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Unformatted text preview: Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-1 Chapter 5 Analyzing and Interpreting Financial Statements Learning Objectives coverage by question Mini- exercises Exercises Problems Cases LO1 Prepare and analyze common size financial statements. 15, 16, 19, 20 35 LO2 Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL). 14, 17, 21, 22, 24 25, 26, 27, 28, 29, 30, 31, 34 36, 38, 41, 45 50 LO3 Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. 14, 17, 21, 22, 24 25, 26, 27, 28, 29, 30, 31, 34 36, 38, 41, 46, 47 48, 49, 50 LO4 Compute and interpret measures of liquidity and solvency. 18, 23 32, 33 37, 39, 42 LO5 Measure and analyze the effect of operating activities on ROE. 40, 43 LO6 Prepare pro forma financial statements. 35 44 Cambridge Business Publishers, 2011 Financial Accounting, 3 rd Edition 5-2 QUESTIONS Q5-1. Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet. Q5-2. ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt. Q5-3. Gross profit margins can decline because 1) the industry has become more competitive, and/or the firms products have lost their competitive advantage so that the company has had to reduce prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly-turning products to lower- margin/higher-turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively. Q5-4. Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D are more asset-like and create long-term economic benefits....
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This note was uploaded on 08/16/2011 for the course ECON 300 taught by Professor Laren during the Spring '11 term at Missouri State University-Springfield.
- Spring '11