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Unformatted text preview: CHAPTER 23 QUESTIONS 1. In addition to identifying a companys weaknesses, financial statement analysis can be used to predict a companys future profitability and cash flows based on its past performance. 2. Comparative financial statements provide a better indication of the nature and trends of changes affecting a business enterprise. Absolute amounts, in the absence of a benchmark, are not very good indications of performance or efficiency. Comparative statements at least provide a basis for judgment with respect to other periods of time or industry data. Comparative statements are more useful if there is uniformity of presentation and con- tent, consistency of application of account- ing principles, and disclosure of significant changes in circumstances and the resulting impact of those changes. 3. Analysis of financial ratios does not reveal the underlying causes of a firms problems. Financial statement analysis only identifies the problem areas. The only way to find out why the financial ratios look bad is to gather information from outside the finan- cial statements: ask management, read press releases, talk to financial analysts who follow the firm, and/or read industry newsletters. Financial ratio analysis does not give the final answers, but it does point out areas about which more detailed ques- tions should be asked. 4. A common-size financial statement is a fi- nancial statement for which each number in a given year is standardized by a measure of the size of the company in that year. A common standardization is to divide all fi- nancial statement numbers by sales for the year. Common-size statements make pos- sible a ready comparison of financial data for companies of different sizeeither the same company in different years or differ- ent companies at the same point in time. 5. The DuPont framework decomposes re- turn on equity into three components: profitability, efficiency, and leverage. For each of these components, a single ratio is used to give a summary measure of how the company is performing in that area. The summary measures follow: Profitability: Return on sales Efficiency: Asset turnover Leverage: Assets-to-equity Once the DuPont framework calculations have given a general picture of a com- panys performance, more detailed ratios can be computed to yield specific informa- tion about each of the three areas. 6. a. Inventory turnover is computed by divid- ing the cost of goods sold for the period by the average inventory. b. In arriving at a rate of inventory turn- over, it is essential that the inventory figures used to compute the average in- ventory be representative. If the begin- ning and ending balances are unusually high or low, the turnover rate may be misleading....
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