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Unformatted text preview: Chapter 14 - Analyzing Financial Statements Chapter 14 Analyzing Financial Statements ANSWERS TO QUESTIONS 1. Primary items on the financial statements about which creditors usually are concerned include: (a) incomeprofit potential of the business, (b) cash flowsability of the business to generate cash, and (c) assets and debtsfinancial position. 2. The notes to the financial statements are particularly important to decision makers because they explain, usually in narrative fashion, circumstances and special events that cannot be communicated adequately in the body of the financial statements. The notes call attention to such items as pending problems, contingent liabilities, and circumstances surrounding certain judgments that were made in measuring and reporting. They are useful in interpreting the amounts given in the financial statements and in making projections of the future performance of the business. 3. The primary purpose of comparative financial statements is to provide the user with information on the short-term trends of the various financial factors reported in the financial statements. For example, the trends of such factors as sales, expenses, income, amount of debt, retained earnings, and earnings per share are particularly important in assessing the record of the company in the past and the present. These short-term trends should be used in predicting future performance of the business. Comparative statements usually report only two consecutive periods which often is too short to assess adequately certain trends. 4. Statement users are interested especially in financial summaries covering several years because the long-term trends of the business are revealed. Statement users must make projections of the future performance of the business in their decisions to either invest or disinvest. Long-term financial summaries provide particularly useful information in making these projections. Financial data covering only one or two periods have limited usefulness for this particular type of decision. The primary limitation of unusually long-term summaries is that early years may not be useful because of changes in the business, industry, and environment. 14- 1 Chapter 14 - Analyzing Financial Statements 5. Ratio analysis is a technique for computing and pinpointing certain significant relationships in the financial statements. A ratio or percent expresses a proportionate relationship between two different amounts reported on the financial statements. A ratio is computed by dividing one amount by another amount; the divisor is known as the base amount. For example, the profit margin ratio is computed by dividing net income by net sales. Ratio analysis is particularly useful because it may reveal critical relationships that are not readily apparent from absolute dollar amounts....
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- Fall '08
- Financial Accounting