SM_Chap013

Fundamentals of Financial Accounting with Annual Report

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Chapter 13 - Measuring and Evaluating Financial Performance Chapter 13 Measuring and Evaluating Financial Performance ANSWERS TO QUESTIONS 1. Trend analysis compares individual financial statement line items over time, with the general goal of helping financial statement users recognize important financial changes that unfold over time. 2. A year-over-year percentage simply expresses the change in the current year as a percentage of the prior year total, using the following calculation: Year-over- year change (%) = Change this year x 100 = (Current year's total - prior year's total) x 100 Prior year's total Prior year's total 3. Ratio analysis is conducted to understand relationships among various items reported in the financial statements. It involves comparing an amount for one or more financial statement items to an amount for other items from the same year. It is useful because it takes into account differences in the size of amounts being compared, allowing you to evaluate how well a company has performed given the level of other company resources. 4. Benchmarks can be established by comparing a company to itself over time, and to its competitors and industry averages. 5. The three categories of performance into which most financial ratios are reported include: (1) Profitability – relates to performance in the current period. The specific focus is on the company’s ability to generate income during the period. (2) Liquidity – relates to the company’s short-term survival. The specific focus is on the company’s ability to use current assets to repay liabilities as they become due in the short term. (3) Solvency – relates to the company’s long-run survival. The specific focus is on the company’s ability to repay lenders when debt matures (and to make required interest payments prior to the date of maturity). 13-1
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Chapter 13 - Measuring and Evaluating Financial Performance 6. The names “horizontal” and “vertical” represent the direction to which a financial statement item is compared. Horizontal analyses involve comparing an item horizontally within the financial statements to prior period amounts. Vertical analyses involve comparing an item vertically within the financial statements to an amount above it (sales revenue on the income statement) or below it (total assets on the balance sheet). 7. A favorable interpretation of an increase in the current ratio is that the company has more assets that can be converted into cash to pay current liabilities. An unfavorable interpretation is that the company has been slow in turning over its inventory and slow in collecting its accounts receivable. 8. The primary difference between the quick ratio and current ratio is that the current ratio includes inventory and prepaids but the quick ratio does not. If the current ratio increases when the quick ratio decreases, the implication is that the company’s inventory and/or prepaids have increased.
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