analysis). Since the Moody’s and Standard and Poor’s ratings assess bond default risk, these agencies are most interested in leverage ratios. A stock market analyst would be most interested in profitability and market price ratios. 4. ROA = ROS × ATO The only way that Crusty Pie can have an ROS higher than the industry average and an ROA equal to the industry average is for its ATO to be lower than the industry average. 5. ABC’s Asset turnover must be above the industry average. 19-1
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Chapter 19 - Financial Statement Analysis 6. ROE = (1 – Tax rate) × [ROA + (ROA – Interest rate)Debt/Equity] ROE A > ROE B Firms A and B have the same ROA. Assuming the same tax rate and assuming that ROA > interest rate, then Firm A must have either a lower interest rate or a higher debt ratio. CFA PROBLEMS 1. ROE = Net profits/Equity = Net profits/Sales × Sales/Assets × Assets/Equity = Net profit margin × Asset turnover × Leverage ratio = 5.5% × 2.0 × 2.2 = 24.2% 2. SmileWhite has higher quality of earnings for the following reasons: SmileWhite amortizes its goodwill over a shorter period than does QuickBrush. SmileWhite therefore presents more conservative earnings because it has greater goodwill amortization expense. SmileWhite depreciates its property, plant and equipment using an accelerated depreciation method. This results in recognition of depreciation expense sooner and also implies that its income is more conservatively stated.
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