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HW2_Answers - Q2-2 Distinguish among the types of financial...

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Q2-2. Distinguish among the types of financial information contained in the various financial statements. Which statements provide information on a company’s performance over a reporting period, and which present data on a company’s current position? What sorts of valuable information may be found in the notes to financial statements? Describe a situation in which the information contained in the notes would be essential to making an informed decision about the value of a corporation. A2-2. Data on a company’s performance over a reporting period: income statement, statement of cash flows, statement of retained earnings (how much additional retained earnings will be added to existing retained earnings) Data on a company’s performance about the company’s current position: balance sheet Notes to the financial statements contain details about the composition and cost of the companies debt, any liabilities such as lawsuits that are still pending, revenue recognition, taxes, significant clients, detailed breakdowns of fixed asset accounts, executive compensation, descriptions of employee benefit plans. An example of a situation in which the notes would be essential to valuation would be a company that relied on a few clients, rather than a wide base of clients. The notes would detail current and expected revenue from those clients and how that revenue would be recognized. An analyst would need this information to develop a set of cash flows for the company which would provide the basis of a company valuation. Q2-4. What is operating cash flow (OCF)? How is it calculated? What is free cash flow (FCF)? How is it calculated from operating cash flow ( OCF )? Why do financial managers focus attention on the value of FCF ? A2-4 . Operating cash flow is earnings before interest and taxes minus taxes plus depreciation. Financial analysts like this measure because it uses only operating flows, with no financing cash flows like interest. This makes it easier to separate the effects of operating decisions from those from financing decisions. Free Cash Flow (FCF) is the Operating Cash Flow (OCF) minus the amount of the firm’s net investments in fixed and current assets. The larger the firms FCF, the better positioned the company is for growth, debt repayment, and dividend payouts. Q2-8. How is the DuPont system useful in analyzing a firm’s ROA and ROE ? What information can be inferred from the decomposition of ROE into contributing ratios? What is the mathematical relationship between each of the individual components (net profit margin, total asset turnover, and assets-to-equity ratio) and ROE ? Can ROE be raised without affecting ROA ? How? A2-8. The DuPont system is useful in breaking down ROE and ROA into its component parts. If ROE is increasing (decreasing), a manager can see if the cause is a higher (lower) profit margin, a higher (lower) asset turnover or a higher (lower) equity multiplier. If one of the components is improving (declining) the firm can take steps to pay attention to that area of the business. ROE is equal to ROA times the equity multiplier. It would be possible to raise ROE by choosing to
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